Middle Income is Not $250,000!

The Tax Policy Center’s Howard Gleckman points out the 10 biggest differences in President Obama and Mitt Romney’s tax plans in his newest piece. At the end, he points out a couple of ways that the candidates are similar:

And both apparently believe that households making up to $200,000 or $250,000 are middle-income.

It’s amazing that we just gloss over this like it’s okay. Gleckman is right here. Romney deems the high-end of middle-income Americans to be $250,000 while Obama has continually pushed to raise taxes on high-income Americans, starting at $250,000.

In what world is making $250,000 a year middle class? Or $230,000? Or $200,00?

Here’s the Census Bureau’s 2011 estimates for household income and where that falls across America:

United States
Estimate Margin of Error
Quintile Upper Limits:
Lowest Quintile 20,585 +/-48
Second Quintile 39,466 +/-89
Third Quintile 63,001 +/-119
Fourth Quintile 101,685 +/-108
Lower Limit of Top 5 Percent 187,087 +/-436

The 95th percentile of Americans makes $187,087 a year! And yet, we’re okay saying that earning $250,000 a year is the upper limit! Once you look at the numbers, it’s crazy but we’ve grown to accept it.

Why? I’d hypothesize that people making $250,000 really do believe that they’re in the middle class. They hear all about these millionaires and billionaires and don’t put themselves in the same category as them. And it’s true, they aren’t in the same category: those billionaires and millionaires are at the high level of upper class, but households making $250,000 a year are certainly still upper class.

But this also works in the opposite direction as well. People at the other end of the spectrum dream of making it to the middle class. They want to believe that making $250,000 a year is middle class because that sounds attainable for them. If we were to drop the upper limit of middle-class down to the 80th percentile – $101,685 – people in the lowest 20 percent would probably find themselves disheartened. Yes, low-income households dream of making $100,000 a year but they also dream of a lot more. If we lower the upper limit of the middle class, we may cut back their dreams.

Of course, that’s just a hypothesis. But it doesn’t make it okay for the media to let this lie permeate across every campaign, tax proposal and policy statement. It’s tough to make arguments about the tax code when we are so clueless about what income level constitutes the middle class.

The Question I Want to See Asked Tonight

It goes to Romney:

Are there any tax expenditures on savings and investment that you would eliminate or reduce and if so, what are they?

If the answer, is no, well then the math simply does not add up for his plan to be feasible.

But if the answer is yes, then things get more interesting. The Tax Policy Center’s analysis of Romney’s tax plan found that it either had to raise taxes by $86 billion on the middle class or else not be revenue neutral. The numbers couldn’t add up.

But Alex Brill at the American Enterprise Institute dug into the numbers and found some areas where Romney’s plan could possibly gain revenue without raising taxes on the middle class. Some are legitimate complaints. Some aren’t.

In Brill’s analysis, the numbers come out to a $1 billion tax cut for the middle class. But it includes the specific assumption that Romney will eliminate tax deductions for high earners on savings and investment. Specifically, Brill and AEI colleague Matt Jensen found $45 billion from the exclusion of interest on state and local bonds and the exclusion of inside buildup on life-insurance products. But, these are tax exclusions on savings and investment.

If Romney refuses to eliminate those exclusions, then even under the AEI analysis, the math doesn’t add up. It’d be a $44 billion tax increase on the middle class.

So, which is it Governor Romney, eliminate those tax exclusions or raise taxes on the middle class?

Yglesias’s Faulty Economics

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.