The Romney tax cut.

Today, the Sunday morning TV shows on politics demonstrated the response of the Obama campaign to Romney’s debate win last week. Paul Krugman, who looks more and more like a political cheerleader and less like an economist, led the charge. The topic was the “five trillion dollar tax cut.”

The Obama campaign is already backing away from this claim, but let’s consider it.

This “five trillion dollar tax cut” figure is arrived at by taking his statement that he will cut rates by 20% and limit deductions. Multiple the total tax revenue per year by 20% and you get five trillion. This same reform was done in 1986 and the result was a 15 year economic boom. The results are discussed here.

Twenty years ago today (2006), President Ronald Reagan signed into law the broadest revision of the federal income tax in history. The Tax Reform Act of 1986 — the biggest and most controversial legislative story of its time — had lawmakers, lobbyists and journalists in Washington in an uproar for two years. Despite nearly dying several times, the measure eventually passed, producing a simpler code with fewer tax breaks and significantly lower rates. The changes affected every family and business in the nation.

Of course the Congress undid it over the ensuing years. We all expected that. What about Romney’s plan ?

Here is some discussion.

The Romney plan would raise actual and potential GDP by about 7.4 percent over a five to ten year adjustment period. The private business sector would grow about 7.8 percent. About two-thirds of the growth in GDP would go to labor income, across the board, in the form of more hours worked and higher wages per hour. Total labor compensation in the private business sector would rise by 7.8 percent in line with GDP. About a third of the gain, pre-tax, would accrue to savers and investors. The plan would boost the capital stock by about 18.6 percent (over $5 trillion in additional investment), which is what drives the increase in productivity, wages, and hiring.

The reduction in the corporate tax rate yields the largest improvement in GDP and wages, followed by the 20 percent reduction in individual tax rates and the elimination of the capital gains and dividend taxes on middle income taxpayers. However, relative to the static revenue loss, the biggest bang for the buck comes from the capital gains and dividend relief, followed by the corporate rate reduction and the elimination of the estate tax.

The specific features of Romney’s plan are here:

The following portions of the Romney tax plan were modeled, which are the specified tax rate cuts but not the unspecified base-broadeners (closing of various tax preferences, such as credits and deductions):

1. A 20 percent reduction in individual marginal income tax rates in all brackets.
2. Elimination of tax on capital gains and dividends for lower and middle income tax taxpayers. (The tax on these items was zeroed out in the bottom four brackets, which roughly match the income thresholds suggested in the Romney tax proposal. This somewhat overstates the tax relief for the fourth income tax bracket for single filers, but is very close to the thresholds in the Romney plan for married couples and heads of households. Due to time constraints, we did not model the proposal to eliminate tax on interest income in the same brackets.)
3. Elimination of the alternative minimum tax (AMT).
4. Reduction of the corporate income tax rate from 35 percent to 25 percent.
5. Elimination of the federal estate tax. (We kept the gift tax, as does the Romney plan, and retained the step-up in basis at death; ending step-up would reduce the effective tax cut on capital formation, dampen growth, and actually lose revenue compared to retaining step-up.)

Democrats have a great deal of trouble understanding the dynamic effects of taxes. They relied on static analysis when Reagan proposed tax cuts. They never accepted the Kemp-Roth concept of increased revenue from lower tax rates. They ridiculed the Laffer Curve concept.

The Romney tax plan would recover nearly 60 percent of the static projected revenue cost due to economic growth, higher wages and employment, and higher tax collections on the higher incomes. To keep the reform revenue neutral, the government would only need base-broadeners equal to about 40 percent of the static cost.[6]

People need to be aware that each dollar of federal spending costs them several dollars in lost wages and income from saving due to the economic damage from the taxes imposed. In the case of the Romney tax plan, each $1 of lost government revenue would raise incomes by nearly $8. Would the public be willing to trade a $1 reduction in government spending for an additional $8 in personal income? Some elements of the Romney plan yield even higher benefits to the public, raising incomes and employment with no cost, and some benefit, to the federal budget, and actually help to pay for the other tax reductions.

Democrats will fight this concept as they have in the past. One would hope that the effect would convince them but it did not convince them after Reagan. They pointed to deficits used to rebuild the US military after the Carter post-Vietnam draw down. Now, we are in a similar period where the military has immense deferred maintenance costs to replace equipment used in Iraq and Afghanistan.

The Romney tax plan is very nearly as powerful as the Kennedy tax cuts that were phased in between 1962 and 1965. The Romney plan is as strong in lowering the service price of capital, mainly due to its 10 percentage point cut in the corporate tax rate. The Kennedy cuts included a four point reduction in the corporate tax rate, a 7 percent investment tax credit, and faster depreciation write-offs. The Romney plan’s 20 percent across-the-board individual cuts are of the same pattern as the roughly 20 percent across-the-board Kennedy individual income tax rate cuts. The Kennedy tax cuts were not paid for with tax offsets (base broadeners) but were accompanied by some spending reductions. The economy surged following the Kennedy cuts, “broadening” the tax base through economic growth and employment gains, which is the best kind of base broadener there is. The federal deficit was significantly lower in 1965 ($1.4 billion) than in 1961 ($3.3 billion) before the tax cuts began to take effect.

This argument needs to be made, possibly by Paul Ryan next week.

What about the “loophole closures?” These have been ridiculed by such worthies as Paul Krugman, who sounds increasingly like a member of the Obama campaign and less like a Nobel Prize winning economist. OK, Here goes.

The TPC study (Quoted by the Democrats) insists on revenue neutrality rather than budget neutrality in its analysis of the Romney tax plan, and does its arithmetic on the assumption of a static economic baseline. It restricts its offsets to the cost of the reduction to base broadeners chosen from the Income Tax Expenditures list in the Federal Budget. If on a dynamic basis the necessary offsets are only 40 percent of the amounts assumed using the TPC static economic analysis, the job becomes much simpler.

For example, the largest tax expenditure, as of the 2008 budget, was the exclusion of employer provided health insurance and health care, estimated at $160 billion. The static revenue loss from the tax cut ($336 billion) is more than twice that amount. The dynamic revenue loss from the tax cut ($136 billion) is only 85 percent of that amount. If we capped the exclusion for upper income taxpayers to trim a fifth of the cost ($36 billion), it would pay for more than a quarter of the dynamic long term revenue loss.

This will be controversial but will be a part, no doubt, of further reform of US health care and how it is paid for.

One of the major subsidies to states in the tax code is the exclusion of tax on public purpose state and local bonds, amounting to $27 billion in 2008 and used mainly by upper income taxpayers. Eliminating that would cover nearly 20 percent of the dynamic revenue loss. Other tax expenditures considered by TPC, such as deductibility of state and local property taxes ($13 billion) and mortgage interest ($89 billion) on owner-occupied homes, and state and local income and sales taxes ($28 billion), all of which are currently limited by the AMT, might be capped. Taking a fifth of each, from the upper income, would provide $26 billion at 2008 levels, another 20 percent of the dynamic cost of the tax cuts.

The deduction of income from domestic production (often called the “manufacturers’ credit”) would probably be repealed as part of business and personal tax rate reductions. That is valued at $14 billion for 2008. However, that would dampen the expansion of capital formation by reducing returns to investment.

These items would cover about three-quarters of the long run dynamic cost of the Romney plan. As noted above, corporate welfare reductions could cover the remainder. We do not necessarily endorse these specific tax expenditure changes as our first preference and would prefer more spending restraint. We merely offer them as evidence that one does not need to attack the middle income tax expenditures, nor offset the middle income tax cuts, to pay for the Romney tax reductions.

Here are a few examples of the deductions that might be repealed. The home mortgage deduction will be fiercely defended by the real estate lobby but deduction of interest on high cost mortgages is harder to defend. It probably contributed significantly to the housing bubble. A cap on this deduction could, for example, exclude interest on amounts over $250,000 in mortgage total balance, including home equity loans. Cities and states will try to protect the deduction for bonds, state and municipal. All of this will have to be done with legislation and it will be a feeding frenzy of lobbyists. It was the same in 1986 and they later succeeded in revoking many of the 1986 reforms. Providing tax breaks for supporters is what politicians do. Depending on the next Congress and the influence of the TEA party, this may get accomplished by Romney and Ryan. If Obama should be re-elected, bankruptcy or its equivalent, will be the only option. Hyperinflation might be the specific form it would take.

Other effects of a Romney administration would be a surge in energy production, a steep reduction in regulation, including reining in the EPA, and modification of Dodd-Frank which has done nothing to end “too big to fail.” Romney mentioned this in the debate.