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

Friday, November 2, 2012

Here’s a clarification of the concepts behind the Romney-Ryan proposal for tax reform.

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.” Alex Brill discusses “The Romney Tax Plan: Not a Tax Hike on the Middle Class.” Kevin Hassett explains that the “Laffer Curve Pays Billions If Obama Just Asks.”

Image by Dianna Ingram / Bergman Group

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