“Mitt Romney: “I’ll pick a number -- $25,000 of deductions and credits, and you can decide which ones to use.”
Tax analysts haven’t passed final judgment on Republican nominee Mitt Romney’s tax plan, which he says will cut everyone’s tax rates by 20 percent, lower taxes on the middle class and hold wealthier citizens’ tax payments constant without increasing the deficit.
The only way to accomplish this fiscal jujitsu is by limiting tax expenditures, which the Tax Policy Center has said would sharply increase taxes on the middle class. During last night’s debate, the public finally got some specifics on how Romney might reform the tax code, give tax breaks yet maintain fiscal neutrality.
He said he would cap the amount of tax deductions and credits that any household could take at $25,000.
Tax experts will need time to figure out how large the tax rate reduction could be without running up the deficit – if it is even possible. But it’s not too early to figure out how that might affect a typical household.
Imagine a married couple in their 30s with one child living in a $300,000 home they purchased in 2010 with a $60,000 down payment. Together they earned an adjusted gross income of $80,000, putting them slightly above the national average.
Because of that year’s relatively low interest rates (they’ve gone lower since), they got a 4 percent mortgage that translated into a manageable $1,146 monthly payment. With over 90 percent of that going toward interest in the early years, they paid $12,500 in interest tax deductible interest payments in the first full year in their new home. The property taxes come to another $300 a month or $3,600 for the year.
Since it takes both parents working to make ends meet in today’s economy, they paid $250 a week for childcare. While it takes a hefty bite out of that second salary ($12,000 a year), it’s reduced somewhat by the government allowing them to use $3,000 of that to calculate a special tax credit that reduces their taxes by $600. Regular churchgoers, this young couple also faithfully give to their church, donating $50 a week or $2,600 a year.
Our couple is also very responsible. They don’t want to be a burden on their young daughter when they are old and she is in the prime of her life. So they are saving for retirement. Each takes maximum advantage of their employer’s 401(k) matching savings program by setting aside 6 percent of their salary (the employer match is half that). So between them, they are putting away $4,800 a year, matched by $2,400 from their employers.
And since they purchased a new automobile last year for $22,000 (it was a small car, very fuel efficient), they paid an extra $1,100 in extra sales tax. That brought their general sales tax deduction at tax time to $1,950, according to a handy calculator provided by the Internal Revenue Service.
So to recap, this average young couple’s itemized tax form for 2011 included $25,450 in tax deductions and a $600 tax credit, or $26,050 in total. Under current tax law, their deductions and credits would leave them with an adjusted gross income of $54,550 and federal income tax of $7,329, according to IRS tax tables. But the child care tax credit would reduce that to $6,729, an overall effective income tax rate of 12.3 percent on their taxable income ($54,550).
Under Gov. Romney’s plan, this young couple would only be able to deduct $25,000, leaving them with an adjusted gross income of $55,000. Their federal tax bill at current rates would be $7,396. That’s an increase of $667. To pay the same amount of taxes as under current tax law ($6,729), their effective rate would have to drop minimally to 12.2 percent, which isn’t surprising since their deductions and the Romney cap are about the same.
Now let’s move up the income scale into the upper-middle class. Imagine a married couple in their 40s with one child living in a $400,000 home they purchased in 2010. College educated and in the mid-points of their careers, they together earned an adjusted gross income of $160,000 last year.
They had $100,000 from the sale of their starter home to use as a down payment on their new home, and got a 4 percent interest rate on their $300,000 mortgage, which last year translated into a manageable $1,432 monthly payment. With over 90 percent of that going in interest in the early years, they paid $15,600 in interest in the first full year in their new home.
But that isn’t the only payment they need to make when owning their own home. Besides insurance, the property taxes come to another $400 a month ($4,800 a year); they also paid $250 a week for childcare; and donated the same $50 a week or $2,600 a year to their church.
Like the other couple, each takes maximum advantage of their employer’s 401(k) matching savings program by setting aside 6 percent of their salary, so between them they put away $9,600 a year. And since they purchased the same automobile last year for $22,000, they were able to take a general sales tax deduction at tax time of $2,242.
So this better-off couple’s tax return included $34,842 in deductions and $600 in tax credits. Under current tax law, their deductions and credits left them with an adjusted gross income of $125,158 and federal income tax of $23,539. The child care tax credit reduced that to $22,939, an effective tax rate on taxable income of 18.3 percent.
Under Gov. Romney’s latest plan, this couple would only be able to deduct $25,000, leaving them with an adjusted gross income of $135,000. To pay the same $22,939 in taxes, their effective tax rate would have to fall to 17.0 percent. That’s a 7.1 percent reduction in tax rates.
Clearly, lowering rates by 20 percent across-the-board would lower taxes for both couples. But it would also be a huge drain on the federal treasury. If Romney kept his pledge to hold tax collections constant, the rate reduction would have to be far less or the tax expenditure limits would have to be structured differently.
Martin Feldstein, a professor at Harvard and a former top economic adviser to President Ronald Reagan, suggested in a recent op-ed in the Wall Street Journal and in an explanatory note on Romney adviser Greg Mankiw’s blog that in order to make a 20 percent rate reduction deficit neutral, caps on tax deductions should be phased beginning with tax returns that rose above $100,000, which he defined as “high-income.”
“Eliminating a few of the ‘tax expenditure’ exclusions and credits that are important for high-income taxpayers would raise more than enough revenue to compensate for assuming a smaller marginal tax increase,” he wrote.
Romney cited Feldstein’s work as one of the studies justifying his claim his reform wouldn’t raise taxes on the middle class.
As the above examples show, it’s clearly possible to lower rates without raising taxes on the middle class by limiting tax deductions and credits for high-income people. The only problem is that you have to define that latter group as those earning $100,000 or more.