Would the Romney Tax Plan Necessarily Reduce After-Tax Incomes for the Middle Class?

Introduction

In August, the Urban-Brookings 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) released a report[1] claiming to show that Mitt Romney’s tax reform plan would necessarily raise taxes on middle-class taxpayers and reduce their after-tax incomes, while giving a significant tax cut to high-income taxpayers. This conclusion is based on a distributional analysis that assumes Romney’s revenue-neutral tax reform plan, which includes an across-the-board 20 percent cut in marginal income tax rates and an elimination of the alternative minimum tax (AMT), would require a significant reduction in most 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 (EITC), child tax credit (CTC), deduction for employer health-care contributions, and tax-advantaged savings plans. s, including most notably the child 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. , 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 (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. , state and local tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. , and the exclusion of employer-provided health insurance.

This TPC study showing Romney’s tax plan as “raising taxes on the middle-class yet cutting taxes for the rich” has generated quite a bit of attention. Some economists such as Martin Feldstein[2] and Harvey Rosen[3] have taken issue with the study, arguing that Romney’s tax plan would not necessarily require raising taxes on the middle class.

One shortcoming of the TPC paper pointed out by Rosen is its “static” nature, meaning it fails to account for any income growth effects from the tax reform plan. Most economists would agree that revenue-neutral tax reform like that pushed by Romney would reduce economic distortions in the tax code and thereby increase economic efficiency and incomes by some degree over the long-term. Furthermore, unlike tax cuts that require debate over the economic effects of their financing, revenue-neutral tax reform does not need financing. In fact, if the plan was revenue-neutral on a static basis, it would likely raise revenue because it increases the size of the overall 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. in the long-run.

The TPC study, which assumes no change in pre-tax incomes, claims that Romney’s plan would decrease the after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. s of tax units earning between $75,000 and $100,000 by an average of $884, or 1.2 percent, while increasing the after-tax incomes of those earning more than $1 million by $87,000, or 4.1 percent. For all tax units earning less than $200,000, TPC estimates the average after-tax income would fall by $539 and a rather significant $2,041 for tax units with children in that income range. These are the numbers that Obama’s campaign has been hitting Romney with in television ads.

However, if one assumes that the Romney plan increases the size of the income tax base, then depending on the magnitude of such a dynamic effect, the supposed after-tax income decrease of low-and-middle-income groups may not be necessary, or at least not as large. The accompanying table walks through four such scenarios, showing the average change in after-tax incomes by income cohort under varying assumptions about the growth effects of Romney’s plan. The scenarios are as follows: 0.5 percent growth in across-the-board pre-tax incomes, a 1 percent growth, a 1.5 percent growth, and a 2 percent growth. This analysis differs from that of Feldstein and Rosen in that it directly uses Tax Policy Center’s figures and assumes that all of the other assumptions that the Tax Policy Center report made regarding Romney’s plan are true, despite the fact that the Romney campaign disputes some of those assumptions.[4]

For a detailed step-by-step discussion of this study’s methodology and the difference between after-tax income and economic welfare, see the accompanying working paper: Methodology of Dynamic Adjustment to Tax Policy Center Analysis of Romney Plan.

What the Numbers Show

As the table below shows, if the Romney plan was to cause an across-the-board 1 percent growth in pre-tax incomes, then the low-and-middle-income groups would no longer face a decrease in after-tax incomes as a result of his plan. The change in after-tax income would be relatively modest for low-and-middle-income earners at less than $100 per return, but it would nonetheless constitute an increase in after-tax income.

Average Change in After-tax Income from Romney Revenue-Neutral Tax Reform Plan ($ per tax unit)
Cash Income Group	Static TPC Estimate (0%)	0.5% Increase in Pre-Tax Incomes	1.0% Increase in Pre-Tax Incomes	1.5% Increase in Pre-Tax Incomes	2.0% Increase in Pre-Tax Incomes
$0-$30,000	-183	-82	20	121	223
$30,000-$50,000	-431	-198	35	269	502
$50,000-$75,000	-641	-302	36	375	714
$75,000-$100,000	-884	-418	48	514	979
$100,000-$200,000	-1,339	-624	91	806	1,521
$200,000-$500,000	1,808	3,274	4,740	6,206	7,672
$500,000-$1,000,000	17,136	20,517	23,898	27,279	30,660
$1,000,000 +	87,117	100,454	113,792	127,129	140,466
All Tax Units	0	404	808	1,213	1,617
Note: Figures in the Tax Policy Center report are for tax year 2015; baseline is current policy. Sources: Tax Policy Center, and Author Calculations

The results do indicate, however, that anything less than a 1 percent growth rate would result in a decrease in after-tax income for low-and-middle-income groups. On the other hand, if incomes are assumed to grow faster than 1 percent, then lower-and-middle-income earners would see a fairly sizable increase in after-tax income. In the case of a 2 percent growth rate, this increase would range from $223 for those earning less than $30,000 to $1,521 for those earning between $100,000 and $200,000.[5]

There are two primary reasons for the difference between the TPC static numbers and the dynamic numbers shown in the table. First, higher pre-tax incomes increase tax revenue, other things being equal, thereby reducing the amount of 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. that would be necessary to finance the 20 percent rate reduction that Romney has proposed. If pre-tax incomes were to grow by 1 percent (across the board) as a result of Romney’s plan, this dynamic effect would be $28 billion. Second and more simply, higher pre-tax incomes increase after-tax incomes. That is, if Romney’s plan increases economic efficiency and thereby overall pre-tax incomes, then that obviously will increase after-tax incomes.[6]

Conclusion

Overall, this analysis shows that if one assumes a 1 percent dynamic income growth effect under Romney’s plan (as interpreted by the Tax Policy Center), then low-and-middle income earners would experience a slight increase in after-tax income as opposed to a decrease. A more modest growth of less than 1 percent would imply a decrease in after-tax income for low-and-middle-income earners, but a more robust growth of more than 1 percent would imply a substantive increase in after-tax income.

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