NR Digital

Tax Talk

by Ramesh Ponnuru

What Candidate Romney has said, and what a President Romney should do

For much of the fall campaign, the major domestic-policy debate between the presidential candidates has concerned taxes. In that debate Obama has taken a position he probably does not believe, and Romney has defended a plan he probably won’t enact if he wins. Congress should go in a different direction from either candidate.

Romney has set forth many of the right goals for tax reform: He wants a tax code that is simpler and more pro-growth, with fewer deductions and lower rates, than the one we have now. Toward those ends he would cut all income-tax rates by 20 percent, cut the corporate-tax rate, eliminate the alternative minimum tax and the estate tax, and end taxes on investment income for everyone making less than $200,000 a year. He says he would scale back enough tax breaks that the new tax code would raise as much money, and as much money from people making more than $250,000, as the old one does.

Those final promises have been the subject of most of the debate, with critics saying that there aren’t enough deductions available to make them come true. Whether or not his plan is mathematically impossible, as they assert, it may not be legislatively possible. If Republicans take the Senate at all, they will do so narrowly — and Democrats seem less inclined to compromise on taxes than they were when a closely divided Senate approved George W. Bush’s tax cuts in 2001 and 2003. Republican voters nowadays seem less enthusiastic about tax cuts, too: Spending, the debt, and Obamacare are the topics of conservative conversation. The expiration of the Bush tax cuts at the end of this year also reduces the likelihood that Romney will deliver additional tax cuts: He will be hard pressed just to keep taxes from rising.

Conservatives should not be very disappointed that Romney’s tax plan seems unlikely to pass, because it isn’t a well-designed plan. The critics are right to say that there is no good reason for a plan to specify the tax rates and revenue levels for which it aims but not the tax breaks it would pare back. Nor is it urgent to reduce the top tax rate. Good supply-siders always want to make the top tax rate as low as possible, so as to improve incentives to work, save, and invest. Today’s top rate of 35 percent is, however, relatively low: For only five of the last 80 years has it been lower.

When Ronald Reagan cut the top tax rate from 70 to 50 percent, he increased the after-tax return on a dollar earned from 30 to 50 cents, or 67 percent. Cutting the top tax rate from 35 to 28 percent, as Romney proposes, would increase that return by only 11 percent. Cutting the bottom tax rates delivers even less economic gain. Taking the 10 percent tax rate to 8 percent increases incentives by 2 percent. As our tax code is structured, everyone passes through the bottom tax brackets before getting to the higher ones. So most people will get a bit of extra money from the reduction of the 10 percent rate — and tax revenue will correspondingly take a hit — but they will not see their incentives improve at all.

Cutting taxes on investment returns for people making less than $200,000 sounds like a nice way to promote saving and help the middle class, but it’s not very effective at either. People above that threshold are, not surprisingly, responsible for a disproportionate share of national saving. They should not be excluded if the goal is to increase it. Since taxes on returns to saving aren’t a major budget item for most middle-class households, their reduction also won’t do much to help them.

If you were designing an ideal tax code from scratch, you wouldn’t include the alternative minimum tax. Congress passed it out of concern that a small number of wealthy taxpayers were using tax breaks to pay nothing, or almost nothing, to the government. Instead of curtailing the breaks, they made these taxpayers calculate their liability under a second set of rules and pay whichever was higher. Over the years this second tax code has affected more and more people — and it would affect millions more if Congress didn’t regularly enact temporary “patches” to limit its reach. Repealing the AMT would mean a very large reduction in federal revenues, though, leaving less money available for deficit reduction or other tax cuts. Given the existence of other priorities, the AMT should probably be scaled back but not repealed.

Notwithstanding the imperfections of his plan, Romney is certainly right to think that the tax code could use substantial improvement. It is needlessly complicated, and its complexity adds to compliance costs. It damages the economy much more than necessary to raise the revenue it does. It privileges consumption today over consumption tomorrow. It shortchanges parents, who have to pay just as much in taxes as childless people even though the costs they incur in raising children are an additional contribution to the future of entitlement programs. A tax code free of all these distortions is not achievable, but considerable progress against them ought to be.

Given today’s deficits, it makes sense to set the goal that a new code should raise at least as much revenue as the current one; and it is prudent not to count on heroic assumptions about the effects of tax reform on economic growth to meet that goal. In these respects Romney’s approach makes sense. Within those constraints, though, Romney went about designing a reform backwards. It makes more sense first to think through what should and can be done about tax breaks and only then to determine what tax rates, applied to a reformed tax base, will meet the revenue target.

Some of the largest tax breaks are politically invulnerable, and some of them ought to be left alone on the merits, or even expanded. The deduction for charitable donations isn’t going to be eliminated or significantly scaled back. Most economists dislike the mortgage-interest deduction, but it too is staying — although it would be worthwhile trying to trim it on the margins. Second homes shouldn’t be deductible, and inflation should be allowed to shrink the maximum mortgage amount deductible over time.

Employee health benefits aren’t taxed, which is a historical accident arising from the use of those benefits to evade wage controls during World War II. Phasing out the tax break for health insurance is politically unthinkable, but it ought to be restructured. Right now the value of the tax break rises the more expensive the health-insurance policy is. The value should be flattened so as to encourage economy. Someone who chooses a policy that is more expensive than the size of the tax break should pay the full difference, and someone who chooses a cheaper one should pocket the full savings.

We ought also to move toward parity between people who buy insurance on their own (who don’t get a tax break now) and people who get it through their employer. Moving all at once to parity would be disruptive. The market would move rapidly away from employer provision of insurance, and many people who like their current plans would lose them. We should, however, at least allow people who lack access to employer coverage to receive the tax break for insurance they purchase themselves. That move would reduce the number of people who lack insurance and allow a market in individually bought insurance to grow after decades of being stunted by federal tax law.

Two other sets of tax breaks should be expanded: those for saving and those for raising children. Properly viewed, in fact, these aren’t tax breaks at all, in the sense of deviations from an ideal tax base. Romney, like most Republicans who think about these matters, sees this when it comes to capital accumulation. He wants to reduce taxes on capital because he sees those taxes, rightly, as a governmental thumb on the scales against saving. The only way for the government to be neutral between consumption and saving is to refrain from taxing the returns to saving at all. It should also, however, be neutral among investments. There is a good case for exempting all interest from taxation; there is no good case for granting a special exemption from taxation for interest on municipal bonds.

The child credit is often seen as a sop to a large interest group, namely parents. The popularity of the credit is not, however, an argument against it. The credit is a tiny corrective to the entitlement state’s bias against child-rearing. It ought to be expanded. The expanded credit should be applied against both income taxes and payroll taxes, both because most middle-class parents pay more in payroll than in income taxes and because both sets of taxes support entitlement programs.

The deduction for state and local taxes should, ideally, be ended. It is a subsidy from low-tax states, some of them poor, to high-tax states, some of them rich. Conservatives and libertarians ought to dislike it because it leads to larger state and local governments than we would otherwise have. High-tax states beat back a Reagan-administration proposal to end this deduction as part of the 1986 tax reform, but it is worth another try, especially since Republicans are now less likely to represent high-tax jurisdictions than they were then.

As a fallback position, tax reform should cap the amount of state and local taxes that can be deducted from federal taxes. That step would increase the sensitivity of high earners to state and local taxes, and thus increase states’ and localities’ competition for those taxpayers. Democrats might object to these effects, but in doing so would have to suffer the cognitive dissonance of standing for lower taxes on high earners. Kevin A. Hassett, an economist at the American Enterprise Institute and a contributing editor of NR, has pointed out that with a smaller deduction, a lot of people in high-tax jurisdictions would also come off the rolls of the alternative minimum tax. So they would not take as big a hit as you might think they would, and paying taxes would become less of a hassle for them too. Cutting the deduction for state and local taxes is a way to limit the AMT’s reach while actually raising money for the federal government.

The net effect of these changes to the tax base is, however, likely to be a reduction in the government’s revenue take: Among the big tax breaks, those for saving and child-rearing would expand while only the state-and-local-tax deduction would shrink much. That result would seem to suggest that to meet the goal of raising as much revenue as today’s code, tax reform would have to raise tax rates.

There is, fortunately, an alternative, albeit one that a lot of people have a hard time seeing. Romney has confused many people by saying he wants to cut tax rates on rich people without cutting the taxes they pay. The distinction they miss is between average tax rates and marginal tax rates. Romney wants to reduce marginal tax rates on everyone by 20 percent. The federal government would take 28 cents of the next dollar a rich person earns under his plan, rather than 35 cents. The idea, though, is that average tax rates — total taxes paid divided by income — wouldn’t fall for rich people, or people in general. Cutting marginal tax rates would bring average tax rates down, but scaling back tax breaks would bring them right back up.

A change in the tax code that improves incentives to work, save, and invest but continues to raise the same amount of money is an improvement in the code’s efficiency. That’s what Romney wants to do. There’s a way to do it besides cutting tax breaks, and that’s to lower the threshold of income at which the top tax rate (or rates) applies.

Instead of raising the millionaire’s tax rate to be higher than 35 percent, that is, you would increase the percentage of his income that is subject to that 35 percent rate. The rate could kick in after someone makes $288,000 in taxable income, for example, instead of after today’s $388,000. That change wouldn’t decrease his incentive to make more, but it would generate more revenue for the federal government.

The people making between $288,000 and $388,000 would, in this example, face slightly worse marginal tax rates than they do now. It’s the top tax rate that matters most, though, for two reasons. First, it’s the highest rate, and the deadweight economic loss of the income tax rises with the square of the rate. Second, only the top rate raises all of its revenue as a marginal tax rate. The vast majority of the money that the 10 percent tax rate raises, for example, comes from people who are passing through the 10 percent bracket on their way to higher ones. A sufficiently aggressive threshold-reduction strategy can not only obviate any need to raise the top rate: It can even make it possible to reduce it. A larger number of people would be paying a lower top rate, just as the flat tax envisions.

This strategy differs from the flat tax in being compatible with a much higher degree of tax progressivity. Conservatives will like it less on that account, but should also recognize its greater political feasibility. How liberals would react to it is an open question, one that turns on what kind of progressivity they value.

It would be easy to design a plan along these lines that increases the proportion of taxes paid by the highest-earning 10 percent of Americans — those in households making more than $140,000 a year — and decreases the proportion paid by everyone else. Lower thresholds and a capped state-and-local-tax deduction would raise the first proportion; a bigger child credit would lower the second. In recent years, though, some liberals have had a different kind of progressivity in mind: They want to increase the tax rate on the top 1 percent (those in households making more than $500,000 a year) relative to the people in percentiles 90 through 99.

To achieve that goal would require higher marginal tax rates at the top, because it requires taxing the 501,000th dollar of income more steeply than the 250,000th. Some people who are affluent but not super-rich seem to feel keenly that tax policy should distinguish between these two groups. To most people, though, those who make $200,000 a year are rich, and fairness among rich people isn’t a high priority.

If Romney should win, this kind of tax reform — reducing distortions in the tax code, including the bias against investment and children — seems more promising than an across-the-board reduction in tax rates, which is an approach well-suited to the circumstances of 1980, in which it was first tried, rather than to those of today. Both types of plan have elements that could cause budgetary heartburn: An expanded child credit, like cutting all tax rates, would sharply reduce federal revenue. The credit would almost surely be more popular because it does more to help middle-class families, however, and would also do more to rectify a problem with the tax code.

The challenges for conservative tax reformers will be rather different, of course, should Obama win reelection. He claims to want to keep the Bush tax rates on middle-income Americans while letting the rates on high earners revert to the higher levels of the Clinton years. What he truly wants to do, it can be surmised, is to let all of the tax rates revert to those higher levels while blaming the middle-class tax hike on the Republicans. In this scenario, all the tax cuts would expire, Republicans would insist that all the tax cuts be extended, Democrats would block that solution, and then Democrats would succeed in blaming the middle-class tax increase on Republicans’ intransigent defense of the rich.

If Democrats try this maneuver, the Republicans might well decide just to fight it out and see who wins. It may be that voters will blame a tax hike under a Democratic president on that president’s party, especially since they know it’s the party that likes tax hikes the most. It wouldn’t hurt, though, if Republicans had an attractive counteroffer. Expanding the child credit, keeping marginal tax rates low, and still raising current levels of revenue would qualify.

The main obstacle to this sort of tax reform, in fact, may be that it requires a bit more creative thinking than the people around the presidential candidates have mustered.

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