How Would Governor Romney Pay For His Tax Cuts?

Among the many policies Governor Romney has proposed in his run for President are substantial reductions in tax rates for individuals, including a 20 percent across-the-board cut in marginal rates (for example, the top rate would fall from 35 percent to 28 percent). Governor Romney has called for making this plan revenue neutral, in part by offsetting the roughly $3.6 trillion of individual income tax cuts (through 2022) and $5.1 trillion of total tax cuts by reducing or eliminating tax preferences (especially for high-income earners).

To date, Governor Romney has yet to publicly discuss what cuts would need to be made to tax expenditures in order to finance his very specific tax cuts. However, we got a little preview last weekend when he was overheard talking about two possibilities for reducing tax expenditures at a private fundraiser -- cutting the mortgage interest deduction for second homes and the state and local tax deduction.

How much of the $3.6 trillion in cuts would these changes pay for? In part, it depends on the details -- particularly since it is unclear whether the cuts would apply to all taxpayers or higher earners. However, we do have enough information to make some estimates.

The former policy, eliminating the mortgage interest deduction on second homes, is certainly a sensible one and one with bipartisan support. According to the Bipartisan Policy Center, however, the ten-year savings would total only about $15 billion.

The second idea, to eliminate the federal tax deduction for state and local taxes (income, real estate, other property, and sales), could raise substantial revenue. It is unclear from reports whether Governor Romney intends to make this proposal formally, and if so, whether he would cut this deduction for high-income earners only or for all earners. 

Importantly, estimating the revenue from eliminating the state and local tax deduction is not so easy as citing the $862 billion estimate in CBO's 2011 Budget Options. That estimate goes only through 2021 and is based off of current law -- which assumes the 2001/2003/2010 tax cuts all expire and AMT patches are discontinued. There is, however, a substantial interaction between the deduction and the Alternative Minimum Tax, as well as with the rate cuts set to expire this year and the further rate cuts and AMT elimination proposed by Governor Romney. The level of tax rates determines the value of the deduction, while the AMT does not allow the deduction, essentially taking away its value for those who are hit by the tax. Governor Romney's rate cuts lower the value of the deduction, while his repeal of the AMT enables everyone who itemizes to take advantage of the deduction.

Relying in part on information from a 2008 CBO report on the state and local tax deduction, we estimate that eliminating the deduction starting in 2013 would raise about $950 billion relative to current law, closer to $1.45 trillion assuming current law with AMT patches, around $1.3 trillion relative to current policy, and about $1.2 trillion with Governor Romney's plan from 2013-2022.

If Governor Romney would only eliminate the deduction for higher earners, the calculus becomes a bit more complicated -- indeed it depends both on what he considers a higher earner and on how he would limit the deduction. For example, he could phase it out altogether above a certain income threshold, or he could cap it in dollar terms, or he could limit the bracket against which one could collect the itemized deduction.

For simplicity, we assume he simply eliminates the deduction in full for those making above $200,000 per year and retains it in full for everyone else. Relying on recent distributional estimates for the deduction from JCT, we estimate a policy like this would raise about $550 billion -- both against current policy and against Governor Romney's tax plan.

Assuming Governor Romney takes the most aggressive possible action on the state and local deduction and the mortgage interest deduction for second homes, he will still only have offset about one-third of his individual income tax cuts. When looking at all of his tax cuts -- including to the corporate code and estate tax -- this base broadening would cover slightly less than one-quarter of the cost.

This means Governor Romney still has a long way to go to achieve his goal of of revenue neutrality. So where else must he look? The answer is probably everywhere. The rates he is proposing won't require wiping out all tax expenditures, but it will require making some tough choices. Here are the top ten tax expenditures, as estimated by OMB on a static basis. Note that their value is not necessarily equal to the revenue raised from eliminating them and that their value also varies based on other aspects of the tax system (as we noted above).