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Tax Experts Show Why Mitt Romney's Middle-Class Tax Cut Would Work

October 10, 2012

By Avik Roy

Mitt Romney has proposed a significant overhaul of America’s income tax code, revolving around three principles: reducing tax rates for everyone, achieving deficit neutrality, and ensuring that taxes on the middle class go down. Two months ago, a center-left think tank called the Tax Policy Center claimed that such a tax reform was "impossible," and that Romney’s plan would raise taxes on middle- and lower-income households by $86 billion a year. This led the Obama campaign to claim that Romney was raising taxes on the middle class to pay for "tax cuts for the rich." But several critics have found flaws in the think tank’s assumptions. Adjusting for these assumptions validates Romney’s claim that his plan would cut taxes for middle- and lower-income households at the expense of the rich.

(DISCLOSURE: I am an outside adviser to the Romney campaign on health care issues. The opinions contained herein are mine alone, and do not necessarily correspond to those of the campaign.)

President Obama has been going around claiming that Romney was seeking a "$5 trillion in tax cuts that favor the wealthy," because part of Romney’s plan involves reducing tax rates for everyone by 20 percent, which some estimate as costing the Treasury $5 trillion in revenue over ten years. But Obama’s claim doesn’t take into account the fact that Romney intends to fund those tax cuts by reducing or eliminating many of the deductions and loopholes in the tax code that primarily favor the wealthy.

The Tax Policy Center report

Two months ago, the Tax Policy Center—a joint enterprise of the Urban Institute and the Brookings Institution—put out a report in which they made several assumptions about Romney’s approach to deductions and loopholes, concluding that it would be "impossible" for Romney to cut income tax rates by 20 percent, and keep the government’s tax revenues the same, without raising taxes on the middle class.

If Romney insisted on keeping his plan revenue-neutral, argued the TPC authors, Romney’s plan would "likely result in a net tax increase for lower- and middle-income households and tax cuts for high-income households" of $86 billion a year in 2015. (The authors defined "high income" as income above $200,000 per year.)

But the authors of the TPC report—Samuel Brown, William Gale, and Adam Looney—made a number of assumptions that others have rightly pointed out to be flawed. Indeed, five simple adjustments of TPC’s assumptions turn their $86 billion shortfall into a $40 billion surplus.

TPC ignores three important tax expenditures

First, the TPC authors assumed that it would be "off the table" for Romney to "reduce tax expenditures that aim to promote saving and investment." But while that is indeed a general goal of Romney’s approach, Romney hasn’t issued a blanket opposition to such changes.

As Matt Jensen and Alex Brill of the American Enterprise Institute have pointed out, there are a few such tax expenditures that conservatives have long considered to be "on the table." These include: (1) eliminating the deduction for interest income on state and local bonds, and (2) income related to the inside buildup of life-insurance products. Indeed, in response to the Jensen critique, the TPC authors produced an update to their paper, conceding that these two changes would raise as much as $25 billion and $20 billion, respectively, from high earners. That brings the alleged middle-class shortfall down from $86 billion to $41 billion.

Furthermore, as Curtis Dubay of the Heritage Foundation has noted, the TPC authors "assume that the Romney plan would not change the step-up in basis of capital gains at death." Let me try to translate. Romney’s plan would eliminate the estate, or "death" tax. Under our current code, if you inherit a house from your parents, and then later sell it, because you already paid estate tax on the home, when you sell it you’re only liable for the capital gains that have accrued since your parents died. However, if we eliminate the estate tax, we need to change that rule so that capital gains apply to the preceding period when your parents owned the home, which is called the "carry-over basis."

Dubay calculates that eliminating this deduction for people with incomes over $200,000 would raise approximately $19 billion in 2013, which we can call $20 billion for 2015. That brings the TPC shortfall from $41 billion to $21 billion.

TPC included Obamacare taxes, but not spending, in their baseline

Mitt Romney has pledged to repeal Obamacare, which includes new taxes on upper-income earners: a 0.9 percent surcharge on "earned income" and a 3.8 percent surcharge on "unearned income." The TPC authors count this as revenue that Romney has to make up elsewhere, without taking into account that Romney would also repeal Obamacare’s spending.

This is clearly incorrect on their part. Alex Brill calculates that this change takes another $29 billion in 2015 revenue out of TPC’s alleged middle-class shortfall, turning a $21 billion shortfall into an $8 billion surplus.

The TPC report assumes that Romney’s plan would have no effect on economic growth

We’ve established that with four simple adjustments, we can turn TPC’s alleged $86 billion in new taxes on middle- and lower-income households into an $8 billion surplus. But it’s important to note that the TPC analysis is static, and assumes that the plan would do nothing to improve economic growth, leading to increased tax revenues.

The TPC authors acknowledge this fact, arguing that "there are particular reasons to be skeptical that revenue-neutral tax cuts will have much effect on growth." But, just to be sure, the TPC authors used the work of Gregory Mankiw and Matthew Weinzierl to estimate that optimistic assumptions about economic growth could add an additional $53 billion in tax revenue to Romney’s plan.

If we decide to reduce these optimistic assumptions by 40 percent, resulting in $32 billion in additional income from growth, we arrive at a total surplus of $40 billion for the Romney plan: $8 billion with static scoring, and $40 billion with dynamic scoring of economic growth.

There are other estimates out there. Harvey Rosen of Princeton suggests that the Romney plan could add $25 to $58 billion in revenue from economic growth. Alex Brill of AEI calculates that every 0.1 percent in extra GDP growth per year would add $13 billion in revenue.

Further thoughts

There may be other aspects of the TPC study that bear additional analysis. It’s not clear whether or not TPC modeled the impact of their assumptions on payroll taxes. Some tax expenditures, most notably the tax exclusion for employer-sponsored health insurance, significantly reduce revenues from the payroll tax.

In addition, it’s not obvious why someone making $200,000 is considered "rich" while someone making $190,000 is not. The arithmetic would work out quite differently if "middle- and low-income households" were defined as those with less than $150,000 or even $100,000 in income.

I’ll say one thing in defense of the TPC authors. While their analysis missed a few things, and contains a few bits of inflammatory and biased language, their report isn’t a piece of hackery, especially in comparison to some of the shoddy work from Families USA and the Commonwealth Fund that I’ve recently reviewed. The TPC authors assume in their report that Romney is successful at reducing and/or eliminating a wide swath of tax expenditures that primarily benefit the wealthy, even though Congress has been reluctant to eliminate those expenditures in the past.

It may be that Romney can’t convince Congress to go along with his proposal. But that’s different from saying that his proposal is a fraud, or that Romney’s lying when he says that his plan will cut taxes for the middle class. The math I’ve walked through above shows that Romney’s plan can, indeed, achieve all of his stated objectives. That’s a big part of why he won last week’s debate, and why President Obama is struggling to find a better argument against him.

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