The Clever Economics Behind Romney's Tax Plan

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.