Romney’s Tax Plan: Bad Math and Terrible Economics

There is a lot of talk this election cycle about the Romney tax plan. Is it a huge unpaid-for tax cut skewed to the wealthy that must either blow up the deficit or necessitate an as-yet unspecified tax increase on the middle class, or is it a revenue neutral simplification of the tax code that will encourage growth and prosperity. Do the numbers simply fail to add up, or is it a well crafted vision for a different type of relationship between the individual and government. One side says one thing, the other side says the other. They both say they have studies to support their views, so what is the average voter to do?

I've been teaching math my entire life, and one thing I've learned is that ordinary people are capable of understanding even very complicated ideas if they are explained in simple terms that make sense. The Romney tax plan should be no exception, so let's take a look at it.

It's available for anybody who's interested to see at: http://www.mittromney.com/issues/tax

There are five bullet points about individual taxes:

1)  Make permanent, across-the-board 20 percent cut in marginal rates

2)  Maintain current tax rates on interest, dividends, and capital gains

3)  Eliminate taxes for taxpayers with AGI below $200,000 on interest, dividends, and capital gains

4)  Eliminate the Death Tax

5)  Repeal the Alternative Minimum Tax (AMT)

And there are four bullet points for corporate taxes:

A)  Cut the corporate rate to 25 percent

B)  Strengthen and make permanent the R&D tax credit

C)  Switch to a territorial tax system

D)  Repeal the corporate Alternative Minimum Tax (AMT)

On the face of it, the idea that this plan is revenue neutral is absurd: every single bullet point is a tax cut (apart from (2) which represents no change). Moreover, it is clearly skewed to the wealthy: The headline item (1) gives a tax cut of 7 percentage points, from 35% to 28%, on the margin to someone currently in the top federal tax bracket of $380,000 per year and above. On the other hand for someone making just $30,000 per year the tax cut on the margin is just 3 percentage points, from 15% down to 12%. In terms of dollar amounts the difference would be even larger.

However the republican argument goes like this: when you have lower taxes, that causes higher growth, because people are more incentivized to work. That higher growth causes tax revenues to go up, which can in turn be used to reduce the deficit, pay for services, and in general benefit everyone.

There is certainly some merit in this argument. There is a point above which tax increases lead to lower revenue, and the relationship between taxation and revenue is something economists refer to as the Laffer Curve.

So what about the Romney plan? Can high-growth alone pay for a tax cut on the scale of the Romney plan?

To answer this we need to understand the answer to this question: Why is it that higher rates of growth tend to cause an increase in tax revenue? The main reason is that times of high growth tend to also be times of low unemployment. With higher rates of economic activity you have fewer people unemployed, you have more people in work paying taxes, and fewer people living on social security.

And now we're into the math: the current unemployment rate is 7.8%. When there's `full-employment' you typically want to see 2 to 3 percent unemployment, because otherwise you get inflation.

(That is an interesting economic phenomenon, and the real reasons are quite complicated. But very roughly, and just for intuition, imagine that there were no unemployed people in the workforce and you wanted to hire a worker. There would be no unemployed people looking for work, so you'd have to tempt somebody away from a job they already had with a higher salary, leading to increased wages and increased prices.)

So let's suppose that we were to move from the current 7.8% unemployment to `full-employment' at 2.8%. That would mean the number of people in work going up by about 5%, meaning you have about 5% more people paying taxes, and similarly fewer people living on social security.

So it figures that if, by magic, we were to go from the current 7.8% unemployment to `high growth' full-employment, that would lead to an increase in income tax revenue of, at best, about 5 to 10 percent, assuming current income tax rates.

That is clearly not a big enough increase to pay for an across the board tax cut of 20%. It's not even half way there.

And that doesn't even take into account the other tax cuts in the Romney plan. And it doesn't take into account that in reality unemployed people tend to be lower income people who pay less taxes than the average worker, meaning that a five percent increase in the number of people working would give less than a five percent increase in income tax revenue.

As if that wasn't convincing enough, there are also historical case studies. Previous republican administrations have used the low-taxes/high-growth pitch before, most notably Ronald Reagan. Look at this chart of federal debt as a percentage of GDP:

Publicly Held Federal Debt 1790-2009Publicly Held Federal Debt 1790-2009

Note how debt as a percentage of GDP had been falling steadily form the end of World War 2 until about 1980. Even during the much maligned Carter administration, and despite the 1979 energy-crisis, federal debt as a percentage of GDP fell slightly. But under Reagan-Bush, federal debt went from 33% of GDP in 1980 to 56% of GDP in 1990. It's true that there were low taxes and high growth for most of this time, but the increase in revenue caused by the high growth was not enough to offset the revenue lost by the low tax rates. That's why the federal government had to borrow money to cover the shortfall, increasing the national debt in the process.

So the math and the history both say the same thing: lower taxes can help stimulate higher growth and lower unemployment, but a tax cut on the scale of the Romney plan can't possibly cause enough growth to offset the loss in revenue caused by the lower tax rates.

So when Romney says, as he did in the first debate, "What I’ve said is I won’t put in place a tax cut that adds to the deficit" it is a simple and bald lie, in the absence of other tax increases that are not listed on his website. But there is no point in the other side just saying that it's a lie, because too many people think all politicians are dishonest. Instead they need to go into the numbers and explain them. They need to have more faith in the intrinsic mathematical ability of the American people.

This article was originally published on Fair Observer on October 15th, 2012.