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Missing from Romney's tax plan: Reality

October 16, 2012: 10:52 AM ET

Even under the most generous economic assumptions, Mitt Romney's tax plan simply doesn't work.

By Cyrus Sanati

mitt-romneyFORTUNE -- With the federal budget closed as of September 30, we now have the final numbers on how much money was spent and raised by the federal government in the 2012 fiscal year. These fresh numbers give some insight as to the trajectory of the federal budget deficit and can help us gauge the impact Mitt Romney's ambitious tax plan could have on the nation's precarious fiscal situation. Unfortunately for the Romney campaign, when you dig into the numbers, it looks like he will need a magician, not an economist, to help him implement his tax cuts if he is serious about sticking to his word to cut and balance the budget anytime in the next decade.

Romney has been able to coast through much of the election season without really having to explain how his tax plan adds up. But since September, his campaign has been under increasing pressure by both the media and the Obama campaign to reveal how it intends on cutting taxes and balancing the budget at the same time. Under pressure, the Romney campaign revealed a major missing piece of the puzzle last week, announcing that he would cap itemized deductions at $17,000 per taxpayer. But even with that piece of data it is going to be difficult to make the numbers work.

At the center of his fiscal plan is a bold 20% across-the-board tax cut for all Americans. Romney would also cut taxes on dividends and capital gains to almost nothing for people making below $250,000 and bring the corporate tax rate down to 25%. At the same time he promises to balance the federal budget, which, as of Friday, showed that the federal government ran another $1 trillion-plus deficit for the fourth year in a row. He plans on balancing the budget in the first year in office, while also maintaining full funding for some of the biggest government entitlements like Medicare and Social Security, and increasing spending on the military.

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The debate over the Romney fiscal plan has gotten stuck on the revenue side of the equation, namely, how the tax cut would impact the amount of money coming into the Treasury. The Romney campaign insists that the tax cut is what they call "revenue neutral," meaning that it would essentially pay for itself. There are only a few ways that this could be possible: 1) If taxes will ultimately be going up for certain tax payers through the elimination of deductions or 2) If the amount of economic growth generated by the tax cuts would increase revenue as more people start paying into the system or 3) A combination of both.

Quantifying any scenario requires some very generous assumptions on the part of the Romney campaign – assumptions they have yet to quantify. But in order to analyze the Romney fiscal plan, let's just assume for the moment that tax cuts are indeed revenue neutral. Giving the Romney campaign the benefit of the doubt here frees us to fully assess the impact of his fiscal plan. Cutting taxes is just one side of the equation, the other side focuses on balancing the federal budget in the first year in office, which is a very important for the fiscal conservatives in his party, especially those that consider themselves to be "Tea Party" members.

Let's start by looking at the 2012 federal budget and using it as a template for our analysis. The government spent a total of $3.54 trillion for the 2012 fiscal year, which ended on September 30. That was 1.7% less than what it spent the previous year thanks to a combination of factors like the expiring stimulus provisions and the drawdown of military spending in Iraq and Afghanistan. Meanwhile, tax receipts increased much more than expected, up a whopping 6.4% from the previous year to $2.45 trillion, as the economy improved and the IRS got more aggressive in collecting taxes.

In one way these numbers look good for the Obama campaign in that it shows that it has been successful in cutting spending without crushing economic growth. But it is bad in that it is the fourth year in a row that the federal government has run a deficit over $1 trillion -- $1.089 trillion to be exact. This adds to the nation's already large national debt pile, bringing it up to around $16.17 trillion. Romney can therefore push the point that the Obama administration has indeed added to the federal debt, even though it shrank the budget deficit by $200 billion from last year.

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The way the Obama administration was able to cut the budget deficit by a relatively large amount, though, is sure to give the Romney campaign some headaches, as it takes away some of the "easy" cuts that it was most likely counting on for Romney's balanced budget plans, namely those associated with the two wars. Cutting through the rest of the budget looks much harder to accomplish given the meteoric rise in entitlement spending.

On the spending side of the equation, Romney has proposed bringing federal spending from where it currently stands at around 22% of the nation's gross domestic product (projected to be around $16.1 trillion for 2012), to the "historic average" of around 18% to 20% of GDP. Through economic growth, GDP would catch up to federal spending to allow for a balanced budget.

Let's now assume that Romney's plan was executed in full during the 2012 fiscal year. If the government stayed to the 18% to 20% GDP spending bands, federal spending would have fallen from $3.42 trillion to between $2.89 trillion and $3.22 trillion, for an annual savings of between $322 billion to $644 billion. That means that if revenue was unchanged (by assuming the tax cuts were indeed revenue neutral), the federal government would have still overspent by between $450 billion and $770 billion in 2012 – far from a balanced budget.

The Romney camp would call this an unfair comparison because it doesn't take into account the incremental growth the economy would derive from the tax cut. We are already assuming that the increase in growth allowed the revenue side of the equation to stay flat but let's also assume that the US economy grew by 3.5% in 2012 instead of the projected 1.5% due to the tax cuts (yes, these are very generous assumptions). Under this scenario, the nation's GDP would have grown from $16.1 trillion to $16.4 trillion and revenue would have stayed flat. So if the government stuck to the 18% to 20% GDP spending bands, things would have actually gotten worse as it would have allowed the government to spend more money ($58 billion to $65 billion more) than if growth wasn't factored in the equation because the revenue line stayed flat. In the end the government would have overspent by $506 billion to $835 billion.

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This all seems counterintuitive, but it shows that not only does Romney's tax plan need to be revenue neutral, but it also needs to be revenue positive to be anywhere close to reality. If it isn't revenue positive, then spending will need to fall by a massive degree if the budget is to balance, even more than the draconian cuts that would need to happen just to get spending to fall within the GDP band limits.

Now, it is very difficult to cut anything in Washington, let alone a third of the national budget that would be needed to balance the budget. But Romney claims he can make the government more efficient, therefore alleviating him from making big cuts in places like Medicare and the military.

So let's add up the efficiency gains and the spending cuts that Romney has identified during his campaign. There are the cuts in foreign aid ($100 million), public arts spending ($600 million) and family planning organizations ($300 million). All together these three "hot button" expenses add up to a whopping $1 billion in annual savings – basically a rounding error. He has also announced that he would try to equalize government worker pay to that of the private sector and "cut government waste," which Romney's campaign values at $47 billion and $60 billion in savings, respectively. In total, with a few other savings like privatizing Amtrak ($1.6 billion), reducing the federal workforce by 10% ($4 billion), reversing labor union rules ($11 billion) and reversing President Obama's health care initiative ($95 billion), the Romney campaign has identified a grand total of $219 billion in potential savings – a fraction of the $1.1 trillion needed to close the budget gap and less than a half needed to get him to within the 18% to 20% band.

Romney maintains that he won't make cuts to social security ($778 billion) or defense spending ($902 billion) and will continue to pay the interest on the national debt to avoid default ($225 billion). Just these three line items would cost $1.9 trillion, leaving just $564 billion left over for everything else. Health spending, Medicare and Medicaid, cost $864 billion this year, so Romney's proposed voucher system, which would replace President Obama's health care plan, would need to achieve $300 billion in annual savings for the budget to balance -- three times the amount expected.

But let's assume he solves the healthcare problems and is able to cut spending and maintain care (again a very generous assumption), there would still be nothing left over to pay for anything else. Not only would this entail unrealistic cuts in health care spending it also would require wiping out total federal support for education ($153 billion); all social welfare projects - including unemployment benefits ($452 billion), civil protection - including federal grants for local police & firefighters ($62 billion), all government agencies and regulators ($33.6 billion), transportation like interstate highway maintenance ($102 billion), and every other government program you can think of from stimulus funds to research grants ($199 billion). In this case, much of the $219 billion in savings the Romney campaign identified would ultimately not be necessary here because the government would essentially no longer exist.

President Obama promised to cut the budget deficit in half by the end of his first term in office – he missed his target by about $700 billion. While voters loyal to the President will probably excuse him for not shrinking the budget gap, Romney's core constituency won't be as forgiving. Unless the Romney campaign presents a clear vision of its plans, then many of those fiscally conservative Republicans might not bother showing up at the polls.

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