4 Middle-Class Tax Deductions Washington is Targeting

By David Sterman
May 04, 2011

In a bid to tackle the out-of-control budget deficit, politicians are loath to raise taxes. Yet it's increasingly clear that Uncle Sam will need to raise more revenue in some fashion. To keep current tax rates intact, it increasingly looks as if we'll be forced to live with fewer deductions.

That's why a bipartisan group of legislators is taking ai at the whole roster of tax deductions. These deductions deprive the U.S. Treasury of $700 billion very year. Legislative efforts to close these loopholes are likely to elicit many complaints, but you should be prepared to take action as they may well succeed. Here's a brief look at the most cherished tax deductions and what may happen to them.

Mortgage Interest Deduction

Talk about sacred cows. A wide range of interests -- from banks to construction firms to homeowners themselves -- have come to depend on this deduction. A typical $2,000 a month mortgage payment yields, on average, a $7,000 deduction against annual taxes. In fact, in 2008 the average taxpayer saved $12,200 from this deduction alone. Indeed you could argue that housing prices are partially supported by the value created with these deductions as the benefit can boost a borrower's lending capacity. 

The mortgage interest deduction is mostly used by the middle class, as lower income consumers tend not to be homeowners and upper-income consumers have these deductions phased out by the Alternative Minimum Tax (AMT). And neither party wants to lose favor with the middle class. Yet a growing chorus of economists believe that this deduction serves no real purpose, especially in light of the fact that home ownership may have been over-emphasized during the Bush administration and the new consensus that some consumers are simply better off as renters.

Odds of Passage: Under 20%

What You Should Do Now: Re-think the appraised price of a home you are looking to buy, calculating your purchasing power if you'll soon be unable to take a tax deduction.
 

Charitable Deductions

Were it not for these tax breaks, a number of charities would struggle to stay in existence. The Obama administration is not looking to eliminate the tax deduction for charitable giving but would instead like to cap it at 28% of adjusted gross income. That seems to be a fair proposal, at least as far as the middle class is concerned. Bu major donors to charity are sure to raise a stink, as it enables them to shield much of their income from taxes, if they so chose.

Odds of Passage: 20% to 40%

What You Should Do Now: Accelerate planned charitable giving now if you had planned to make a large gift in the future.

State Taxes

We're allowed to deduct our state taxes from our Federal tax return. This was initially put in place by legislators representing residents of highly-taxed states such as New York and California as a way to balance out financial burdens when compared to residents of states that have no income taxes such as Florida and Texas. At this point, it's not clear why this benefit is still in place as it provides little by way of behavioral incentives.

Odds of Passage: 20% to 40%

What You Should Do Now: Other than moving to a place with low or no state tax, there's not much you can do to avoid this. However, if you do feel that strongly about it, check out our list of the 10 Cities for the New Economic Reality -- not only do these urban meccas boast low tax burdens, they all have unemployment rates under 9%.

Earned Income Tax Credit

This tax credit, which was put in place in the 1990s, has saved many working class families from even greater financial strain than they are already experiencing. It has only partially mitigated the fact that working class and middle class incomes have steadily eroded over the last two decades.

Yet many citizens still see this tax benefit as a form of welfare, and in principle, remain strongly opposed to it. It's hard to see how Democratic legislators would be willing to give up the Earned Income Tax Credit, but it is likely to be a lead issue for GOP legislators when the issue of tax deductions comes up for debate.

Odds of Passage: 20% to 40%

What You Should Do Now: Open a Roth IRA that is funded with after-tax money.

These odds are simply a relative measurement of the likelihood that these cherished tax deductions will be put in play. Perhaps none of them will, in which case formal tax rates may need to be raised to close the budget deficit. If all of these deductions were to be reduced or eliminated, then formal tax rates would be able to stay intact or even be reduced. How it plays out will be a reflection of voters' priorities along with Washington gamesmanship.

Photo: Field Music by Lali Masriera