John Arensmeyer, the founder of small business advocacy group Small Business Majority, recently suggested that small business owners accept President Obama’s demand that marginal tax rates be raised on the top two percent of earners as part of any plan to avoid the fiscal cliff. He told  the Washington Post, “There’s no reason to not just let the tax cuts on the top two brackets expire.”
For the head of a small business advocacy group seeking to build a positive relationship with the administration, this is a politically savvy position. Only about 3 percent of small business owners would face a tax increase under the President’s proposal; and the President might be willing to support preserving the tax breaks small businesses favor if they went along with his plan. But as Columbia University economist Glenn Hubbard wrote in a recent Financial Times commentary , a better economic approach would be to cap tax deductions.
Higher marginal tax rates mean that people keep less of each additional dollar they earn, which lowers their willingness to work an extra hour or invest an extra dollar. For small business owners who run pass through entities (subchapter S corporations, partnerships, and sole proprietorships), higher marginal tax rates also discourage capital investment and hiring in their businesses. For everyone, higher marginal tax rates motivate people to find ways to avoid paying taxes, even if those solutions aren’t economically productive. That’s why the Congressional Budget Office estimates that allowing the Bush tax cuts on the top two percent of earners to expire would lower real GDP growth next year.
Tax deductions also distort incentives by encouraging people to spend money in ways that lower their taxes, rather than ways that don’t, but are more productive. The mortgage interest deduction, for instance, leads people to borrow money to buy bigger houses than they need.
Collectively, we would be better off if the government raised additional revenue by cutting tax deductions rather than raising marginal tax rates.
During the campaign, Mitt Romney proposed a politically shrewd way to do this. Just cap tax deductions. Do that and you get fewer distortions without political battles over which special interests get to keep their cherished deductions.
The Tax Policy Center estimates that capping tax deductions at $50,000 per year would raise roughly the same amount of revenue as letting the Bush tax cuts on the wealthy expire, Greg IP of the Economist explains . Since rich people deduct more than than poor people, a $50,000 cap in tax deductions would hit mostly high income tax payers.
While capping deductions doesn’t have the soak-the-rich appeal of raising the marginal tax rate, and requires President Obama to take a page from the Republican playbook, it allows him to achieve his goal of making high earners “pay a little bit more.”
Republican leaders have signaled that they would go along. Speaker of the House John Boehner and former Republican vice presidential candidate Paul Ryan both have said that they would accept higher tax revenues, but not higher tax rates. As Ryan told  the Milwaukee Sentinel, “Our fear is that if you raise tax rates you hurt economic growth. You hurt small businesses. So through tax reform you can get higher revenues without damaging the economy.”