Wonkblog’s comprehensive guide to the debate over Romney’s tax plan

September 27, 2012

The Obama campaign citing the Tax Policy Center in an attack ad. / Obama for America

There's no think tank report or academic study in recent memory that's dominated a campaign the way the Tax Policy Center's analysis of Mitt Romney's tax plan has dominated this one.

The Obama campaign seized on TPC's finding that Romney's tax plan, even under very generous assumptions, raises taxes on the middle class, citing the paper in attack ads and stump speeches. The Romney campaign in turn dismissed the report, and numerous conservative economists and think tanks have written responses disputing its conclusions. The Heritage Foundation's Curtis Dubay's attempted debunking yesterday is just the latest.

It's all a bit much for a technical report with the dry-as-bone title, "On the Distributional Effects of Base-Broadening Income Tax Reform." So let's take a step back. Given what the report actually said, have any of the studies responding to it debunked its conclusions?  Not really. If anything, they highlight the priorities that Romney is going to have to compromise on to get tax reform done.

What the Tax Policy Center study actually said

The study started by noting that Mitt Romney has stated he wants his tax reforms to achieve (at least) five things:

  1. A 20 percent reduction in marginal personal income tax rates.
  2. Elimination of the estate tax.
  3. Elimination of the Alternative Minimum Tax.
  4. Enough base-broadening, through the elimination of tax expenditures, to fully pay for policies 1 through 3.
  5. Preservation of incentives for saving and investment.

The paper then demonstrated that you can't do 1-5 without raising taxes on people making under $200,000 a year. None of the responses to the study have disproven that. All either use a different definition of the middle class, rely on inappropriate estimates of growth caused by Romney's plan, or else violate Romney's promise to preserve the savings and investment incentives. Let's go through the studies, one by one.

Feldstein: Depends on the definition of "middle class"

Martin Feldstein, a highly respected conservative economist at Harvard, found that you can complete all five without raising taxes on people making under $100,000 a year, but that to do so you'd need to raise them a lot on people making between $100-200,000. So Feldstein's findings don't really debunk the TPC study. Given that Romney has explicitly stated that people making between $100,000 and $200,000 are "middle income," Feldstein's study shows that Romney, by his own standards, would be violating his pledge to prevent a middle-class tax hike.

Rosen: What about growth?

Harvey Rosen, a public finance expert at Princeton, argued that the Romney tax plan will increase economic growth dramatically, which in turn would raise revenue and negate the need for tax increases on the middle-class. He finds that if the Romney plan increases economic growth by 3 percentage points relative to where it would be under current policies -- a huge, and many economists think implausible, boost -- then Romney's numbers might work out. But behind his analysis lurk two assumptions that might not add up. 

Rosen bases his growth estimates on a study of Romney's plan done by Rice economist John Diamond. Diamond assumes that Romney's plan is implemented under conditions of full employment. That's important because it means that if you eliminate tax breaks for one industry and they have to fire workers, those workers can relatively easily find jobs in another industry. But barring a miraculous labor market recovery in the next few months, that won't be the situation when Romney takes office. In the current world, wiping out tax breaks for an industry could lead to displaced workers who simply join the ranks of the unemployed, dragging down growth.

But more damaging for Rosen's case is that Diamond's study assumes that Romney's plan is revenue-neutral before you take economic growth into account.* That is, Diamond assumes that the tax cuts have been fully paid for first, and that's part of why they do so much for growth. Rosen, conversely, is making the case that you don't need to fully pay for the tax cuts because growth will fill in the gap. So the Diamond-Romney tax plan and the Rosen-Romney tax plan are quite different, and growth estimates that apply to the first don't necessarily apply to the second. 

Jensen: TPC forgot about muni bonds and life insurance

Another set of criticisms notes that you can satisfy Romney's first four policy priorities and not raise taxes on those making under $200,000 if you sacrifice the fifth one: preserving incentives for savings and investment. Matt Jensen at AEI points out that two saving incentives that TPC rules off the table — to whit, the exemptions for state and local bonds and for interest on life insurance savings — disproportionately help high earners. If you eliminate them, then at the very least the Romney plan's hit to middle class taxpayers is lessened.

But as the TPC study authors pointed out in a follow-up paper, eliminating those exemptions cuts the tax hike on people making $200,000 in half, but their taxes still go up. So even if you relax Romney's fifth goal, a tax hike on the middle class could still be required.

Dubay: The estate tax changes things

That brings us to the Heritage Foundation's response, written by Curtis Dubay. Dubay argues that TPC misestimated the revenue effects of eliminating the estate tax. Dubay argues that eliminating the tax will likely be paired with a move to "carryover basis" capital taxation. Under that system, inherited goods that are then sold would be taxed based on their value upon initial purchase, rather than upon being inherited.

For example, imagine your grandfather bought a Jackson Pollock painting, back before Pollock hit it big, for $50. When your grandfather dies and leaves you the painting, it's worth $10 million. You decide to sell the painting for $25 million. Under the current law (called "step basis"), you'd pay taxes on the $15 million difference between the price when you inherited it and the price when you sold it. Under carryover basis, you'd pay taxes on the $24,999,950 difference between the price your grandfather bought it at and the price you sold it at. So carryover basis raises more revenue.

But as Suzy noted, Dubay's estimates for exactly how much revenue it raises are flawed. His numbers compare the current "step basis" policy not to carryover basis, but to a policy in which all assets are taxed at capital gains rate when someone dies. That's a much more dramatic change than carryover basis, and likely to raise much more revenue. So Dubay's revenue estimates are considerably too high. And the less revenue gained from the carryover basis change, the bigger tax the hikes on middle-class people to make things balance out.

And in any case, the policy Dubay highlights, like the ones Jensen highlights, is a savings incentive. So Romney has to abandon one of his tax policy commitments to implement them.

So Romney has to give something up for his plan to work. He can give up defining the middle class as those making under $200,000. He can give up preserving savings incentives. He could also sacrifice on rate cuts, as his advisor Kevin Hassett has implied he might. 

Ezra asked the Romney campaign whether Hasset was speaking for Romney when he said the governor would sooner give up his tax cuts than increase the deficit, if it came to that. The Romney campaign's answer: "The Governor's plan calls for a 20% rate cut for all brackets, revenue neutrality, while ensuring that high-income earners continue to pay at least the same share of taxes.  All of these goals are achievable, and the Governor will work with Congress to enact tax reform that meets each of the goals he has proposed."

That aside, TPC's conclusion holds up. Romney can't get everything he wants. So the question is what he'll give up.

Tax plans aren't just about math

It's worth emphasizing just how low a bar the Romney plan is being asked to clear. The question the Tax Policy Center asked was whether it's mathematically possible to do all the things Romney says he wants to do. But even if it were mathematically possible, it may not be politically possible or substantively wise.

All of the above analyses assume that Romney totally eliminates the charitable deduction, mortgage-interest deduction, all education tax breaks, all state and local tax deductions the employer-provided health care exemption, all Health Savings Account and medical expenses deductions, and more for people making over $200,000. Even if TPC is wrong, you'd probably have to limit them for people making under that amount too, so middle-class people pay the same amount when you take into account the rate cuts. 

These are enormous changes. Eliminating the charitable deduction for the rich could effectively wipe out funding for thousands of charitable, artistic, and educational institutions. Small theaters could shut down. Anti-malaria groups would buy fewer bednets. Private colleges would lose donations, and hike up tuition to make up the difference, even as tuition deductions and credits are eliminated. In 2009, when President Obama proposed simply limiting the charitable deduction at the to end, Martin Feldstein, author of the first study trying to show Romney's plan could work, wrote, "in effect, the change would be a tax on the charities, reducing their receipts by a dollar for every dollar of extra revenue the government collects. It is hard to imagine a rationale for taxing schools, hospitals, medical research budgets and arts organizations in this way."

Eliminating the mortgage-interest deduction would upend the housing sector, reducing demand to buy dramatically and shifting the sector toward renting. Eliminating the employer health exemption could mark the beginning of the end of the employer-based health system as we know it.

Perhaps these are good ideas. Many countries' tax codes are less tolerant of charitable contributions than the US and make up for that with direct artistic and educational subsidies. The mortgage-interest deduction arguably fueled the housing bubble. The employer-based health care system keeps people from moving freely between jobs, and ending the exemption that keeps it in place could do a lot of good. But these aren't just technical changes. They're transformative shifts in American public policy. And the debate over whether they would make Romney's plan possible has obscured the debate over whether they're a good idea, or likely to happen. 

Further reading:

— The original Tax Policy Center paper by Adam Looney, William Gale, and Samuel Brown.

— The authors' response to criticism.

— Harvard economist Martin Feldstein's latest critique of the TPC study.

— Ezra Klein on the Feldstein critique.

— Princeton economist Harvey Rosen's critique.

— Rice economist John Diamond's estimates of the plan's effects on growth.

— AEI's Matt Jensen's suggestions for improvements to the study.

— Heritage's Charles Dubay's critique of the study.

— Suzy Khimm on the Heritage critique and TPC's response to it.

 * Thanks to UC Berkeley's Alan Auerbach for pointing out these assumption in the Diamond estimate to me.

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