Bruce Bartlett: Romney's Tax Plan and Economic Growth Mitt Romney and his running mate, Paul Ryan, are quite insistent that their tax plan is just the elixir that the economy needs to jumpstart growth. As Mr. Ryan said at last week's debate, "Our entire premise of these tax reform plans is to grow the economy and create jobs." He pointed to the similarity between Mr. Romney's tax plan and the one that became law under Ronald Reagan in 1986. Indeed, there is similarity between the Reagan and Romney tax plans. Reagan broadened the tax base by eliminating tax deductions and loopholes and used the revenue to lower the top statutory federal income rate to 28 percent - exactly as Mr. Romney proposes. In principle, a change that holds revenues constant while lowering marginal tax rates - the rate on the last dollar earned - should increase growth. That is because, in economist-speak, both the income and the substitution effects are pushing in the same direction. The income effect results when taxes rise. People have to work and produce more to pay the additional tax in order to have the same amount of disposable income they had previously. Conversely, if taxes fall, the opposite effect occurs - people can work and produce less and still have the same disposable income. The substitution effect arises when marginal tax rates alter the trade-offs between work and leisure, saving and consumption, taxable investments and tax-sheltered investments such as municipal bonds, taxable wages and nontaxable fringe benefits such as health insurance, renting and owning a home and so on. What Reagan did and Mr. Romney proposes is to keep taxes constant but to reduce marginal tax rates. By "taxes" I mean aggregate tax revenues; there was no overall tax cut in 1986 or in the Romney plan. Mr. Romney has said repeatedly that the level of tax revenues will be exactly the same after his plan is implemented as they otherwise would be. In the aggregate, there is no tax cut in the Romney plan. But under the Romney plan, marginal tax rates would fall by 20 percent across the board - not 20 percentage points but 20 percent of the rate. With the top rate at 35 percent presently, a 20 percent reduction would lower it by seven percentage points to 28 percent. Other rates would fall proportionately. A full distributional analysis of the Romney plan cannot be done because Mr. Romney hasn't said what deductions and loopholes would be eliminated to pay for his rate cut. He only recently suggested that he would not eliminate them individually but rather would cap all deductions at $17,000 per taxpayer. For the sake of argument, let's assume that the Romney plan is revenue-neutral. Thus for those with itemized deductions larger than $17,000 in total, taxes would rise. But their tax rate would fall. In the aggregate, the rate reduction will offset 100 percent of the tax rise. Of course, the aggregate tax change will affect different taxpayers differently. Some people will pay more total federal income taxes than they pay now, and others will pay less. Those who don't itemize will get the benefit of the rate cut but not pay more taxes as a result of the loss of deductions, because they don't have any. People with large deductions relative to their income may see a large increase in taxes that is only partially offset by the rate reduction. Leaving aside the question of fairness, this is not necessarily a bad thing. The idea of tax reform is to get people away from basing economic decisions, such as whether to rent or a buy a home, on tax considerations. In principle, work and investment decisions become more efficient and thereby raise growth. As noted earlier, economic theory is unambiguous that holding taxes constant and reducing marginal rates will increase growth. But it is important to understand that this effect is neither large nor instantaneous. At best, it will raise the long-term trend rate of growth by perhaps tenths of a percent. With compounding, the effect can eventually be large. But the idea that tax reform will jump-start an economy suffering from the after-effects of a cyclical downturn is nonsense. This can be illustrated by looking at the impact of the 1986 tax reform. Real gross domestic product growth was about the same after the 1986 act took effect in 1987 as it was before, and tax reform obviously did nothing to forestall the 1990-91 recession. Unemployment fell, but it had been trending downward before tax reform, and the 1986 act probably had nothing to do with it. Within a couple of years it was trending upward again. By the mid-1990s, it was the consensus view of economists that the Tax Reform Act of 1986 had little, if any, impact on growth. In an article in the May 1995 issue of the American Economic Review, the Harvard economist Martin Feldstein, a strong supporter of tax reform who had served as chairman of Reagan's Council of Economic Advisers, found large changes in the composition of income, but the only growth effect was a small increase in the labor supply of married women. In a comprehensive review of the economic effects of the 1986 tax reform act, in the June 1997 issue of the Journal of Economic Literature, Alan Auerbach of the University of California, Berkeley, and Joel Slemrod, the University of Michigan economist, also found that the primary impact was on the shifting composition of income. They could find no significant growth effects. They concluded, "The aggregate values of labor supply and saving apparently responded very little." Compositional changes in income are not unimportant and may be worth the effort of doing tax reform, even if there is no growth effect whatsoever. For example, it may improve fairness, simplicity and tax administration. But it appears that even in a best-case scenario in which the top rate comes down a lot - the 1986 act lowered the top rate 22 percentage points from 50 percent - the real economic effects are at best very modest. Mr. Romney's plan is not likely to be enacted in anywhere near the form he has proposed, if only because Congress is far more polarized today than it was in 1986, and the major political parties are much farther apart on the goals of tax reform. Consequently, there is little reason to think we will see tax reform any time soon, and even if Mr. Romney's plan is enacted as proposed the growth effect will be small to nonexistent.