How Paul Ryan Would Transform the US Tax System

Republican budget wonk Paul Ryan clearly believes in big ideas. His "roadmap" for America received harsh criticism in the press this week, but the plan is such an enormous grab bag of ideas it would be a shame to dismiss them off-hand. So here's my attempt to dig into his tax plan. It is truly nothing short of revolutionary and transformative -- and probably impossible.

Let's start with the big numbers. The non-partisan Tax Policy Center found that Ryan's plan came up hundreds of billions of dollars short of his revenue goals. If enacted tomorrow, his plan would lose the US government an additional $550 billion of tax revenue.

But before we get to the losses, the fascinating thing is that much of Ryan's plan would actually raise more than a trillion dollars from currently untaxed sources. Where does Ryan find all that money for the government? In two big things. First, he eliminates deductions and tax expenditures -- that is, money purposefully left untaxed by the government. Second, he creates a new consumption tax.

Ryan eliminates most tax expenditures -- the employer-sponsored health care subsidy, the mortgage interest deduction, the charitable donation deduction, savings incentives, and so on. That could retrieve as much as $800 billion yearly for the government if we enacted the law today. Ryan also institutes a rigorous value-added tax (he calls it a "business consumption tax") at 8.5%, which I've learned from conversations with tax experts at Brookings and the Urban Institute is on the high end of most VAT considerations (to learn how a VAT works, check out my explanation here). The Tax Policy Center estimates that a 8.5% VAT could raise 4.25 percent of GDP a year: say, $600 billion a year by the middle of the decade.

That's $1.6 trillion in possible additional revenue. So how does Ryan's plan wind up bleeding money? It's all about the top of the tax bracket.

The rich, as you know, are different from you and me. They have more money. How much more? According to TPC 2011 projections, the top 20 percent of earners take 55 percent of all US income. The top one percent alone takes 18 percent. (The top 0.1 percent hauls in 8.2 percent.) Slash taxes on these folks, and you leave a lot of dollar bills on the ground. That's what Ryan does.

He starts by making the Bush tax cuts permanent. But that's just the beginning. Ryan takes the top marginal income rate down from the high 30s to 25 percent. He eliminates taxes on capital gains, dividends and stocks. He kills the estate tax and the alternative minimum tax. As a result, this is what happens to taxes for the richest Americans:

1) The richest 1 percent of Americans see their taxes cut in half.
 
2) Households with incomes of more than $1 million receive an average annual tax cut of $500,000.
 
3) The richest 0.1 percent of Americans -- those whose incomes exceed $2.9 million a year -- would receive an average tax cut of $1.7 million a year.

Another way to think about the effect of the Ryan tax plan is what happens to effective tax rates. ETR is the average percent of your income you pay through all federal taxes -- including individual, corporate, payroll and estate. Ryan's plan would cut ETR (barely) for the bottom 20 percent of tax payers and raise ETR (barely) for the middle 60 percent. But at the top, Ryan's cuts taxes for the top 1 percent by 14 percentage points. The top 0.1 percent of taxpayers -- because they receive so much of their income from tax-free capital gains -- would have an effective federal tax rate of 11 percent: less than half the ETR of the bottom 20 percent.

I spoke with Joe Rosenberg, the author of the Tax Policy Center report on the Ryan plan, about what he liked and didn't like about the bill. He likes the VAT. He also calls the capital gains changes a "windfall gain" for the rich:

I think the VAT is an interesting thing especially coming from Congressman Ryan. That is a good way to look at how you can fill a deficit gap with the least disruptive form of taxation.

But I think completely exempting capital income is a problem. There is so much wealth up there that you're giving a windfall gain to the rich by completely exempting capital income. From a revenue standpoint you lose a lot. And you introduce these very, very strong incentives to play games and make your income look like its capital gains.

More on the potentially explosive incentives of Ryan's tax plan in my next post.