Prepare for budgetary magic.
To avert the "fiscal cliff" and prevent a sharp tax increase for every American in 2013, Democrats and Republicans alike now seem to be seeking a way to raise taxes without really raising them. The convoluted U.S. tax code actually makes this possible.
Up till now, President Barack Obama and his Republican foes in Congress have been locked in a standoff over taxes. Obama's longstanding plan has been to hike the tax rates for top earners by three to five percentage points or so, while also raising the tax rates on investment income. Republicans have basically said "over my dead body," doubling down on their stand that tax hikes on anybody are bad for the economy.
This is why the nation will soon face a political showdown over the "fiscal cliff," with tax hikes and spending cuts totaling more than $600 billion per year due to go into effect in 2013 if the two parties can't work out a deal to prevent that from happening.
But since Election Day, both sides have subtly adopted a softer stance that might allow the government to reel in more tax revenue—desperately needed to help close the $900 billion gap between spending and revenue this year—without exactly raising taxes. A change in rhetoric hints at the strategy. Prior to the election, Republican House Speaker John Boehner insisted that his party wouldn't stand for any increase in taxes. Now he says they're opposed to an increase in tax rates. President Obama, similarly, has called for the wealthy to pay more in taxes, but not necessarily via higher rates.
What they're both getting at is the huge collection of budgetary miscellany known as tax expenditures, which ordinary people recognize as the many deductions and tax credits for things like mortgage interest, charitable donations, retirement savings, childcare expenses and employer-paid healthcare benefits. Collectively, all of these loopholes in the tax code reduce federal tax revenues by about $1.1 trillion per year, which alone is big enough to erase the government's annual deficits, without any spending cuts at all.
There's no chance Washington would simply zero out all those tax breaks, since that would torpedo the finances of millions of Americans who made long-terms decisions, such as buying a house, dependent upon a continuation of existing tax policies. But a budget-cutting deal could certainly trim many of those deductions, and do so in ways that would mostly hit wealthier taxpayers while leaving middle-class families unscathed.
That would allow Republicans to say they stood firm against an increase in tax rates, while Obama would be able to say he raised taxes on the wealthy while safeguarding the middle class.
Many tax experts have long called for plugging the nearly 200 tax expenditures riddled throughout the tax code. Even Republican presidential challenger Mitt Romney proposed a version of this, through his idea to set a cap on the total amount of deductions any single taxpayer could claim. Tax experts tend to like that idea because it wouldn't require a huge lobbying battle over which tax breaks to keep and which to kill. Instead, they'd all stay on the books, while taxpayers would choose how to allocate them, up to whatever the limit might be. Romney suggested various caps ranging from $17,000 to $25,000.
That sort of approach wouldn't target wealthy taxpayers per se, but they're the ones who would be most affected. Only about one-third of taxpayers itemize their deductions, and of those, the average amount of deductions is about $26,000, according to the IRS. (The other two-thirds typically claim the standard deduction, which is far lower, mainly because their incomes are lower and they don't have big expenses to claim as deductions.)
The average deduction for taxpayers with incomes above $250,000—Obama's threshold for tax hikes—is a whopping $130,000. Mitt Romney, on his 2011 tax return, claimed $4.7 million worth of deductions on gross income of $13.7 million—even foregoing some charitable deductions he could have claimed, to keep his effective tax rate in the double digits. (He can still claim those deductions retroactively.)
Since wealthy taxpayers would still take a hit if there were new limits on deductions, Republicans aren't likely to agree to a deal without getting something in return, such as sizeable spending cuts or an agreement to reform hugely expensive entitlement programs like Medicare and Medicaid. And Democrats will continue to fight against spending cuts that go too deep. But both sides, bruised by too much political warfare, may be drafting a peace agreement before this battle begins.
Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.