“Revenue-neutral tax reform” is the holy grail of tax wonkery. The idea is to eliminate distorting tax deductions and use the revenue raised to lower distorting headline rates. In the end the government has the same amount of money and the economy can grow faster. But there’s actually substantial ambiguity around what constitutes a distorting tax deduction.
The 1986 tax reform compromise worked out between Ronald Reagan and congressional Democrats, for example, equalized the tax treatment of investment income and labor income and considered that part of base-broadening. Since 1986, however, we’ve gone back to giving a strong tax preference to investment income and Mitt Romney’s version of tax reform involves keeping those preferences in place. As a new Tax Policy Center analysis shows, with that constraint in place the kind of revenue-neutral tax reform Romney is talking about becomes strongly regressive:
Our major conclusion is that a revenue-neutral individual income tax change that incorporates the features Governor Romney has proposed—including reducing marginal tax rates substantially, eliminating the individual alternative minimum tax (AMT) and maintaining all tax breaks for saving and investment—would provide large tax cuts to high-income households, and increase the tax burdens on middle- and/or lower-income taxpayers. This is true even when we bias our assumptions about which and whose tax expenditures are reduced to make the resulting tax system as progressive as possible. For instance, even when we assume that tax breaks—like the charitable deduction, mortgage interest deduction, and the exclusion for health insurance—are completely eliminated for higher-income households first, and only then reduced as necessary for other households to achieve overall revenue-neutrality—the net effect of the plan would be a tax cut for high-income households coupled with a tax increase for middle-income households.
In addition, we also assess whether these results hold if we assume that revenue reductions are partially offset by higher economic growth. Although reasonable models would show that these tax changes would have little effect on growth, we show that even with implausibly large growth effects, revenue neutrality would still require large reductions in tax expenditures and would likely result in a net tax increase for lower- and middle-income households and tax cuts for high-income households.
My view is that the regressivity of curbing large tax deductions is not per se a problem. Indeed, one of the worst aspects of President Obama’s pledge to never raise taxes on people earning less than $250,000 a year is that it seems to foreclose the possibility of what’s really the economically soundest way to raise revenue. But the question of what you raise the revenue for matters a lot. Raising taxes on the rich and middle class alike in order to afford spending on social insurance, education, and infrastructure is one thing. Raising taxes on the middle class in order to afford tax cuts for the rich is another.