Garett Jones  

Josh Barro, Progressive Taxation, and Public Choice

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Josh Barro today claimed that the Romney tax plan can't work. 

The Romney plan is simple to summarize: Cut income tax rates across the board, then end enough deductions and exclusions (informally, "loopholes") to make it revenue neutral.  Plus, the Romney plan is to keep the system at least as progressive as it is today--so the overall tax bill paid by those earning over $200K per year wouldn't change.  

The Barro claim is that it's impossible to cut taxes on those earning over $200K per year, make up for it by eliminating deductions and exclusions from that same group, and have the minus and plus sides balance.  

The reason?  High earners just don't use enough deductions and exclusions: Even if you took away all their home interest deductions, the benefits of deductible health insurance, their child tax credits, and all the rest, it's not enough to make up for a big cut in income tax rates for the top earners.  Somebody else would have to chip in.  

I won't try to adjudicate this claim--far be it from me to judge IRS data--though I confess I do like Barro's arithmetic. Also, note David's useful post on the debate over the Romney tax plan.  

This post is about something quite different.  

Here's what this post is about: If Barro is right, the rich are not buying themselves a disproportionate share of tax loopholes.  

My inner public choice scholar wonders, "If Barro is right, why aren't the rich getting a better deal from the U.S. government? What does this tell me about the ability of elites to control U.S. politics?" 

Barro's post is also another reminder that the U.S. tax system, taken together, is highly progressive by modern standards.  Maybe that's partly because American elites have nowhere else to go.  

So if the Romney plan doesn't add up, then some people should change their views on progressive taxation and elite control of U.S. politics.  Note that I'm not saying they will

Update: Here's my favorite part of Barro's math: For the over-$200K crowd, taxable income is 82% of adjusted gross income (AGI).  AGI is only a rough measure of income (aren't they all?), but this group is paying tax on the vast majority of this income.  

For the under-$200K crowd, taxable income is only 55% of AGI.  This second group is almost halfway to being lucky duckies, with no taxable income at all.  

The excellent Harvey Rosen offers a look at how Romney's tax plan could work (PDF): I like his arithmetic too!  

Rosen shows how it could work by scaling back deductions that are well outside the deductions included in Barro's measure.  The Rosen proposal (which you should consider illustrative only--it's not a Romney campaign document) would be a massive base-broadening, a massive rise in AGI.  It gives a sense of what would have to happen to make it all go.  Economics aside, the public choice implications of reducing tax preferences for life insurance are well worth reflecting upon.  

Perhaps the Governor would win a battle for a massive base-broadening. As of this writing, Intrade says there's a 39% probability that he'll get to try.  


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COMMENTS (14 to date)
kurt writes:

I thought Romney's defense is simply Laffer curve arithmetic. Lower tax rates, get more people employed, more people paying taxes, thus revenue neutral over the long run. Using current taxation figures - as Barro does - suggests a static economy.

Kevin writes:

Barro's use of percentages compared to percentages is a red flag for me that he either is misled or misleading. Particularly worrisome is that he does not acknowledge that a deduction/exemption is "worth" more at the top bracket. The top 2.8% had 26% of the income but only 18% of the deductions? So what? What is their marginal rate compared to the other 98%? Put another way, is the actual tax effect of these deductions greater or less than 26% of the total of all deductions? And why is that comparison relevant anyway? Barro skips all this.

Maybe Bloomberg put a limit on the length of Barro's piece, but this reads a lot like a politician's carefully selected out-of-context "evidence" of fiscal responsibility/irresponsibility. Not a very informative piece at all.

David R. Henderson writes:

@Garett,
I'm not sure why you like Josh's arithmetic. He doesn't give any.

Garett Jones writes:

@David and Kevin:

The numbers are right there, I think: for the over $200K folks, AGI is pretty close to taxable income. For other folks, taxable income is ~55% of AGI.

That's the math that matters, if I understand correctly: AGI versus TI.

AGI isn't a perfect measure, and it could be awful in important ways, but it's better than gross income (which would be close to a measure of total revenues, at least for businesses).

Methinks writes:

I wouldn't be so sure about the "nowhere else to go" statement. I can think of quite a few places, actually. Technology is making it ever easier to produce from anywhere in the world and growing economic freedom in other parts of the world is making other countries more attractive relative to the U.S.

The already rich have nothing to worry about. They can easily adjust their incomes and the amount they work to reduce the tax burden. I think businesses aren't leaving in large numbers because the all-in cost of staying has been lower than the cost of leaving. With the U.S. slipping in the economic freedom ranking, I don't expect that to remain the case.

My husband and I immigrated here only for the freedom and economic opportunity. If America turns into a more despotic version of Europe (the direction it seems to be headed in), we'd rather live somewhere with better food. We can run our business from anywhere in the world.

MichaelM writes:

The 'deduction' the wealthy in the US benefit from the most, I thought, was the difference between the top bracket of individual income taxes and individual capital gains taxes.

Chris Koresko writes:

Barro: "That’s why Romney can't find enough tax preferences to offset his across-the- board rate cut -- unless he raises taxes on earners making under $200,000."

Barro's conclusion sounds consistent with that of the Tax Policy Center, but inconsistent with the calculations of Rosen and (I think) Feldstein. If I understand this correctly, the reason for the discrepancy is that Barro and the TPC do not account for what Rosen calls “the macro-dynamic behavioral effects of the Romney proposal, that is, the effects on the size of the economy.”

It's pretty well known that the taxable income of high earners is disproportionately sensitive to both the tax rates and to the health of the economy, so it's at least plausible that if the Romney plan achieves its principal goal of boosting growth then it should also tend to increase the proportion of income taxes paid by the top earners. That would tend to compensate – perhaps overcompensate – any shortfall due to the smaller share of income deducted by those high earners.

But suppose Barro is right and that there aren't enough reducible deductions at the top end to keep the average tax rate as progressive as it currently is, given a 20% marginal rate cut. How does that lead to the idea that earners in the lower brackets need to have their taxes raised? In other words, why does Barro think that the 20% MTR cut is sacrosanct to Romney while the progressivity is not?

Finally, isn't it fair to ask whether tax progressivity should be sacrosanct to Americans in general, especially if it comes at the expense of overall prosperity?

Garett Jones writes:

@Chris:

Much turns on whether the temporary tax cuts expire at the end of this year.

Case 1: Romney's tax cut is compared to the 2012 Obama/Bush tax baseline:

In Rosen's estimate, you don't even need to assume behavioral responses to make up the lost revenue from the tax cut---but you do have to take on municipal bond interest, tax preferences for life insurance companies (including annuities), and much else. Rosen's plan is to increase taxable income largely (maybe mostly?) by increasing AGI.

Case 2: Obama/Bush tax cuts expire (2013 law as baseline).

I think this is in context, from the Rosen paper:

"[U]nder the Romney proposal, maintaining an approximately constant tax burden on high income individuals would be more challenging. But I imagine that doing so would not be mathematically impossible."

Doug writes:

@MichaelM

A lower capital gains tax rate isn't a deduction on earned income. The vast majority of capital gains is simply return on investment from a capital base originally earned from labor income.* E.g. a doctor invests his money in the stock market, then retires 30 years later.

Savings is just a way to consume goods in the future instead of the present. If you earn $1 today you can buy $1 worth of goods today or an expected $1+(return on investment) in the future.

Another way to view this is that consumption is cheaper in the future than it is in the present. This is due to simple time value of money. So a tax on capital gains, dividends or any other investment income is not a tax on income. The income that produced the original capital base was already taxed.

Rather these taxes are a tax on consumption. Particularly deferred consumption, with the tax rate rising the longer the wait. The rich defer consumption (which is taxed) far more than the poor who tend to instantly consume (which is untaxed). Capital gains is evidence that the federal government's tax policy is biased against the rich.


* Some small proportion of what falls under the tax code as capital gains is effectively labor not capital compensation. The most notorious example would be carried interest to pay private equity managers.

However despite liberals' insistent outrage at this, income in this category makes up less than 1% of total capital gains receipts.

Methinks writes:

Some small proportion of what falls under the tax code as capital gains is effectively labor not capital compensation. The most notorious example would be carried interest to pay private equity managers.

This has become quite the meme, but it isn't true. Carried interest is no different from "sweat equity" afforded entrepreneurs by their investors (and that's part of the problem in trying to tax it at the regular income tax rate). The regular labour income in hedge funds, VC and PE firms is paid from the 2% management fee.

Also, this tax treatment applies only to investments held for more than a year and 5 year capital lock-ups are common for VC and PE firms because of the nature of their business. short term gains are taxed at the regular income tax rate. So, if you take an investment risk (defer consumption) and realize a positive return within 364 days instead of 366, then it's suddenly considered labour income. Explain that magic to me.

Anyway, for anyone who nurtures the dream of sticking it to these Wall Street guys, dream on. The ones I know have already figured out how to get around a tax treatment change, but the entrepreneurs are not going to be able to pull off the same structures. In a world where a handful of monkeys in congress, spurred on by people with nothing better to do than camp out in NYC drum circles for weeks on end, dream up a way to stick it to thousands of people who are much smarter and excel at solving thorny problems, the losers will not be the intended group.

MG writes:

@Profs Jones and Henderson

I am surprised that whenever the subject comes to taxes, to this observer, you all never (or seldom, please correct me if I am wrong) cite research done by the Tax Foundation. For example, these two links add a lot of light to this issue:

http://taxfoundation.org/article/simulating-economic-effects-romneys-tax-plan
and here
http://taxfoundation.org/blog/more-how-pay-romneys-tax-cuts

They are not doing back of the envelop math, like many of the analysts whose opinions attract more discussion. They are not, of course, without ideology. But I perceive their ideology to be one an economist could support: The tax code should be simple, mostly economically neutral, and if biased in favor of anything, it should be growth. But can anyone claim that the TPC is not ideological too?

@Prof Jones on the Tiebout effect, no-where to go, etc

Even if you disagree with what @Methinks (T hink correctly) points out above, I think you should consider the "unseen Tiebout effect", which would manifest itself in terms of how many entrepeneur-dollars this country HAS NOT been attracting (that it SHOULD have been attracting) because high-skill/high-capital immigrants decide this is no longer the place to build a business. (Or is it to think you built a business, since you did not really build that...)

Methinks writes:

I agree with MG. Besides that, you don't have to leave to reduce your tax burden.

We produce to consume, do we not? There are lots of ways for high earners to maintain their consumption and lower their AGI. Companies will provide high earners with company cars, company apartments and houses, company-owned lodges (or similar) for vacations, company planes, etc. instead of increases in money compensation. You just won't believe how imaginative smart people can get when government tries to steal more. Meanwhile, they'll have more incentive to seek rents. And the people who have the most flexibility? Business owners.

You know, rich people didn't get rich by allowing the clowns in congress to pick their pockets.

Mike W writes:

Yada, yada, yada...both candiddates have said they will not raise taxes on the middle class. Both candidates know full well this is not possible.

Under the current tax regime taxpayers earning more than $200k have total AGI of about $2 trillion and they pay about $400 billion in taxes...20%. Reverting to the pre-2001 tax regime for these folks would increase that percentage to 24%...an additonal $80 billion in tax revenue. That additonal revenue is not going to put a dent in the trillion dollar deficits that will occur with the aging of the population.

The most recent tax increase on the middle class has been the excise taxes on the health care industry contained in ObamaCare. These taxes will be passed through to consumers. Look for more of the VAT-like taxes in the future.

In a world where a handful of monkeys in congress, spurred on by people with nothing better to do than camp out in NYC drum circles for weeks on end, dream up a way to stick it to thousands of people who are much smarter and excel at solving thorny problems, the losers will not be the intended group.

Methinks, you doeth protest very effectively.

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