Deficit Dilemma: Will Washington Finally Tackle the Sacred Cows?

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Democrats like Pelosi would prefer to place more of the burden on wealthier Americans. That could mean paying smaller benefits to well-off retirees and subjecting more income to the Social Security payroll tax (currently levied on the first $106,800 of annual income — less in inflation-adjusted dollars than in the 1980s). But while top Republicans including incoming House Speaker John Boehner support raising the retirement age, their very political identity is built on opposition to higher taxes.

The public doesn't offer much guidance. According to a September Gallup survey, 77% of Americans believe that programs such as Social Security and Medicare will cause major economic problems unless we take action soon. But when asked to choose between cutting benefits and raising taxes, the public splits, with more than a third of respondents saying, not very helpfully, that they oppose doing either.

It's hard, then, to imagine a solution that the leaders of both parties can sign off on. But Social Security reform has happened before. When the program faced a funding crisis in 1983, President Ronald Reagan appointed Alan Greenspan to chair a commission that recommended a mix of tax hikes slanted toward wealthier workers and benefit cuts that included a slight bump in the retirement age. A liberal Democratic Congress approved the plan, and Reagan signed it into law. No electrocutions were reported.

III. The 'American Dream' Subsidy
Americans tend to hate the length of the U.S. tax code (17,000 pages), but they tend to love all the exemptions and loopholes — about $1.1 trillion in all — that apply to them. That includes everything from credits for having children to breaks for buying a Prius. But at about $130 billion per year, few breaks are as expensive — or as fiercely cherished — as the home-mortgage interest deduction.

This granddaddy of tax preferences amounts to a massive government subsidy for homebuying: taxpayers can deduct the interest they pay on mortgages of up to $1 million. Originally born from a quirk dating to the tax code of 1894 that allowed all interest payments to be deducted, this one survived a tax-code purge in the 1980s and has gone unchallenged ever since. Never mind that economists grow hoarse arguing that taxes should treat economic activity neutrally and, thus, preferences like the mortgage deduction "distort private decisionmaking, create unfairness and reduce economic growth," as former Reagan White House adviser Bruce Bartlett has put it. Over decades, politicians in both parties have seen the subsidizing of mortgages as a fine opportunity to appear as champions of the middle class. "I want you to know that we will preserve the part of the American Dream which the home-mortgage interest deduction symbolizes," Reagan said in 1984.

The subprime-mortgage disaster, however, showed that Americans could stand a bit less encouragement to take on six-figure debts for real estate. These days, it's hard to defend writing off the interest on a $1 million mortgage (which is probably not held by a struggling middle-class family) or getting a break on buying a new vacation house.

Bowles and Simpson have proposed capping the deduction at $500,000 and disallowing it for that beach house. Yet even such a modest change — phased in over time to protect housing prices — would provoke a hurricane of opposition. Some would come from the public: nearly 80% of respondents supported the deduction in a recent poll sponsored by the homebuilding industry. Then there's the power of the National Association of Realtors (NAR), which spent more than $20 million lobbying Congress last year and pumped $11 million into the 2010 elections. Mere talk of changing the interest deduction has the NAR springing into action, warning of a 15% drop in home prices (unlikely for a phased-in plan) and claiming that a home-sales "chilling effect" is already under way. In a letter to Simpson and Bowles, the NAR rhapsodized, "The cottage with a picket fence is an iconic part of our heritage. Do not take that imagery or that passion lightly."

Nobody does. Which is why the only realistic way to prevent a mass revolt over scaling back the deduction would be to incorporate it into a sweeping revamp of the tax code. "What needs to be done is fundamental tax reform," says Curtis Dubay, a tax expert at the conservative Heritage Foundation. That's one idea Bowles and Simpson offer: wiping out all special tax preferences and, in return, lowering personal income-tax rates to as low as 8%.

Ripping up those 17,000 pages of tax code may sound ridiculously ambitious. But it's actually been done before. In 1986 Congress hammered out a sweeping tax reform that closed $300 billion in loopholes and lowered rates across the board. Under such a reform, "the market will allocate resources and not the special interests that influence the political process," says former New Jersey Senator Bill Bradley, who led the 1986 tax overhaul. "It's not easy but still possible."

Yes, it is. Washington may seem sclerotic now, but so did it in the spring of 1986.

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