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The · Psychohistorian


Tax cuts and revenues - do Romney's numbers add up?

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Mitt Romney has stated that his proposed tax cut would be revenue neutral, in part because it would help restore a healthy economy. He's taking credit for the increase in tax revenue from that additional economic activity to help offset his decreases in tax rates. The rest of the tax rate cut will be made up through closing loopholes, primarily on upper income taxpayers.

While Romney has not yet made his full calculations public, he has now made public enough information to make a reasonable approximation to his calculations, at least with respect to personal income taxes. The question is, do the numbers work out?

To address this question, let's lay out the information Romney has made public:

1. All earned income tax rates will be cut by 20% - one fifth. The 35% bracket will become a 28% bracket, the 10% bracket will become an 8% bracket, etc. Capital gains would continue to be taxed at 14% - except that for incomes below $200,000, there would be no taxes on capital gains, dividends, or interest.

2. 12 million new jobs will be created over the next 4 years. Since this is an assumption, we'll examine the reasonableness of this assumption before using it.

3. Personal income tax deductions will be capped - numbers for the cap range from $17,000 to $50,000 - and the deductions would be phased out for higher income taxpayers.

Now, we're going to make some simplifying assumptions.

a. Because capital gains, dividends, and interest income are generally minimal for those with incomes below $200,000, we're going to ignore the effect of removing those taxes on that income.

b. Because Romney has not said where the deductions would be phased out, we're going to ignore the phaseout and assume that the capped amount of deductions can be taken by anyone.

Now, on to the calculations.

First, let's look at the tax cuts. Tax rates on earned income, which accounts for about 90% of tax revenues, would be cut by 20%. Tax rates on capital gains, accounting for the other 10% of tax revenues, would not be cut. The net tax rate cut would be 90% x 20% = 18%.

To compensate for the reduced tax rate and keep revenues constant, the tax base must be increased. Specifically, the tax base will need to be increased by 22% to bring us back to 100% of revenues:

(1 - 0.18) x (1 + 0.22) = 100.

Now, let's go to the first element of increasing the tax base - the number of additional jobs. The estimate of 12 million new jobs over 4 years - 250,000 per month - is what forecasting firms estimate ought to be happening in a normal healthy recovery today. It would bring us to an employment to population ratio of 0.477 at the end of 2016. Since this is almost a full percentage point below the peak employment to population ratio of about .485 in 2007, this seems like a more than reasonable estimate of new job creation under an improved tax regime.

The tax cut doesn't get full credit for all those additional jobs, though. Since the end of the recession, jobs have been created at approximately what's needed to keep up with population growth. That's 4.5 million jobs over the next four years - coincidentally equal to Obama's job creation claim for his term, measured since the bottom of the recession. The Romney tax cut only gets credit for additional jobs beyond that number - 7.5 million additional jobs over 4 years. That's 5% more jobs than would exist without the tax cut.

In addition to the increase in jobs, the tax cut should result in increased hours worked and increased wages. Romney hasn't given a number for this, but over the past 4 years, median real income has dropped by 8%. It's reasonable to expect that, with the Romney tax cuts, real income will recover by at least that amount, to the levels at which it was largely steady for the decade before the 2008 recession.

To avoid making the calculations too complex, we'll ignore the fact that income gains come at the marginal tax rate and push some people into higher tax brackets, and assume that the tax revenue gain is proportional to the income gain. Note that this is quite a conservative assumption; typically, the marginal tax rate on additional income is much more than the average tax rate, often twice as much. We'll come back to this at the end of the analysis.

The combined effect of the increased employment and the real income restoration is an increase in the tax base by a ratio of 1.05 / 0.92 = 1.14, or a 14% increase. Since we're looking for a 22% increase in the tax base, this means that we'll also have to increase the taxable proportion of income by 7%, based on the following equation:

(1.14) * (1.07) = 1.22

It now remains to figure out whether this 7% increase is achievable with a capping of deductions in the $17,000 - $50,000 range. I've put together a spreadsheet to figure this out. The short story is, this can be achieved by capping itemized deductions at $24,000, assuming tax bracket distributions from 2007:

                            Taxable  Taxable  Taxable
         Fraction            income   income   income     Tax
Income    of tax   Average  without   with    percent   percent
bracket   revenue   income    cap      cap    increase  increase

Top 0.1%   0.202   4423000  3896000  4399000    12.9      2.6

rest of
top 1%     0.202    575000   488000   551000    12.9      2.6

2nd %      0.083    280000   232000   256000    10.3      0.9

3rd %      0.051    214000   175000   190000     8.6      0.4

4th %      0.038    182000   148000   158000     6.7      0.3

5th %      0.031    162000   131000   138000     5.3      0.2

rest of
top 10%    0.107    130000   104000   106000     1.9      0.2

Total increase in taxable proportion of income             7
(some numbers may not multiply due to rounding)

If we accounted for the fact that recovery of the 8% decline in income would result in recovery of much more than 8% in tax revenue, as mentioned in the discussion above, the deduction cap would be substantially higher.

My bet is that Romney has accounted for that factor. And to take the speculation a bit further, I suspect that the $25,000 and $50,000 numbers he mentioned in the first debate are caps on the total of itemized deductions and personal exemptions for single and married filers respectively - and the $17,000 number is the cap on itemized deductions but not personal exemptions for single filers. That's certainly the ballpark I'd expect to be in if we accounted for the marginal effect of the income recovery properly.

The bottom line is, yes, Romney's numbers do work out, with quite reasonable assumptions, and we can expect him to be able to cut taxes as claimed without reducing tax revenues.

Source for tax revenue and income information:
http://www.irs.gov/pub/irs-soi/09in05tr.xls
Source for tax deduction information:
http://www.forbes.com/sites/baldwin/2011/04/16/are-you-getting-enough-in-tax-deductions/2/
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On October 17th, 2012 07:58 pm (UTC), bakedweasels commented:
Not sure I can agree with this analysis. Couple of points:

1. Laying out a target 4 years out to say, "We'll be revenue-neutral THEN" creates a false comparison, doesn't it? That's ignoring the fact that between then and now there will be a shortfall. It's also ignoring the fact that the current tax regime will be bringing far MORE tax revenue in 4 years. So it's disingenuous--I could craft a tax plan that would be revenue neutral in 2062 and that would look great!

2. I don't buy the idea that 7.5mm extra jobs will be created by Mitt's plan. Is that borne out by anything other than intuition? I can accept the "normal" trajectory and the current trajectory, but as you say why should they get any credit for anything that is relatively normal? So I'd need to see a lot more evidence that tax cuts = jobs before being willing to expand the tax base and attribute it to the tax cuts.

3. Is it fair to assume that new jobs created are equally spread across the job distribution spectrum? I'd guess without knowing that they'd be aggregated at the bottom end of the income curve, and therefore far less accretive for tax purposes on a pro rata basis than the current universe of US jobs.

So...I don't think the numbers DO add up, or perhaps I should say that I think that to the extent they DO, it's because of a series of assumptions under which the existing tax regime would be significantly revenue POSITIVE, and which I wouldn't be willing to attribute as benefits of the Romney plan which wouldn't exist otherwise.

Doesn't mean it's a bad plan, just that I don't agree with the argument.

Edited at 2012-10-17 07:58 pm (UTC)
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On October 17th, 2012 10:14 pm (UTC), psychohist replied:
Your point 1 in my opinion has some validity. There will be a shortfall in the first few years. However, it will be small compared to the current deficit, and will go away rather rapidly; it will probably be about a half trillion one time shortfall.

Regarding your point 2, there's plenty of evidence of job increases after tax cuts - as one example, I've posted a graph showing the effect of the Reagan tax cuts below. There were similar effects after the Kennedy and Bush tax cuts. There are also theoretical reasons to believe this will happen - see my previous post on supply side economics 101 for an explanation.

That said, I do personally think part of the reason the current trajectory is so poor is because of other suppressive policies such as Obamacare and greatly extended unemployment benefits. Of course, Romney is likely to get rid of those, too. I strongly suspect the result will be considerably more than 12 million jobs created - if he manages to get rid of the policies suppressing jobs, and also cuts tax rates, we should see the employment to population ratio a point or two above, rather than a point below, the 2007 peak.

As for your point 3, given the marginal tax rates are cut across the spectrum, yes, I think it's reasonable to assume that the new jobs will also be spread across the spectrum.

Finally, I am not ignoring the fact that the current regime will be bringing in more revenue in 4 years; that's why I subtracted current job growth rates from the 12 million projected increase under Romney. The 5.5 million additional jobs under the current plan will result in growth under the current regime and under Romney's plan; the 7.5 million more additional jobs will make up for the tax rate cut and will keep revenues at that time as high as they would be then under the current regime.

Edited at 2012-10-17 10:18 pm (UTC)
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On October 17th, 2012 09:53 pm (UTC), psychohist commented:
For those who are skeptical of the "12 million jobs" claim, here's a graph that shows it can be done. The approximately 10% increase in jobs in two years of recovery from the 1981 recession would equate to over 14 million jobs today.


http://www.heritage.org/research/reports/2010/09/~/media/Images/Reports/2010/wm3000_chart2.ashx?w=500&h=631&as=1
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On October 18th, 2012 04:38 am (UTC), izmirian commented:
You know in my mind I separate Romney's plan into two different aspects, one of which pretty clearly makes sense and the other is less clear. On the plus side is his proposal to cap deductions in exchange for reducing the nominal tax rates. It'll reduce the economic distortions and improve overall efficiency. I think it'll also tend to make the income tax more progressive which I consider a good thing. I think a lot of people could get behind that.

The other part of the plan is to reduce the overall tax collection rate on the theory that the economy will grow, eventually bringing the total revenue collected back up to the original rate. I've seen lots of arguments on both sides of this and it will be a lot harder to get a consensus on that part.
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On November 6th, 2012 07:58 am (UTC), (Anonymous) commented:
Martin J Potter
Much informative and useful article… I like it personally…
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