April 20, 2014

How Politics Can Turn a Good Tax Policy Idea Bad

Last week the Tax Policy Center (TPC) released this distributional analysis of the Romney tax plan, exploring how the plan could be made revenue-neutral, as Romney has claimed it would be.  The TPC analysis found that it is impossible to pay for Romney’s proposed additional tax cuts (which are skewed heavily toward upper-income households ) with base-broadening revenue offsets (which according to the Romney plan cannot include increasing the taxation of capital income) without increasing tax burdens on net for most Americans.

What does the TPC analysis actually tell us about the Romney tax plan?  It’s well summarized in Figure 2 of the TPC paper, which decomposes the bottom-line conclusion that a revenue-neutral Romney plan would give generous tax cuts to households with incomes above $250,000, paid for with net tax increases on everyone else, into two parts:

(i) how much the tax cuts from the tax rate reductions are skewed toward wealthier households, and

(ii) how much the revenue offsets from (Romney-limited) base-broadening are skewed toward lower- and middle-income households.

 Combined, we would end up with a revenue-neutral (relative to a business-as-usual, policy-extended baseline) and highly “regressive” set of changes in the tax system, with relative and absolute tax burdens falling for “the rich” ( households with incomes above $250,000–about the top 5 percent) and increasing for everyone else.  That’s true even with all the pains the TPC analysts took to make the revenue offset otherwise as progressive as possible.

The Romney proposal will strike many as a bad idea,  but it  should not be taken as a blanket indictment of any kind of tax reform proposal that tries to pay for low (or even lower) marginal tax rates by broadening the tax base.  

From a purely mechanical standpoint (leaving aside politics), both parts of the reform could be modified fairly easily to come up with a revenue-neutral but much more progressive  tax reform package. 

On part (i) – the rate cuts – just don’t cut rates so much (or at all) at the top.  From a cost-benefit perspective, they are either not affordable or are not worth their costs. 

On part (ii) – the base-broadeners – just make sure you reduce some of the tax expenditures that currently benefit capital income, which is highly skewed toward those with high incomes, and ideally also limit other tax expenditures so that higher-bracket households don’t receive higher percentage subsidies. The President’s proposal to limit itemized deductions to the 28 percent rate is an example of this latter strategy. 

Romney runs into problems  on both parts because he chooses to cut tax rates the most for households with more than $250,000 of income  and at the same time refuses to reduce current tax subsidies that produce very low effective tax rates on capital income. 

The TPC analysis explains that taking tax preferences on capital income completely off the table (as Romney says he would do) not only eliminates the most progressive ways to offset the revenue loss of the tax cuts, but also means that the revenue-raising potential from base-broadening is cut by about one third. So from my perspective, this particular version of a base-broadening tax reform scores poorly on fiscal responsibility grounds as well as distributional grounds.

President Obama and his campaign seized upon this TPC analysis and talked about it on the campaign trail because it is indeed a pretty damning criticism of the Romney tax proposal, showing that Romney clearly puts a high priority on giving high-income households further tax cuts even if it means shifting more of the overall tax burden onto the middle class. 

The Obama campaign’s emphasis, however, was far more on the higher tax burdens on the middle class suggested by the revenue-neutral part (the implied base-broadening) of the Romney plan than on its too-large and too-skewed tax rate cuts.

The Obama campaign has jumped at the chance to highlight the burden of the implicit Romney revenue offset -- which should be criticized because of its distributional effect, but not because it is an offset, nor because it is a base-broadening offset. 

In my view, the most important and very objective, basic-math lessons of the TPC analysis of the Romney plan are (i) we really can't afford such large tax rate cuts, and (ii) it's not possible to offset their large cost while taking capital-income tax expenditures off the table without creating a very regressive tax package on net. 

In an ideal world these very important lessons from the TPC analysis would lead policymakers on both sides of the aisle to scale back their tax-cutting plans and/or restructure the offsets to make for a more progressive package. Unfortunately, the Obama campaign’s political capitalizing on the TPC analysis may have  resulted in the Romney campaign saying to itself now: "Gee, we shouldn't have proposed a fiscally responsible version of our huge tax cuts for the rich; we should have just said we would deficit-finance it."

Indeed, if you follow this logic, why should any politician propose a fiscally responsible tax cut, as opposed to a deficit-financed one?  By offsetting the cost of tax cuts, you open yourself to attack for the burden that will be placed on some households. In contrast, if you don't offset the cost, you can claim all households win.

It’s a shame that Romney’s particular version of base-broadening tax reform might be a bad-enough version that the more general (and wise) strategy of tax-base broadening for deficit reduction — a strategy emphasized by all of the bipartisan deficit-reduction groups — has now been tainted. 

Both the President’s fiscal commission (Bowles-Simpson) and the Bipartisan Policy Center’s task force (Domenici-Rivlin) showed that we can broaden the tax base, lower tax rates, and raise revenue — and yet still maintain or improve the progressivity of the overall tax system. What the TPC analysis of the Romney plan demonstrates is that we can’t get this desired outcome without increasing the taxation of capital income. (Both Bowles-Simpson and Domenici-Rivlin recommended increasing the tax rates on capital gains and dividend income.)

The TPC analysis of the Romney tax plan should be taken as a critically important, objective analysis to inform policymaking. It should serve as a teaching moment to help policymakers on both sides come up with better tax policy. But both campaigns have just used it to ramp up their political posturing and sharpen their blame games.  Let’s hope that this blow to the idea of fiscally-responsible, progressive tax reform is only superficial and temporary.