As the debate continues over raising the federal debt limit, lawmakers have also turned their attention to how individual and business income taxes can be overhauled to reduce the federal deficit. As usual, these discussions will center on who pays and how much.

Currently, individuals pay tax across six rate brackets ranging from 10% to 35%. A proposal currently garnering bipartisan support would collapse the six brackets into three – 12%, 22%, and 29%. These new rates are consistent with the recommendation of President Obama’s deficit reduction panel.

On its face, this appears to be a big win for supporters of low taxes and tax simplification; however, this same plan proposes a limitation on certain deductions that, for many taxpayers, would drive effective tax rates up. The primary targets are mortgage and home equity loan interest and charitable contributions of high income taxpayers. Additionally, this plan would lower the annual deductible amount of retirement plan contributions.

On the business tax side, the story is the same – reduced tax rates and broadened tax base. The top corporate rate, currently 35%, would fall to between 23% and 29%. This rate reduction would be funded by the elimination of the Domestic Production Activities Deduction (DPAD), less favorable depreciation rules, and a scale back or elimination of the R&D credit. These concessions will certainly set off a fight between small businesses that benefit greatly from DPAD, generous depreciation, and the R&D credit and large corporations that view a lower corporate tax rate as essential to effectively competing in the global marketplace. We discussed this dynamic in greater detail back in March.

Bear in mind that any overhaul in individual and business income tax will result in greater revenue to the Federal government. Also bear in mind that the Federal government will collect this additional revenue from those with the greatest ability to pay – high income taxpayers. The silver lining is that no legislator would dare push through a big tax increase ahead of an election, so we are probably looking at a 2013 implementation at the earliest.