Can tax reform spur growth without reducing tax bills?

Former Massachusetts Gov. Mitt Romney has been talking about tax cuts for more than a year, but his bottom line has evolved considerably since last year’s 57-point plan for the economy. Those changes raise questions about whether Romney’s plan would actually promote economic growth, which was supposedly the point. The answer depends on the details, many of which Romney hasn’t provided. But if it’s designed the right way, a tax reform like the one Romney has advocated could still spur growth, even if it doesn’t actually cut the tax bill faced by “job creators.”

The first iteration of Romney’s plan called for maintaining the Bush-era tax cuts in the short term, with a “long-term goal” of pursuing a “lower and flatter rates on a broader tax base.” The next iteration was a 20% across-the-board cut in rates below the Bush-era levels, offset by unspecified reductions in credits, deductions and other tax breaks. The latest version adds a wrinkle to the 20% across-the-board cut: a promise to keep individuals with the highest incomes paying the same (disproportionate) share of the total tax burden that they do today. In fact, at one point during last week’s debate, Romney said his plan wouldn’t “reduce the revenues going to the government” and that he “will not reduce the taxes paid by high-income Americans.”

A tax cut that doesn’t, you know, reduce taxes doesn’t seem like a plan to promote economic growth. There are other important reasons to simplify the tax code -- for example, to reduce compliance costs and tax avoidance while diminishing the market-distorting effect of tax breaks for favored industries and behaviors. But if so many of the country’s “job creators” are in the top tax brackets -- remember, that’s Romney’s biggest criticism of President Obama’s plan -- how would Romney promote hiring and investment if he’s not reducing their tax burden?

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One way is through the corporate tax code, where Romney has proposed to cut tax rates to 25% with no offset (at least not immediately; his long-term plan calls for broadening the base and lowering rates further). Another, potentially, is by eliminating taxes on investment income for taxpayers earning less than $200,000.

But growth can be promoted over the long term by changing taxpayers’ incentives, even if their tax bills don’t shrink. Donald Marron, the head of the nonpartisan Tax Policy Center, says economists generally agree that growth is limited over the long run by “supply factors,” such as the size of the population, the amount of work performed and the supply of capital and knowledge. “It’s possible to write down a revenue-neutral tax reform that improves people’s incentives to work, invest or accumulate knowledge,” Marron said.

It’s easier to articulate that principle than it is to implement it, given the trade-offs involved. Here’s an example. Taxes on income discourage labor more than taxes on consumption, so replacing some of the former with more of the latter (for example, by imposing a carbon tax) should lead to more work performed. But consumption taxes tend to hit low-income families harder than wealthy ones, which would undermine the progressivity of the tax code.

Conservatives argue that lower marginal tax rates inevitably encourage people to work more and take on more investment risk. That may be true for people who can afford to work less than they’re capable of working, although it ignores the drive to compete and achieve that powers many entrepreneurs, regardless of the tax code. Marron says the group most sensitive to the incentives in the tax code may be “secondary earners” -- for example, stay-at-home spouses who’ve decided not to work because they can’t earn enough after taxes to justify the effort.

Of course, the tax code is hardly the only (or necessarily the best) way to address the aforementioned supply factors. The government could invest more in basic research, as Obama suggests, or improve worker training programs to match them better with the skills demanded by today’s economy, as both candidates have proposed.

Again, it’s hard to tell what the effects of Romney’s plan would be on the economy without knowing how, exactly, he would offset the rate cuts to avoid increasing the deficit. But as Marron points out, a plan that’s designed to be revenue-neutral can still promote growth over the long term if it prods people to add to the country’s productive capacity, instead of providing a disincentive to do as much as they could.

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