The Tax Policy Center’s latest research report went viral last week, drawing attention in the presidential campaign and sparking a constructive discussion of the practical challenges of tax reform. Unfortunately, the response has also included some unwarranted inferences from one side and unwarranted vitriol from the other, distracting from the fundamental message of the study: tax reform is hard.
The paper, authored by Sam Brown, Bill Gale, and Adam Looney, examines the challenges policymakers face in designing a revenue-neutral income tax reform. The paper illustrates the importance of the tradeoffs among revenue, tax rates, and progressivity for the tax policies put forward by presidential candidate Mitt Romney. It found, subject to certain assumptions I discuss below, that any revenue-neutral plan along the lines Governor Romney has outlined would reduce taxes for high-income households, requiring higher taxes on middle- or low-income households. I doubt that’s his intent, but it is an implication of what we can tell about his plan so far. (We look forward to updating our analysis, of course, if and when Governor Romney provides more details.)
The paper is the latest in a series of TPC studies that have documented both the promise and the difficulty of base-broadening, rate-lowering tax reform. Last month, for example, Hang Nguyen, Jim Nunns, Eric Toder, and Roberton Williams documented just how hard it can be to cut tax preferences to pay for lower tax rates. An earlier paper by Dan Baneman and Eric Toder documented the distributional impacts of individual income tax preferences.
The new study applies those insights to Governor Romney’s tax proposal. To do so, the authors had to confront a fundamental challenge: Governor Romney has not offered a fully-specified plan. He has been explicit about the tax cuts he has in mind, including a one-fifth reduction in marginal tax rates from today’s level, which would drop the top rate from 35 percent to 28 percent and a cut in capital gains and dividend taxes for families with incomes below $200,000. He and his team have also said that reform should be revenue-neutral and not increase taxes on capital gains and dividends. But they have not provided any detail about what tax preferences they would cut to make up lost revenue.
As a political matter, such reticence is understandable. To sell yourself and your policy, it’s natural to emphasize the things that people like, such as tax cuts, while downplaying the specifics of who will bear the accompanying costs. Last February, President Obama did the same thing when he rolled out his business tax proposal. The president was very clear about lowering the corporate rate from 35 percent to 28 percent, but he provided few examples of the tax breaks he would cut to pay for it. Such is politics.
For those of us in the business of policy analysis, however, this poses a challenge. TPC’s goal is to inform the tax policy debate as best we can. While we strongly prefer to analyze complete plans, that sometimes isn’t possible. So we provide what information we can with the resources available. Earlier this year, for example, we analyzed the specified parts of Governor Romney’s proposal and documented how much revenue he would have to make up by unspecified base broadening (or, possibly, macroeconomic growth) and how the rate cuts would affect households at different income levels.
The latest study asked a different question: Could Romney’s plan maintain current progressivity given revenue neutrality and reasonable assumptions about what types of base broadening he’d propose? There are roughly $1.3 trillion in tax expenditures out there, but not all will be on Governor Romney’s list. He has said, for example, that raising capital gains and dividend taxes isn’t an option and has generally spoken about lowering taxes on saving and investment. Based on those statements, the authors considered what would happen if Romney kept all the tax breaks associated with saving and investment, including not only the lower rates on capital gains and dividends, but also the special treatment for municipal bonds, IRA and 401ks, and certain life-insurance plans, as well as the ability to avoid capital gains taxes at death (known as step-up basis). The authors also recognized that touching some tax breaks is beyond the realm of political possibility, such as taxing the implicit rent people get from owning their own home.
Given those factors, the study then examined the most progressive way of reducing the other tax breaks that remain on the table—i.e. it rolls them back first for high-income people. But there aren’t enough of those preferences to offset the benefits that high-income households get from the rate reductions. As a result, a revenue-neutral reform within these constraints would cut taxes at the high-end while raising them in the middle and perhaps bottom.
What should we infer from this result? Like Howard Gleckman, I don’t interpret this as evidence that Governor Romney wants to increase taxes on the middle class in order to cut taxes for the rich, as an Obama campaign ad claimed. Instead, I view it as showing that his plan can’t accomplish all his stated objectives. One can charitably view his plan as a combination of political signaling and the opening offer in what would, if he gets elected, become a negotiation.
To get a sense of where such negotiation might lead, keep in mind that Romney’s plan is not the first to propose a 28 percent top rate. The Tax Reform Act of 1986 did, as did the Bowles-Simpson proposal and the similar Domenici-Rivlin effort (on which I served). Unlike Governor Romney’s proposal, all three of those tax reforms reflect political compromise. And in all three cases, part of that compromise was eliminating some tax preferences for saving and investment, which tend to be especially important for high-income taxpayers. In particular, all three reforms resulted in capital gains and dividends being taxed at ordinary income tax rates.
TPC’s latest study highlights the realities that lead to such compromises.
I’m sorry, but not specifying the Tough Choices you’re willing to make in Politics is like saying “& then a Miracle occurs” in a Scientific Journal.
Hi Donald,
Thanks for your commentary on the TPC report.
One criticism from the WSJ was:
Another reality is that more than one-third of Americans pay no income tax. Many in this group contribute payroll taxes, but for most their only connection to the income tax is to receive refundable tax credits (in the form of a check) that are effectively government payments. This is the basis for the Tax Policy Center’s wild claim that the Romney plan raises taxes on those who earn less than $30,000—a group that now has a negative tax liability.
The claim is that reducing various refundable tax credits that are cash payments from the government are a “tax increase.” By this logic, reducing unemployment benefits or food stamps would also be a tax increase.
Some view one’s payment of Social Security and Medicare payroll taxes as, in effect, at least partly or in some way, purchasing for himself a personal entitlement to future benefits from those programs. Others take the opposite view — that one is not paying for such an individual entitlement, but rather than these are merely taxes for a transfer payment program, like welfare for all seniors (and disabled people).
Yet many who have the latter view also have the view expressed by the WSJ — that it is absurd to view as a tax cut any refundable tax credit payments that the government sends to people who have zero income tax liability. They view such payments as clearly spending — in particular, as welfare.
Like many expressing this view, the WSJ acknowledges that these recipients pay payroll taxes, which are primarily SS and Medicare. Yet, given their view that SS and Medicare taxes are not an individual’s purchase of anything, but rather just taxes paid to fund a transfer payment program to current beneficiaries — i.e., that income taxes, SS taxes, and Medicare taxes are all just federal taxes on labor income, without any of them entitling the payer individually to benefits later, so all are viewed holistically as federal taxes on labor income — it would seem to follow logically that, insofar as that refundable tax credit payment the recipient receives does not exceed the SS and Medicare taxes he paid, that refundable tax credit is, in effect, a tax rate cut on his labor income, not like spending (not “welfare”). As a note, the same would be said of food stamps, as long as the total of food stamps, the refundable tax credit, and any other cash to which the individual is entitled by virtue of his income level do not exceed the SS and Medicare taxes he paid.
I’ll illustrate, using hypothetical numbers chosen for simplicity, not reflecting actual tax rates and provisions.
Joe’s gross income for a year is $3,000.
He pays, say, $200 total in SS and Medicare payroll taxes (which comes out to 6.7% of his labor income, just for this illustration, not the real world tax rate).
He has no taxable income after his personal exemption, and thus has no income tax liability. (The personal exemption is, in effect, just a tax rate reduction, and in his case it means that the income tax rate at his level of income is zero.).
Thus, if we view federal taxes on his labor income holistically, his tax rate is, in effect, 6.7%.
But at that level of gross income, he receives (just hypothetically) a $150 refundable tax credit, meaning he has paid a net $50 of federal taxes on his labor income, which would be 1.7%
Per the holistic view of federal taxes on labor income, isn’t that $150 refundable tax credit (in this hypothetical case) essentially a tax cut — a reduction in the federal tax rate on his labor income from 6.7% to 1.7% ?
And per that holistic view of federal taxes, wouldn’t it be wrong to regard the refundable tax credit in this case as similar to spending (as a sort of “welfare”) rather than as a tax cut?
To be clear, I’m NOT saying I subscribe to that holistic view of federal taxes on labor income — the view that one is NOT purchasing an entitlement to future benefits, and thus SS and Medicare taxes are just part of all federal taxes on labor income without the payer gaining any individual entitlement to benefits. I’m just saying that it seems internally inconsistent (i.e., illogical) for those who DO have such a view to regard such a refundable tax credit as spending and illogical for them not to view it as a tax rate cut, as long as the individual still ends up paying some federal taxes on his labor income. Do you agree?