The Clever Economics Behind Romney’s Tax Plan

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One of the things which the candidates sparred over repeatedly in the debates was Romney’s tax plan, on which Obama has repeatedly charged “the math doesn’t work”.

Romney’s plan, as it has been presented, is to reduce tax rates by 20%. Thus, for example, the top rate would go down from the current 35% to 28%. Deductions and credits would then be reduced such that while the middle class would experience a net tax decrease, those at the top would continue to pay the same amount in taxes as they do now. Romney suggested how this might be done in the first debate:

[W]hat are the various ways we could bring down deductions, for instance? One way, for instance, would be to have a single number. Make up a number, $25,000, $50,000. Anybody can have deductions up to that amount. And then that number disappears for high-income people. That’s one way one could do it.

The idea here would be that for a family making, say 60k/yr that currently takes a total of $15k in deductions, the deductions would remain untouched while their rate would go down, resulting in lower net taxes. For a family making $400k/yr that currently takes $70k in deductions, their deductions would be capped at $25k but their tax rate would be lower, so they would pay about the same as they do now.

Democrats seem to want to suggest that some sort of secret poison pill would be slipped into the plan such that either the middle class would get a tax increase (while the rich would get a tax break) or such that the deficit would go up because fewer tax revenues would be collected. What this tends to miss is that the president does not get to unilaterally pass a tax plan. He has to ask Congress to pass one along the lines of what he would like. I think it’s highly unlikely that Congress will pass anything that is a net tax increase on the middle class (or, indeed, anyone) if it’s dominated by the GOP, as seems likely, especially if the election has gone well enough for the GOP to put Rommney in the White House. That Congress would pass a plan that increases the deficit is more likely (goodness knows they’ve done it before) but the president himself isn’t exactly standing on a good record in that regard either so that argument seems something of a wash.

The thing about this tax plan which is actually interesting, and which isn’t being discussed (probably because it takes more than one minute of shouting to convey) is how it’s designed to increase the amount of income available to be taxed, and in a way much more clever than the somewhat stale “tax people less and they will make more money” argument. This supply side argument is true, and we’ve seen examples of it working in history, but although tax cuts do tend to result in pre-tax incomes going up as people seek to increase the income that they make more of, the effect is pretty mild when the existing tax rates aren’t absolutely confiscatory. Thus, you might actually see total tax revenues go up cutting the top marginal rate 20% from 80% to 64%, because if 80% of your incremental earnings are being taken away you have little incentive to find ways to increase your earnings. You’re better off finding ways to enjoy leisure with the earnings you already have. However, cutting the top rate 20% from 35% to 28%, it’s a lot less clear that people would increase their incomes enough more to actually lift total tax revenues.

In a good post over at EconLog the other day, David Henderson digs into the different incentives that wage earners experience when their tax rates are cut:

When the government cuts a marginal tax rate, and that’s all it does, that cut has two effects in opposite directions: a substitution effect and an income effect.

The substitution effect is to make leisure more expensive. If you’re facing a 35% marginal tax rate (MTR), for example, and the rate is cut by 20% to 28%, your “price” of leisure rises by (72 – 65)/65, or 10.8%. When the price of a normal good rises (and leisure is a normal good), you buy less of it. So people work harder.

The income effect is to make you buy more leisure. The cut in marginal tax rates increases your real income and therefore you demand more leisure. That is, you work less.

Empirically, the substitution effect tends to outweigh the income effect slightly for men and strongly for married women. This means that cuts in MTRs alone will tend to increase income somewhat for men and a fair amount for married women. That was the effect of Reagan’s cuts in MTRs in the early 1980s.

Now, I’m certainly not one to say that the government has a need to maximize the amount of total tax revenues it takes in. Maximizing the size of government is not an end unto itself, and it can actually cause all sorts of problems. So in the abstract, one might argue that if lowering marginal tax rates were to cause incomes to go up, we should simply do that and find a way for the government to get by with a little less. However, the fact is, right now the government is spending far, far more than it takes in. Even the most aggressive responsible budget cutters (emphasis on responsible here — there are some silly plans out there that claim they can cut spending by huge percentages right off) need tax revenues to remain fairly stable in order to get the budget balanced.

Well, it turns out that by cutting marginal tax rates but also cutting deductions so that the who balance out, you can have the substitution effect that Henderson describes without having the income effect. The rate cuts and deduction cuts are perfectly balanced, so your income is exactly the same as it was before. You don’t “feel richer”, and so you don’t have the incentive to rest on your laurels and enjoy your newfound wealth. However, the substitution effect does come into play. If you have the opportunity to make more, less of that incremental income will be taken away in the form of taxes, and you’ll get to keep more of it. The reward for making more is higher, and so (all other things being equal) people will tend to do it more.

And, of course, if this does result in incremental total income for citizens, that incremental income will be taxed (at the new lower rates) and result in incremental tax revenue which can be used to close the deficit. Thus, a tax reform that was essentially revenue neutral (people pay the same taxes each year) but which decreased marginal tax rates and deductions would have the same stimulative effect on incomes that a tax cut would have, but wouldn’t present the deficit risk of significantly decreasing tax revenues and counting on economic growth to make up for that gap.

The plan really is quite clever, which makes it a shame that no one is willing to talk about it except in tiresome soundbites.

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  1. Sound article. What we never talk about, ever, is the effective marginal tax rate for the poor. That first $1000 of income results in zero change in taxes, but a big drop in aid. I haven’t looked at the numbers in a long time, but as income increases, at times the effective marginal tax rate was greater than 100%. I believe that rate has dropped, but mainly because we’ve been extending the benefits of, say, food stamps to a higher income level.

  2. N.B. The alternative minimum tax already takes away many (except charitable and home loan interest) of the evil, rich dastards’ tax deductions.

    All the democrats have is class hate: tax the rich!

    The essential problem with US taxes is that they are not used for their purpose: fund necessary government activities. They are used for societal engineering and political theater.

    Still: I will vote for Romney as the alternative will make the zombie apocalypse seem like a Summer picnic.

  3. Excellent post, Darwin. I have tried to explain exactly this to the plan’s critics but have not had success. Your presenting it in writing, and so lucidly, should help. I hope you won’t mind if I cut and paste with attribution.

  4. Thanks. Do feel free to copy.

    I was struck by the neatness of the economics behind the plan when I finally found the linked analysis, and I was kind of shocked that virtually no one is talking about this. I would have thought that Ryan would have taken a shot at it in the VP debate, if nothing else, but the thinking must be that ordinary voters just don’t or can’t understand these things.

  5. The only decent democratic solution is to scrap the present debate format. Let the two candidates and their VP/hopefuls describe their financial plans and show how they would reform the tax code, spend the taxes, for military, education and social programmes which as we know are mostly savings and caring for each other and the vulnerable. Explain them and question each other. This waste of time, energy and grand-standing in the debates and the mindless commercials dumbs down an already dumbed down electorate. 2012 will not fix it regardless of who wins the White House or Congress.
    Hoping for genuine concern for the Common Good and the security of the Republic seems too much to hope for at present but it would go a long way toward backing away from the 16 trillion cliff and counting.

  6. I would have thought that Ryan would have taken a shot at it in the VP debate, if nothing else, but the thinking must be that ordinary voters just don’t or can’t understand these things.

    Maybe, but more likely it was because his opponent was incapable of understanding these things. Kind of like when having to explain a joke – no matter how brilliant and accessible – it just never ends well.

    Good post though. 🙂

  7. This is logic which connects most of the tax ideas Mitt has been espousing, but I think has been missing from both Republican candidates’ speeches. I’ve rather assumed that they deem it too complex for the average voter to absorb under the circumstances they would be forced to voice the idea. Alternately, the Dems would simply call it trickle down economics and everyone would dismiss it. Let’s face it it doesn’t make a good sound byte. Nonetheless I agree with it. Unfortunately for conveying the idea, but fortunately for tax revenue, I believe there is a next step.

    You’ve heard Mitt say repeatedly that it would also help small businesses, which are not mentioned in the discourse above. I’ve owned lots of real estate, but never owned a “business” I had to report taxes on. So speculating, my guess is that those businesses Mitt refers to, file on schedule C?, D?, ?, on individuals returns. They, I believe would be proprietorships, partnerships, subchapter S corporations, and perhaps LLCs and LLPs. Should they retain more of their earnings, they would be better predisposed to invest more thereby growing job markets resulting in more taxable income reported by newly hired people.

    A recognized impact on economic expenditures, and therefore growth, is outlook or expectations, especially on the part of business. But I won’t go there as it is also exceptionally hard to measure or predict. Still imagine what this would do to business expectations, excepting of course such things as bankruptcy practices – Sorry Donald R. McClarey.

    The logical next step is ahh, ahh, well, perhaps there are too many to even speculate, and perhaps in 8 years when president Ryan takes office . . .

    I always hate to pray that my will be done, but perhaps if this time God could just agree with me . . .

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