Understanding Romney’s Approach to Taxes: ‘Lower the Rates, Broaden the Base’

Republican presidential candidate Mitt Romney has made tax reform a centerpiece of his campaign. His catchphrase description of the proposal is "lower the rates and broaden the base," a concept that enjoys support not just from other Republican candidates, but also from Federal Reserve Chairman Ben Bernanke and the Bowles-Simpson Fiscal Commission.

But that catchphrase immediately introduces a problem: for the most part, only wonks know what "broaden the base" means. What follows is a two-step clarification of the concept.

For the income tax, "broadening the base" means increasing the amount of income subject to taxation --- and there are two ways to do it. One way is to increase the "taxable income" line on the individual tax return. The second way is to increase the number of taxpayers in the economy, by accelerating the private sector's job creation.

1. Eliminating Deductions to “Broaden the Base” — Static Scoring

The first method of base-broadening, illustrated in Figure 1, focuses on a hypothetical individual tax return and shows what happens when the rate is lowered and the base is broadened by eliminating deductions. Note that, even if the whole pie (gross income) remains unchanged, the taxable income portion (inner circle) will grow as deductions are eliminated.

The red slices indicate tax dollars paid. When the tax rate decreases as taxable income increases, the slices can remain nearly the same size — i.e., there can be no tax increase or decrease on the individual return.

This is called a “microeconomic” analysis because it looks at the effect on individuals. And because it does not take into account the larger, macroeconomic effects — such as any resulting growth of the overall economy — it is also known as “static scoring,” which is the government’s official method for analyzing tax policy.

2. Accelerating Job Creation to “Broaden the Base” — Dynamic Scoring

Figure 2 illustrates the second method of base-broadening — putting more people to work, which would increase the number of tax returns being filed and grow the economy. When a new policy successfully enhances growth, the government enjoys larger tax revenue (the sum total of all the red slices), mainly because the number of taxpayers is increasing more rapidly. This is called a macroeconomic analysis because of its focus on a policy’s effects on the whole economy.

Does the Romney tax proposal enhance the economy’s growth rate? It is an important question, especially when the primary purpose of the proposal is to do just that: enhance the rate of job creation. Unfortunately, we cannot expect an official answer on this, because when the Congressional Budget Office (CBO) analyzes a tax policy proposal, it does not use “dynamic scoring,” or measure any effect on growth. The Center on Budget and Policy Priorities (CBPP) tells us that CBO analyses “do not include an estimate of how any change in GDP would affect revenues." Why not? CBPP gives two reasons: (1) it’s too hard to do; and (2) it would be controversial, and therefore open to politicization.

Eliminating the Goal of Reform from Tax Policy Analysis

Paradoxically, static analysis strikes private sector job growth, the primary goal of tax reform, from the analysis of tax reform. The resultant “scoring” is arguably reduced to an oversimplified microeconomic exercise that determines whether the reduction in federal tax revenue (by reducing the tax rates) would be offset by the increase in tax revenue (by eliminating deductions), within a workforce that somehow remains unaffected by changes in incentives induced by a new tax code.

Static scoring ignores growth effects, which, if incorporated into an official analysis, would help to clarify the debate. Would tax reform (a) enhance economic growth; (b) hurt economic growth; or (c) have no effect on growth? We do not really know, because the answer would require dynamic scoring — which, as a recent Bloomberg article explains, "has been the subject of a decades-long debate between the parties." While the scorekeepers "don’t assume that a [tax policy] change will increase the size of the economy," economists agree that “eventually a more efficient tax code with fewer distortions would be good for growth."

In other words, although everyone knows that growth is good, we choose to ignore it in our official scoring of tax policy proposals, even when the proposal‘s overriding purpose is to generate faster growth.

Romney's plan lays out the general principle: "U.S. GDP growth has averaged 3.3 percent over the past 50 years... But these are shadows that might be, not that must be. U.S. economic growth can be faster. All-important productivity growth can be lifted by better tax and regulatory policy. Changes in retirement ages, immigration policy, and support for employment can boost labor force growth." Dynamic scoring of growth and job-creation effects (bounded by a sufficiently wide confidence interval to allow for uncertainty) would give voters a better idea of what to expect from proposed policy changes.

Taking growth into account (dynamic scoring) is hard, and it is vulnerable to political games — but it’s the only game in town for clarifying which side’s job-creation ideas would be better for growing the macroeconomy and improving the nation’s fiscal balance. Romney is trying to change that game.

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy. His website is www.optimist123.com.

FURTHER READING: Conover also writes “It’s Past Time to Stop Blaming Bush,” “The Only Practical Way Out of Our Economic Doldrums,” and “Missing in Action: Growth

TWhiteBear wrote:

Can you supply a link for your assertion?
Reagan cut the rates and, let me clearly state, cut the base for major taxes. This is not the policy of Mr. Romney, who may be cutting the standard deduction, mortgage interest and raising other rates and bases.

Agreed. The table at this link shows that the 1986 tax cut was revenue-neutral over 4 years, at least according to a Treasury document. Romney's tax plan doesn't even come close. I looked closely at one of the key studies that supposedly supports his plan. Following is a fully sourced table that looks at Romney's tax plan using 2009 IRS tax data:

         Projected Revenue Gain/Loss from Romney Tax Plan
                      (billions of dollars)

                               2009 IRS Data         Feldstein
                          ======================= ===============
Adjusted Gross Income -->     All   100K+   200K+     All   100K+
========================= ======= ======= ======= ======= =======
Income tax before credits     976     682     449     953
Dividends & capital gains      49*                     49*
------------------------- ------- ------- ------- -------
Tax affected by rate cut      927                     904
Revenue loss of 20% cut       185                     181
Alternative minimum tax        23                      23
Investing tax cut              15*                     15*
------------------------- ------- ------- ------- -------
Static revenue loss           223                     219
Dynamic revenue loss          190*                    186*
========================= ======= ======= ======= ======= =======
Home mortgage interest        421     199      67
State and local taxes         252     184     113
Real estate taxes             168      88      36
Contributions deduction       158      99      59
Other itemized deductions     206      67      30
------------------------- ------- ------- -------
Total itemized deductions   1,204     637     305            636
Revenue gain at 30%                   191      91            191
Revenue gain at 25%|27%               159      82            159
=================================================================
Note: following are estimates of revenue loss not included above:
-----------------------------------------------------------------
Estate tax elimination         21*
Phase in of deduction loss     15*
=================================================================
* estimated by Feldstein (else 2009 IRS data)

Sources: 2009 IRS Tax Data, Table 1.4, Sources of Income, Adjustments, and Tax Items
         2009 IRS Tax Data, Table 2.1, Sources of Income, Adjustments, Itemized Deductions
         Martin Feldstein's Wall Street Journal article, August 28, 2012
         Martin Feldstein's blog post, September 02, 2012

You can find an analysis of the numbers at this link. As the table and analysis show, it does not appear to be mathematically possible, much less politically possible, to pay for the Romney tax cuts by cutting deductions without raising taxes on the middle-class, something that Romney has pledged not to do.

To: riverdawg riverdawg wrote:

The 1986 reforms were designed to be revenue neutral but there was a modest short run loss in revenue ( about $10 billion, I recall) attributed to the reform. The Reagan reform did not cut the base for major sources of federal tax revenue (personal and corporate income). Many deductions and credits were eliminated or capped, and the result was a major simplification of the tax code for most of us. However, the special interests squealed and Congress subsequently unravelled many of the simplifications. A good book on the subject is Showdown at Gucci Gulch by Jeff Birnbaum and Alan Murray.

Yes, any revenue loss from the 1986 tax cut was very small, at least initially. However, the following table shows that the loss from the 1981 tax cut was very large, at least over the first four years. That's likely what prompted the various tax hikes in the years that followed (more on that at this link).

      REVENUE EFFECTS OF MAJOR TAX BILLS ENACTED UNDER REAGAN (as percentage of GDP)

                                                        Number of
                                                    years after enactment     First
                                                  --------------------------   2-yr   4-yr
Tax bill                                            1      2      3      4      avg    avg
------------------------------------------------  ----------------------------------------
Economic Recovery Tax Act of 1981...............  -1.21  -2.60  -3.58  -4.15  -1.91  -2.89
Tax Equity and Fiscal Responsibility Act of 1982   0.53   1.07   1.08   1.23   0.80   0.98
Highway Revenue Act of 1982.....................   0.05   0.11   0.10   0.09   0.08   0.09
Social Security Amendments of 1983..............   0.17   0.22   0.22   0.24   0.20   0.21
Interest and Dividend Tax Compliance Act of 1983  -0.07  -0.06  -0.05  -0.04  -0.07  -0.05
Deficit Reduction Act of 1984...................   0.24   0.37   0.47   0.49   0.30   0.39
Omnibus Budget Reconciliation Act of 1985.......   0.02   0.06   0.06   0.06   0.04   0.05
Tax Reform Act of 1986..........................   0.41   0.02  -0.23  -0.16   0.22   0.01
Omnibus Budget Reconciliation Act of 1987.......   0.19   0.28   0.30   0.27   0.24   0.26
------------------------------------------------------------------------------------------
TOTAL...........................................   0.33  -0.53  -1.63  -1.97  -0.10  -0.95

Source: OTA Working Paper 81, Table 2, Office of Tax Analysis, U.S. Treasury Department,
        online at http://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/ota81.pdf

In addition, there appears to be little evidence that the 1986 tax cut and its base-broadening increased the growth in GDP. The following is from an article by Bruce Bartlett:

Real gross domestic product growth was about the same after the 1986 act took effect in 1987 as it was before, and tax reform obviously did nothing to forestall the 1990-91 recession. Unemployment fell, but it had been trending downward before tax reform, and the 1986 act probably had nothing to do with it. Within a couple of years it was trending upward again.

By the mid-1990s, it was the consensus view of economists that the Tax Reform Act of 1986 had little, if any, impact on growth. In an article in the May 1995 issue of the American Economic Review, the Harvard economist Martin Feldstein, a strong supporter of tax reform who had served as chairman of Reagan’s Council of Economic Advisers, found large changes in the composition of income, but the only growth effect was a small increase in the labor supply of married women.

In a comprehensive review of the economic effects of the 1986 tax reform act, in the June 1997 issue of the Journal of Economic Literature, Alan Auerbach of the University of California, Berkeley, and Joel Slemrod, the University of Michigan economist, also found that the primary impact was on the shifting composition of income. They could find no significant growth effects. They concluded, “The aggregate values of labor supply and saving apparently responded very little.”

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