Unveiling large-scale proposals involving the nation’s tax code is becoming a regular occurrence among think-tankers and academics in Washington D.C. In recent months, most of these proposals have shared certain common features:

• Incomplete on details
• No transition rules
• Significant reductions for itemized deductions
• Significant net tax increases, albeit with promised lower marginal rates

Homeowners and anyone involved in the housing industry are well advised from time to time to pay attention to the latest proposal because the focus on itemized deductions typically means the mortgage interest deduction (MID) and the smaller real estate tax deduction are in the crosshairs of most of these plans.

This week, the publication Tax Notes detailed a plan that proposes capping “tax expenditures benefits” from all the itemized deductions, the health insurance exclusion and certain tax credits to a maximum of 2% of adjusted gross income (AGI). (Update – this plan was featured in the New York Times on May 5th.)

This plan would have significant consequences for housing markets because of the importance of the mortgage interest deduction and the real estate deduction to homebuyers, particularly younger homebuyers in the early years of a mortgage when they are paying relatively more interest and less principal on a loan.

To see just how restrictive a 2% AGI cap is, I estimate that for taxpayers with less than $200,000 in income, the average tax benefit (or tax expenditure) of the MID is 1.76% of AGI and 0.7% of AGI for the real estate deduction. Thus, without even considering the state/local income tax deduction, the charitable deduction, and many other tax expenditures that most homeowners typically claim, the average homeowner is over the limit and subject to tax increases under the proposal.

The authors propose that any tax benefits in excess of this 2% AGI cap would be lost. Doing so would raise approximately $278 billion in the first year, according to their estimates. About $50 billion of this total is due to housing (MID and real estate tax deductions). The largest portion, $140 billion, is due to increased taxes on employer-paid health insurance.

The impacts of the proposal are concentrated where you would expect, knowing for example that the MID is primarily a middle class tax break (70% of the tax expenditure is collected by homeowners with less than $200,000 in income). As a percentage of AGI, taxpayers earning $50,000 to $300,000 would see their taxes increase by 3.4% of AGI.  Taxpayers earning more than $500,000 would see a decline of only 2.7% of AGI, because they have lower tax expenditure claims, as a share of household income, and higher AGI cap.

As measured by current tax expenditure claims, the biggest hit from the proposal falls on those making $100,000 to $200,000, who end up losing 95% of the tax expenditure benefit they receive today. In contrast, taxpayers earning $200,000 to $300,000 lose a smaller share (82%) and those above $300,000 lose about 66%.

One of the asserted benefits of this approach is “tax simplification.”  The authors estimate that the cap would induce nearly 75% of current itemizing taxpayers to claim the standard deduction (from about 48 million taxpayers to about 12 million).

However, it is hard to imagine how this proposal would simplify the tax filing process. First, it is worth noting that filling out Schedule A is hardly among the most complicated parts of the tax code.

But more specifically, under the proposal taxpayers would have to fill out Schedule A as they do now, and then use a new worksheet to determine if they are subject to the 2% cap (not an easy calculation since the 2% is determined by tax benefit, not sums of deductions or exclusions). Moreover, taxpayers would be required to report additional information, such as the amount their employer spends on their behalf for health insurance.

An ironic aspect of this proposal to cap tax expenditures is that there already exists a complicated, unpopular rule in the tax code that claws back the value of certain tax deductions and credits, that disproportionately affects the upper middle class and those in high-cost areas, that adds to complexity in the code, and was originally proposed as a means of forcing wealthy taxpayers to pay more: it is called the AMT. The AMT is often cited as one of the reasons the nation’s tax code needs reform.

And while this discussion may seem academic, this proposal of capping the value of itemized deductions, like the MID, as a share of AGI has in recent years been suggested by some leading economists as a way of indirectly cutting back on tax expenditures. This proposal, as incomplete as it now stands, shows just how complicated that approach would be in practice.

And more plans are likely forthcoming in the weeks ahead, including one from the so-called Gang of 6, six senators working on a deficit reduction plan involving major tax changes.