Democrats launched a surprising attack on GOP presidential nominee Mitt Romney in recent weeks when they accused the governor of trying to raise taxes on the middle class. This criticism is odd coming from the party that unapologetically seeks hundreds of billions of dollars in tax hikes and that adopted numerous tax increases, including some on the middle class, in President Obama’s healthcare reform. The Democrats’ attack is also an about-face on their standard argument that Republicans think the solution to every problem is another tax cut.
The Democrats have spent millions of advertising dollars in an intensive and well-coordinated attack on Romney’s proposal to simplify, streamline, and reform the tax code—a tax code that virtually no one thinks works well. Two think tanks, Obama’s campaign, super PACs, and high-profile media reports have all converged on this message.
Romney recently spelled out his tax reform objectives to Meet the Press: “Bring our rates down to encourage growth, keep revenue up by limiting deductions and exemptions, and make sure we don’t put any bigger burden on middle income people.”
What Is Actually Included in Romney’s Tax Plan
In order to objectively assess the claims made by the critics, let’s begin by looking closely at the key components of Romney’s proposal:
Reduce statutory income tax rates 20 percent, from 10, 15, 25, 28, 33, and 35 percent to 8, 12, 20, 22.4, and 28 percent.
Reduce the corporate tax rate from 35 percent to 25 percent.
Repeal the Alternative Minimum Tax for individuals and corporations.
Repeal the estate tax.
Eliminate, curtail, and reform numerous special provisions in the tax code—the credits, deductions, and exclusions that cause complexity, compliance problems, distortions, and inefficiencies.
In many regards, the Romney plan is like that of Obama’s bipartisan Simpson-Bowles Commission. Both plans share a structural consistency of low tax rates and a broader tax base. One important difference is that Romney proposes to keep the top tax rate on capital gains and dividends unchanged while Simpson-Bowles proposes raising those rates considerably. Furthermore, the Simpson-Bowles plan is an explicit tax increase–$80 billion a year more than even Obama has proposed–while Romney’s tax reform plan is revenue neutral.
Fallacies Behind the Democrats’ Attack
The core of the Democrats’ argument is that you can’t reduce income tax rates by 20 percent, as the Romney plan proposes, without raising taxes on the middle class. The analysis supporting this attack comes from a report by the Urban-Brookings Tax Policy Center (TPC), purveyors of a proprietary tax model used to estimate the budgetary and distributional consequences of tax proposals. The TPC analysis concludes that there are not enough tax breaks (excluding tax preferences for savings and investment) for high-income earners to offset the cost of the lower rates. As a result, TPC estimates that the Romney plan would reduce the tax payments of high-income earners by $86 billion in 2015 and that revenue neutrality would then require an $86 billion tax increase on the middle class.
The core of the Democrats’ argument is that you can’t reduce income tax rates by 20 percent, as the Romney plan proposes, without raising taxes on the middle class.
The TPC model has an important limitation when it is used to consider the impact of such large reforms as Romney’s plan. It assumes that any tax reform would not help the economy. In this sense, the TPC model is consistent with the models used by the official revenue estimators at the U.S. Treasury Department and the Joint Committee on Taxation. But those models are intended primarily to analyze the impact of modest changes to the tax code, not fundamental tax reform. In fact, there is plentiful economic evidence that tax reform could result in measurable economic growth. Depending on the reform and the model used to analyze it, tax reform can increase the capital stock, encourage work and innovation, and improve the allocation of resources in the economy.
In addition to the modeling limitation, TPC also misconstrues analysis on the relationship between tax reform and economic growth. Not only does the TPC model assume zero economic growth, but the Center’s analysis (subsequently echoed by many other commentators) points to research I published with AEI colleague Alan Viard to argue that economic growth is not possible from revenue-neutral income tax reform. This conclusion is a false interpretation of our research.
An increase in labor supply is one means by which an economy can grow; as Viard and I pointed out, revenue-neutral tax reform is indeed unlikely to yield gains on that front. But tax reform can also grow the economy by encouraging capital formation and promoting the proper allocation of capital across the economy. Romney’s plan will do just that.
As Viard and I describe in a recent blog post:
Recent discussion of Governor Mitt Romney’s tax reform plan by the Tax Policy Center (TPC) focused on that plan’s implications for work incentives, but that’s just one factor that affects growth ... Governor Romney’s tax plan for individuals would lower statutory tax rates on ordinary income while leaving tax breaks for saving largely untouched. His corporate tax reform plan would further improve the allocation of capital and foster economic efficiency. Overall, the governor’s plan translates into a reduced tax burden on saving and investment, which are key drivers of long-run growth.
Reconsidering the Tax Policy Center’s Analysis
Some of the specific assumptions that TPC made in its analysis of Romney’s tax plan are also highly questionable. By reconsidering just three components of the TPC’s analysis, the conclusions it draws get turned upside down.
Romney has proposed a bold tax reform that would broaden the tax base and lower statutory tax rates across the board.
More base-broadeners are on the table. TPC originally claimed that the Romney plan would raise taxes on the middle class by $86 billion. After a critique by AEI colleague Matt Jensen, who pointed out additional opportunities for base-broadening, TPC downgraded its estimate considerably. Specifically, Jensen pointed out that the exclusion of interest on state and local bonds and the exclusion of inside buildup on life-insurance products could yield more revenue. TPC then acknowledged that repeal of these provisions would raise approximately $45 billion from high-income taxpayers, reducing any need to tax the middle class by the same amount. The result: A purported $86 billion tax increase on the middle class shrinks to $41 billion.
The TPC revenue baseline assumption is inflated. TPC assumed that the baseline against which Romney is seeking revenue neutrality includes a 0.9 percent surcharge on “earned” income and an additional 3.8 percent surcharge on “unearned” income of high-income taxpayers that were adopted in the healthcare law. Romney has proposed repealing these taxes, but has not suggested that the cost of repeal would be paid for by tax reform. Instead, the budget effect of repealing these taxes should be analyzed in the context of the repeal of various other healthcare provisions.
Despite TPC’s assertion that adjusting its baseline assumption “does not alter our primary conclusion,” the revenue consequence of repealing this tax in 2015 is a full $29 billion, all of which falls on high-income earners. Correcting the baseline by removing this provision means that more of the revenue raised by broadening the tax base on high-income taxpayers can be used to finance tax reductions for the middle class. The result: A $41 billion tax increase shrinks to $12 billion.
Even modest economic growth makes a difference. And finally, the important factor that I discussed above. Based on Table 3-1 of the “Analytical Perspectives” report by the president’s Office of Management and Budget, I compute that if the economy were to grow just 0.1 percentage point faster per year as a result of the reform, the additional revenue in 2015 would be approximately $13 billion. The result: A $12 billion tax increase on the middle class actually becomes a tax cut.
And just like that, the Democrats’ attacks that Romney wants to raise taxes on the middle class become false.
But that is not the end of the story. The real story should not be about one campaign nit-picking the budgetary impact of the other campaign’s proposals. Rather the real story should be about the substantive policy visions of each of the candidates.
Romney has proposed a bold tax reform that would broaden the tax base and lower statutory tax rates across the board. While maintaining preferential rates for savings and investment, his proposal repeals the tax expenditures that distort economic decisions and add complexity to tax returns.
There is plentiful economic evidence that tax reform could result in measurable economic growth.
Although Obama has no such plan for tax reform, his vision for the tax system appears clear. He has refused to endorse the recommendations of the Simpson-Bowles Commission, which would also have lowered statutory tax rates and broadened the tax base. Instead, his near-singular focus has been to raise statutory tax rates for high-income households and to leave untouched hundreds of special tax breaks for various political constituencies.
Sadly, no true debate over the merits or means of tax reform is happening. Democrats have refused to engage in a discussion of ideas and have instead pursued a negative strategy, spending millions saying that Romney’s objectives are impossible to achieve and meanwhile offering no alternative.
As America sits down to hear the first presidential debate in four years, I hope that things will change. I believe that tax reform is critically important to our country and can have large benefits for our economy. Perhaps the debate will offer Obama an opportunity to pivot away from these tired attacks on Romney’s proposal and offer his own vision for tax reform. We can always hope.