The TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Policy Center (TPC) has a new paper that claims Romney’s tax plan necessarily leads to lower taxes on high-income earners and higher taxes on everyone else:
“Our major conclusion is that a revenue-neutral individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. change that incorporates the features Governor Romney has proposed – including reducing marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s substantially, eliminating the individual alternative minimum tax (AMT)The Alternative Minimum Tax (AMT) is a separate tax system that requires some taxpayers to calculate their tax liability twice—first, under ordinary income tax rules, then under the AMT—and pay whichever amount is highest. The AMT has fewer preferences and different exemptions and rates than the ordinary system. and maintaining all tax breaks for saving and investment – would provide large tax cuts to high-income households, and increase the tax burdens on middle- and/or lower-income taxpayers. This is true even when we bias our assumptions about which and whose tax expenditureTax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit, child tax credit, deduction for employer health-care contributions, and tax-advantaged savings plans. s are reduced to make the resulting tax system as progressive as possible. For instance, even when we assume that tax breaks – like the charitable deduction, mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act reduced the amount of principal and limited the types of loans that qualify for the deduction. , and the exclusion for health insurance – are completely eliminated for higher-income households first, and only then reduced as necessary for other households to achieve overall revenue-neutrality– the net effect of the plan would be a tax cut for high-income households coupled with a tax increase for middle-income households.
In addition, we also assess whether these results hold if we assume that revenue reductions are partially offset by higher economic growth. Although reasonable models would show that these tax changes would have little effect on growth, we show that even with implausibly large growth effects, revenue neutrality would still require large reductions in tax expenditures and would likely result in a net tax increase for lower- and middle-income households and tax cuts for high-income households.”
The main thing missing here is the context of our current federal income tax code. Imagine a society with 5 people, where the two richest people pay all the taxes, the middle person pays nothing, and the two poorest people actually have a negative tax rate, meaning the rich are paying them through the tax code. Then any cut in the tax rate will disproportionately benefit the rich guys. This is the federal income tax code, in a nutshell. According to the CBO, the top 20 percent of households pays 94 percent of federal income taxes. The bottom 40 percent actually have a negative income tax rate, and the middle quintile pays close to zero. See the two charts below.
The CBO finds that progressivity, or redistribution through the income tax code, is at a record high. This is mainly due to the accumulation of low-income provisions, particularly refundable tax creditA refundable tax credit can be used to generate a federal tax refund larger than the amount of tax paid throughout the year. In other words, a refundable tax credit creates the possibility of a negative federal tax liability. An example of a refundable tax credit is the Earned Income Tax Credit. s such as the Earned Income Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. and the Child Credit. This is pretty exceptional from a global perspective. The OECD finds that we have the most progressive income tax system in the industrialized world. In this context, it is well past time to consider the costs and benefits of such an extremely progressive system.
One major cost of progressivity is economic growth. High-income earners do a disproportionate amount of the saving, investing, entrepreneurship, and high-productivity labor, while low-income earners do a disproportionate amount of the consumption. Extreme progressivity is certainly contributing to a situation where the U.S. now consumes nearly everything it produces, while investment and growth suffers.
Yet the authors give short shrift to such arguments:
“In the context of revenue-neutral tax reform, any positive growth effects are likely to be small. While the lower tax rates under the reform would strengthen incentives for employment and savings, the base broadeners would increase the portion of income that is subject to tax and have incentive effects in the opposite direction. As Brill and Viard note “lowering statutory tax rates while broadening the income tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. generally does not reduce work disincentives because it leaves the relevant effective tax rates unchanged” (Brill and Viard 2011). Moreover, analysis by the CBO and JCT suggest that the revenue effects arising even from rate cuts that were not accompanied by base broadeningBase broadening is the expansion of the amount of economic activity subject to tax, usually by eliminating exemptions, exclusions, deductions, credits, and other preferences. Narrow tax bases are non-neutral, favoring one product or industry over another, and can undermine revenue stability. would be small (CBO 2003, 2005; JCT 2005).
Nevertheless, even if one were to use the model from Mankiw and Weinzierl (2006) and assume that after five years 15 percent of the $360 billion tax cut is paid for through higher economic growth, the available tax expenditures would still need to be cut by 56 percent; on net lower- and middle-income taxpayers would still need to pay higher taxes.”
First, the rest of the quote by Brill and Viard clearly states the economic benefits of base broadening:
“Such reforms may promote economic efficiency by providing neutral tax treatment that allows market forces to allocate resources across different economic sectors.”
Further, Brill and Viard are most concerned that base broadening will destroy the few tax incentives that exist for saving. Romney’s plan explicitly preserves those and aims to reduce taxes on saving and investing.
Second, the CBO and JCT analyses are not relevant, since they do not assume revenue neutrality.
Third, the Mankiw and Weinzierl model is not the only model for comparison. For example, Treasury simulations indicate that nearly 40 percent of the static revenue cost of lowering the top two rates was offset by growth in the tax base. Anywhere close to this level of growth would be more than enough to prevent tax increases on low-income earners.
Lastly, the TPC analysis explicitly ignores any growth effects resulting from Romney’s plan to cut the corporate rate, which economists estimate would grow the economy by 1 to 2 percent annually.
In summary, TPC has correctly identified the Romney plan as a tax cut, at least in static terms, that accrues mainly to high-income earners. But TPC fails to acknowledge any of the benefits of Romney’s plan, most pertinently that lower rates combined with a broader tax base should lead to significant economic growth. The benefits of such growth will benefit some more than others, but arguably the currently unemployed will receive the greatest benefit in the form of a job.
Follow William McBride on Twitter @EconoWillShare