Matt Yglesias just penned a post in defense of Mitt Romney’s tax plan but I think he mixes up the economics quite a bit. He writes:
The good thing about taxes is they raise revenue, which can be used to do useful things. The bad thing about taxes is they may be a drag on economic growth. But here there are two considerations. One 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). Basically it’s a huge win. You get a bunch of revenue in a way that bolsters the country’s growth prospects.
Let’st start at the beginning. The first part about taxes raising revenue and hurting growth is correct. But then it gets murky. Yglesias writes “higher taxes mean less incentive to do economically valuable things” and just a line later says, “less money in your pocket means more incentive to do economically valuable things.” But higher taxes means less money in your pocket. They are different ways of saying the same thing. Yet, Yglesias comes to different conclusions for their effects on economic growth.
I understand his train of thought here. A lower marginal tax rate allows people to keep a larger amount of their income. However, fewer deductions allows them to keep a smaller amount of their income. And if the middle class pays more taxes overall (as Romney’s plan does), that means they are keeping a lower share of their income overall and paying a higher effective tax rate. However, this says nothing about whether people will work more or less (which is what I assume Yglesias means by “do economically valuable things”).
Here, there are two different effects: the “income effect” and “substitution effect.” The income effect says that because the middle class has less after-tax income, people will work more to make-up for their lost earnings. The substitution effect, on the other hand, says that because the middle class will keep a smaller percent of each dollar they earn (remember, overall they are paying more in taxes), they will work less. The question is, which effect dominates the other? If the income effect is a larger, people will work more (or do more economically valuable things). If the opposite is true though, people will work less (or do less economically valuable things).
But we don’t necessarily know which one would dominate; it depends on a number of different things. So it is wrong to say that it bolsters the country’s growth prospects.
Nevertheless, I agree with the rest of Yglesias’s post that using the extra revenue to pay for a lower effective tax rate on high-income earners is a bad idea. In fact, Romney’s tax plan has a number of major flaws, not to mention that it is mathematically impossible. And given that it doesn’t necessarily improve the country’s growth prospects (which are also more complicated than just the middle-class), it’s tough to defend any aspect of Romney’s plan.