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Approach the ‘cliff’ with courage

There appears to be a significant but not overwhelming consensus that the United States should avoid sequestration. The big question is how best to do it. Let me suggest that as a first step, there be a quick agreement that beginning in 2013 there be some moderate rate increase on upper-income taxpayers and a reduced cap on the mortgage interest deduction accompanied by some reduction in discretionary spending.

The Obama administration had proposed that the tax rates increase for individuals back to the level before the Bush-era tax cuts of 39.6 percent for taxable incomes above $250,000 a year. Mitt Romney in his campaign had suggested that instead of a rate increase — in fact, he advocated a tax rate decrease — there be a cap on deductions. Some have suggested this cap be set at $50,000. Such a cap would unfairly affect upper-middle-class taxpayers in states with high tax rates like New York and California, who are subject to the tax through no choice of their own other than where they live and work. Furthermore, the much-criticized Alternative Minimum Tax already serves to limit many deductions, including state income taxes on many middle-class taxpayers.

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While there is a legitimate social policy to encourage home ownership, in an era of necessary belt-tightening, there is certainly a forceful argument to reduce the current deduction on home mortgage interest expenses on acquisition indebtedness up to the current $1 million level to a more realistic figure of perhaps $500,000, and limit the deduction to one’s principal residence. Such a reduction might be phased in to ease the pain somewhat on those who bought their homes in reliance on the current tax rules. In other words, while many still agree tax policy should serve to promote homeownership, why should there be a government subsidy for encouraging the leveraged purchase of a mansion?

Besides reducing the cap on mortgage interest expenses and closing some other obvious loopholes, such as the tax treatment of carried interest, there needs to be a more than symbolic rate increase on the truly wealthy. The administration and congressional Democrats, however, have to be willing to compromise on the rate increase and recognize that dramatic rate increases during a recession might not be either smart politics or economics.

Increasing the top rate on individuals from 35 percent to around 37 percent but limiting that increase to those whose taxable income is in excess of perhaps $750,000 or $1,000,000, accompanied by some tax rate increase on dividends (perhaps to 20 percent) would signal several things.

First, it would show that President Obama and members of Congress can reach meaningful and equitable compromises that stray from rigid ideologies — like no tax rate increases whatsoever, or tax increases to the Clinton-era level without any reduction in social spending. Second, it would signal that our elected officials recognize we have to take immediate meaningful first steps in controlling the national debt, without at the same time doing something that might either impede growth during a recession or dramatically reduce the safety net of those in most need.

To take these actions, it will require our elected officials to move away from pandering to their respective bases and to demonstrate the type of virtue former President Kennedy wrote about in Profiles in Courage many years ago. It’s time, I submit, to do precisely that and indicate to the markets and the American people that our government works.

Cohen is a professor in the Legal Studies and Taxation Department of Pace University’s Lubin School of Business and a retired vice president and general tax counsel for Unilever United States, Inc. The views expressed here are his personal views.