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Analysis: At cliff's edge, old ideas to cap tax breaks are new again

U.S. Senate Minority Leader Mitch McConnell (R-KY) leaves the Senate Chamber for the caucus at the U.S. Capitol in Washington December 30, 2
U.S. Senate Minority Leader Mitch McConnell (R-KY) leaves the Senate Chamber for the caucus at the U.S. Capitol in Washington December 30, 2

By Kim Dixon and Kevin Drawbaugh

(Reuters) - Imposing overall caps on how much high-income people in the United States can claim on their tax returns in deductions, exemptions and other tax breaks is an idea whose time may have come - again.

In the whirl of "fiscal cliff" talks, bipartisan backing has grown for imposing, or in some cases reinstating, caps on tax breaks for top earners.

On Monday, Republicans threw their support behind several approaches to do just that in a framework to step away from the fiscal cliff of $600 billion in new taxes and spending cuts set to take effect on January 1.

Under an emerging deal brokered by Republican Senate Minority Leader Mitch McConnell and Democratic Vice President Joe Biden, curbs on deductions and exemptions for households earning more than $300,000 would be re-imposed, according to a source close to the talks.

For several years, Democratic President Barack Obama has proposed re-imposing the limits. Republicans have opposed such caps for more than a decade, but the idea may be coming full circle.

These limits "were originally done in 1990 at the behest of the Republicans who didn't want tax rates to go up," said Michael Graetz, a Columbia University tax law professor and a former top Treasury Department official.

The main reason for the switch now? The urgent search for politically achievable paths to avoid falling off the fiscal cliff of sharp tax increases and spending cuts.

Talks on avoiding the cliff were moving along on Monday with the fresh offer from McConnell and Biden.

The beauty of the approaches, backers say, is that they let politicians raise government revenue without raising tax rates as much, said economists, Republicans and congressional aides.

Moreover, a strategy that caps several tax breaks broadly could be more expedient than trying to curb tax breaks one at a time that would incur the wrath of lobbyists who would fight them all the way.

Lawmakers are sizing up several ideas.

PEP AND PEASE

Two ideas backed by McConnell are reinstating the personal exemption phase-out (PEP) and so-called Pease limits on itemized deductions. Both were created in 1990 in a budget deal between Republican President George H.W. Bush and Democrats in Congress.

PEP and Pease - often viewed as a package deal - both reduce how much high-income taxpayers can claim in personal exemptions, in the case of PEP, and itemized deductions, in the case of Pease. Both measures work to raise taxes on top earners, without explicitly raising the tax rates that they pay.

When first imposed more than two decades ago, "they were ways to keep the rate at a certain level," Graetz said.

So how do they work?

PEP deals with the personal exemptions that taxpayers claim near the top of the Internal Revenue Service's Form 1040. Taxpayers claim exemptions for themselves, their spouses and their dependents. Last year, each exemption was worth $3,800.

The Pease limit - named after its author, former Ohio Democratic Representative Don Pease - applies to itemized deductions, such as the ones taken for mortgage interest, charitable giving and state and local taxes paid.

By reducing the values of exemptions and deductions, both PEP and Pease would work to raise the taxable income of wealthier people and, as a result, the taxes they pay.

Under a previous proposal offered by Obama, reinstating them would raise about $165 billion in new tax revenue over 10 years, the Tax Policy Center estimated.

Both limits were gradually eliminated under President George W. Bush. By 2010 they were history, a status which was extended for two years by Obama in an agreement with Republicans.

28 PERCENT CAP

Another idea is Obama's proposal to cap the value of tax deductions and certain tax exemptions for high-income taxpayers.

The president's proposal would limit the value of these tax breaks as one moves to a higher tax bracket. For example, a taxpayer in the current 35 percent tax bracket with $100,000 worth of qualified deductions and exemptions gets a $35,000 tax break. Under the 28 percent limit, that taxpayer would only get a $28,000 tax break.

Such a change would raise about $580 billion over a decade, according to a White House estimate, a significant chunk of revenue.

"Republicans have resisted it since the president proposed it," said Alan Viard, an economist at the conservative-leaning American Enterprise Institute think tank.

But a top Republican aide has said that House of Representatives Speaker John Boehner was willing to consider the president's proposed cap in budget talks with Obama.

Viard said that the idea fits with Republican support for broadening the tax base in exchange for lower tax rates.

There are limits already in place for some tax breaks, such as the $1 million limit for home mortgages.

(Editing by Howard Goller and Mohammad Zargham)

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