David R. Henderson  

Feldstein and Rosen on Romney Tax Cut

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I posted recently about Brad DeLong's correct criticism of a Wall Street Journal op/ed by Martin Feldstein. In the op/ed, Marty claimed that under reasonable assumptions, the 20% cut in marginal tax rates that Romney proposes would be revenue-neutral for two reasons: Romney would eliminate or limit many deductions for high-income people and many of these high-income people would make more income, creating offsetting revenue for the government. Feldstein's argument is reasonable but one key number was incorrect. As DeLong pointed out, Feldstein made the mistake of assuming that the additional income that high-income people made in response to the cut in their marginal tax rates would be taxed at their old higher marginal tax rates. This makes no sense.

I was disappointed, therefore, to see Marty's response. He writes:

While I still believe the assumptions that I used in my analysis, I can modify them as suggested by the critics and still support my original conclusion by broadening the tax base in ways suggested but not developed in my WSJ piece.

But why does he believe the specific assumption that I highlighted above? The closest he gets to answering is this:
One further point on the appropriate marginal tax rate (objection 1 above): although the top statutory rate is 35 percent, the effective top marginal tax rate is higher because of various phase-out provisions that affect high-income taxpayers (PEP, Pease, etc.) so my original assumption of a 30 percent marginal tax rate could be appropriate even with the Romney rate reductions.

Well, sure, it could be. But then Marty needs to be consistent. To phase out deductions as people's income goes up, the government implicitly makes marginal tax rates higher for people in the phaseout range. So, for example, if someone increasing his income from $100,000 to $120,000 loses $5,000 in deductions, his marginal tax rate is 25 percentage points higher than otherwise. Surely this would discourage people in that income range from making more income, just as the lower tax rates at the top encourage people to make more income. I have no idea how big an offset this is, but Marty probably does. This is his bread and butter. So his answer is unsatisfactory.

Princeton economist Harvey Rosen takes a better shot at answering the critics. The table at the end of his piece is informative. He shows that given what he thinks are reasonable assumptions about added income growth for high-income people due to lower marginal tax rates, the cuts in tax rates and reductions in deductions could be self-financing. So, for example, by assuming that the 20% cut in marginal tax rates induces high-income people to increase their income by 3%, he finds that the tax changes would increase the federal government's revenue. Here's one paragraph that sums up many of his findings:

Now let's sum things up. For the over $100,000 group, the reduction in revenue because of rate cuts is about $144 billion; the increase in revenue due to base broadening is $200 billion; and with a 3 percentage point growth assumption, the additional revenue from a rise in incomes is $25 billion. The net impact is a positive $81 billion. That is, under these assumptions, taxpayers with incomes of $100,000 or more would pay $81 billion more in taxes. The second row shows analogous computations for taxpayers with incomes of $200,000 or more. Again assuming a 3 percent growth rate, members of this group would pay about $29 billion (or 6.5 percent of current revenues) more in taxes. The implication is that $29 billion less of revenue from base broadening would be necessary in order to keep the taxes levied upon these high-income individuals about the same.

I would have ideally liked to see how Rosen came up with the 3% number. Here's my own back-of-the-envelope stab at it. The marginal tax rate for the highest-income people is roughly 43.9% (35% Federal + 2.9% Medicare + 6% state.) Cutting the highest rate by 20% would give a top rate of 36.9% (28% Federal + 2.9% Medicare + 6% state.) So the person's after-tax incentive to earn an extra $ rises from 56.1% (100% - 43.9%) to 63.1% (100% - 36.9%), an increase of 12.5%. It seems plausible that this would increase income by 3%. That would be an elasticity of about 0.24. The elasticity is probably lower that for men and higher than that for married women. So it could work.


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CATEGORIES: Tax Reform , Taxation



COMMENTS (13 to date)
Tom West writes:

That would be an elasticity of about 0.24.

Is there any evidence that elasticity is that high?

Pretty much everyone I know is already trying to maximize income within reasonable limits, so their elasticity is effectively zero through any reasonable variance of taxes.

At the incomes you're looking at, I suspect most people are salaried, which also reduces their elasticity since it means finding another good paying job.

I understand that cultures differ, but unless the Canadian marketplace is *much* different from the American, the only high elasticity I see is in the young hourly low-paid retail worker, who can often pick up hours if they feel like it and are sensitive to the the extra-dollars vs. leisure time trade-off.

I'd love to see a survey about how many people can tell you their marginal tax rate (and how accurate their observation is). I'd be surprised if more than 1 in 10 can name it accurately within 3-4 percentage points.

Matt C writes:

> Pretty much everyone I know is already trying to maximize income within reasonable limits,

Really? Not even close to true for me. Perhaps a different sense of what reasonable limits means.

> I understand that cultures differ, but unless the Canadian marketplace is *much* different from the American, the only high elasticity I see is in the young hourly low-paid retail worker, who can often pick up hours if they feel like it and are sensitive to the the extra-dollars vs. leisure time trade-off.

Plenty of blue collar guys have the option to take or leave overtime. A couple friends of mine are blue collar, they both decline/refuse overtime sometimes.

Temp workers and contract workers have quite a bit of flexibility in trading work for leisure.

Salaried workers, yeah, less flexibility, but hardly zero, especially over a longer run. People often switch jobs trading off pay for a more agreeable environment.

Steven Kopits writes:

This is a bit of a tempest in a tea pot for me.

For the government, there is spending, and there is revenue. Spending has to be covered by revenue eventually.

That revenue has to be paid in by the taxpayers using some allocative method. This will involve, in general, wealthier people paying a larger pro rata share.

The rest is largely detail. I can have a higher rate with more deductions, or a lower rate with fewer deductions. And the load can be more concentrated at the top or less concentrated at the top. But pretty much that's it. What matters to me in the dollar amount I must pay in taxes net, not any given credit or liability. And that in turn really depends on the spending level and deficit policy, not on tax revenue policy.

I have no idea why Romney got into this whole tax reform thing. The mortgage deduction is not going away, and a lot of the other deductions are not, either.

He should have remained minimalist, arguing that the difference between Obama and the Republicans is that the Republicans see spending at 20% of GDP and Obama at 22.5% of GDP (see his 2013 Budget, p 205). With Obama, taxes go to 19% and a larger budget deficit; with Romney it would be 18.5% and a much smaller deficit.

I would stated that the precise allocation of taxes would be a function of negotiations with Congress in the next term, but that the general themes would be:

- simplify the tax code where possible
- maintain progressivity all the way through (no kink at $250k)
- protect competitiveness of business

I would have left it at that.

Matt wrote;

Plenty of blue collar guys have the option to take or leave overtime. A couple friends of mine are blue collar, they both decline/refuse overtime sometimes.

I remember being told by a mailman, in the 1970s, that he refused overtime because, 'The government takes too much of it.'

At about the same time a small businessman told me that he was leery of expanding because, 'You don't get to keep much of it [profit].'

mark writes:

isn't the medicare rate going up to 3.8% for high earners next year? Or is the repeal of that assumed away in this scenario?

Andy writes:

I am salaried, but a large % of my income is based on performance (bonus, raise, etc.). By working more I could probably earn ~20% more than I do.

Tom West writes:

Interesting. I wonder if there are any solid numbers as to what proportion of workers could significantly (> 3%) increase their income short of drastic measures like moon-lighting, etc.

I'll admit I find it a bit hard to reconcile all this extra work waiting to be done (at presumably decent wages) with a persistently high unemployment rate, but that's based only on instinct.

KLO writes:

Most careers anymore are such that hours worked is not closely connected with pay across time. Given where you are in your career and where you want to go, you have to work a certain number of hours. You have no choice.

The same is true even of self-employed business people. You could put in fewer hours, perhaps, but often the difference in hours is not a difference in income, but rather it is a difference in success and failure. For a lot of people, they wouldn't simply make less money if they worked X minus 10 hours a week, they would make no money at all.

Sure, for overtime eligible government employees, pay is a function of hours worked and their career prospects probably do not much depend on number of hours worked. For most other workers, particularly professionals and business people, the same is not true. You work extra hours each day not so much to make more money, but rather to maintain or advance your career. The pay off, if there is any, is likely well into the future and may be largely non-monetary.

caltrek writes:

Eonomists should be wary of promises. It is fine to play around with hypothetical numbers, but let us not be too gullible. Case in point: "Romney would eliminate or limit many deductions for high-income people".

Right. In the real world, do you think this would actually happen?

I can just see Romney and company explaining themselves four years from now: "Well, we had intended to close tax loopholes, but that turned out to be more difficult than we expected. Too bad, so sad. Gosh darn it, I guess us rich folk will just have to continue to be able to take advantage of these loopholes."

David R. Henderson writes:

@caltrek,
Economists should be wary of promises. It is fine to play around with hypothetical numbers, but let us not be too gullible. Case in point: "Romney would eliminate or limit many deductions for high-income people".
Right. In the real world, do you think this would actually happen?

I completely agree. Notice--and I’m not saying you didn’t--that the person who was gullible with the line you quoted above was not I, but Marty Feldstein.

Alan Reynolds writes:

I survey the elasticity evidence in pages 21-31 of a new working paper, "The Misuse of Top 1 Percent Income Shares As a Measure of Inequality."

The vast majority of studies find an elasticity of taxable income near 0.40 for all taxpayers (0.25 is a modal average, not a median or mean), but closer to 1.0 for the top 1 percent. They all exclude capital gains, where realization elasticity is close to unity. A new University of Kentucky paper by S.K. Burns and J.P. Zilak finds
"significant work disincentive effects of taxation" and "estimates of the ETI in the range of 0.4-0.7"

SCK writes:

I make about 260k base and another 75k for working a night session for a trading firm.

If tax rates go up for me I'm not sure if I will work night session. I don't like working it as is, and if government takes more of pay it will move me over the edge.

Ken P writes:

Capping total deductions is actually a slick way to reduce the mortgage deduction.

Removing incentives that encourages people to make deduction focused expenditures instead of aligning them with their own self-interest is a good thing. Also, encouraging people to buy as big a house with as little down as possible to maximize the deduction was a bad policy.

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