A version of this post originally appeared on the author’s blog.
One controversial feature of Mitt Romney’s tax proposal, detailed in a paper by Brookings last month, is that it would raise the burden on middle and lower income earners. Raising taxes typically flies in the face of conservative orthodoxy, but in the post-Reagan era the Republican Party has shown itself willing to entertain almost any tradeoff that would provide for a tax cut for high-income individuals — the theory being that letting the wealthy keep more of their money is the best way to stimulate the economy. But the Romney proposal, in seeking not only to lower taxes on the rich but also to achieve deficit neutrality, would propose to pay for a reduction in the top marginal income tax rate with increased revenue raised from the middle class.
Hiking taxes on the middle class in the midst of a sluggish recovery would of course be loathsome to liberals and possibly even to some conservatives. After all, for those who see high unemployment as the central problem in our economy, the thought of increasing the financial burden on struggling middle class families would seem cruel and pointless. But on closer inspection, perhaps there is some logic to the Romney proposal.
It’s an enduring truth that taxes are both good and bad. Tax revenue enables the government to do good things like build highways and bridges and provide a safety net for the elderly. But taxes also deprive people of money that they could otherwise spend or invest in ways that would grow the economy. However you feel about tax policy, it’s a mistake to assume that taxation as an institution is wholly good or bad, and therefore it’s a mistake to assume that Mitt Romney’s proposal to increase taxes on the middle class is a wholly bad idea. In a recent column, Matt Yglesias offers two considerations that help us understand why:
One [consideration] is the “incentive effect” of taxes—higher taxes mean less incentive to do economically valuable things. The other is the “income effect”—less money in your pocket means more incentive to do economically valuable things. The genius of Romney’s plan is that by eliminating deductions it leaves middle class families with less money in their pockets (so a pro-growth income effect) while also lowering the tax rate they pay on a marginal dollar of additional earnings (so a pro-growth incentive effect).
One problem with this framework is that within any given income bracket, these “effects” could have disparate outcomes. Two middle class individuals, subject to the same increase in taxes, could react in starkly different ways. Similarly, two wealthy individuals, subject to the same reduction in taxes, could react differently. If “higher taxes” equates to “less money in your pocket,” then all this framework really tells us is that depending on your personality, higher taxes will give you either “less incentive to do economically valuable things” or ”more incentive to do economically valuable things.” That’s not terribly prescriptive as far as tax policy is concerned, but it does make clear that one of Romney’s key assumptions is that the “income effect” overrides the “incentive effect” for middle income earners, while just the opposite is true for the wealthy — thus the proposal for raising taxes on the middle class and reducing them on the rich.
This all fails to capture an issue of even greater importance, however. For the wealthy, incentives matter a great deal. Increasing the top marginal tax rate by a couple of percentage points wouldn’t drastically alter the ability of a rich person to kick money into the economy through spending and investment, but it might weaken his incentive to spend and invest freely. With the middle class this isn’t the case. Increasing the tax rate by a few percentage points on middle earners wouldn’t just affect how they felt about kicking money in the economy; it could actually prevent them from doing so. Romney is, for all we know, aware of this downside, but the gambit is that middle class families, if forced to pay higher taxes, would work harder to regain that money taken out of their pocket. That extra hard work would provide a stable, long-term boost to the economy, and meanwhile, the extra revenues generated by the middle class tax hike would allow the wealthy to keep more of their money and spend or invest it in ways that would allow the middle class to play catch-up more quickly.
So, if you believe that the “income effect” prevails among the middle class and the “incentive effect” among the wealthy, then you have good reason to support Romney’s plan in spite of any emotional qualms about making life harder on the middle class in the short term. Those qualms tend to carry a lot of weight in political discussions about tax policy, but the relevant point is that from a theoretical perspective, there is at least one way to structure a pro-growth tax policy that would increase the burden on the middle class. No politician, Mitt Romney included, is going to get out on the campaign trail and start talking about how the path to prosperity starts with a middle class tax hike, but it’s important to recognize that the left’s safeguarding of the middle class is sometimes just as poorly grounded as the right’s safeguarding of the wealthy.
Whatever the case, if “tax cuts for the wealthy plus deficit neutrality plus long-term growth” is the goal, then your tax proposal may end up looking a lot like Romney’s (although how you sell it to voters is another matter). But for some people, tax cuts for the wealthy is not the foundational element of tax policy around which all other provisions should be structured. That’s not to say that Mitt Romney doesn’t care about growing the economy, it’s just to say that tax cuts for the wealthy maybe shouldn’t be objective number one. For some, objective number one is to bring down unemployment in the short term.
With unemployment still hovering just above 8%, there continues to be evidence of flagging aggregate demand in our economy; firms sense insufficient demand in the market for their products and services, so they become hesitant to increase spending on their workforce, whether that involves training current employees or hiring new ones or both. That ends up being a loss for everyone: firms have a hard time growing and adapting, employed workers have a hard time getting training, and the unemployed have a hard time finding work, making them less inclined to engage in anything but vital economic activity.
When aggregate demand is low, as it currently is, then tax policy can be structured in such a way as to stimulate demand. If that’s the goal, then taking money out of middle class pockets and putting it into the pockets of those who don’t objectively need it (the wealthy) is highly counterproductive. Instead, the theory goes, if you let the middle class keep a larger share of their money, they will go out and buy more goods and services, which will give firms the wiggle room they need to train and hire more workers. As a result, demand throughout the system will pick up, unemployment will go down, and the economy will grow.
The bottom line is that any tax proposal needs to be based in large part on what its author believes is the key factor holding down economic growth. Mitt Romney believes that the economy is being held down by a constrained supply of goods, services, and labor, and that by facilitating greater spending and investment from the wealthy, the supply of these things will become less constrained and the economy will grow. The problem of aggregate demand remains, however, and as long as private firms sense insufficient demand they will be hesitant to hire and train, making it difficult for them to grow.
There’s rarely and objective right or wrong with tax policy, but it’s important to recognize that people hold different priorities at the outset of the policy-writing process, and those priorities overwhelmingly influence the proposal’s final form.