As I contemplate the furor over the Tax Policy Center’s calculation that 47 percent of Americans owed no income tax in 2009, I am reminded of Don Alexander, who was an IRS Commissioner during the Nixon and Ford Administrations. For decades Don, who passed away last year, argued passionately that the IRS’s job is to collect tax revenues, and not administer social programs. And that conflict is at the root of the 47 percent controversy.

The share of Americans owing income tax has dropped so much in recent years mainly because of increased spending through the tax code – expansion of the earned income credit, introduction and expansion of the child credit, and President Obama’s making work pay credit. All of these programs are defensible – but as spending programs to achieve public policy objectives, not as measures to promote a fair distribution of the tax burden based on ability to pay. 

In 2002, Don and I served on a working group that produced a Century Foundation-sponsored report called “Bad Breaks All Around.”  The study critiqued tax expenditures – provisions in the revenue code that provide special benefits for certain industries or activities.

The panel agreed that tax expenditures in general are problematic. They distort economic decisions, often benefit high-income individuals and corporations disproportionately, and subvert the budget process by enabling backdoor spending through the tax code. But most members liked some tax expenditures – especially the earned income credit (EITC), a substantial benefit for low-income working families. Several reasons, including administrative convenience, were advanced as to why it is best to administer this assistance through the tax code.  I am among those who have asserted that a tax incentive is sometimes better than a direct outlay as a way to administer a government subsidy program.

Don disagreed. He was not opposed in principle to federal subsidies for low-income working families.  But he believed that the purpose of the tax code was simply to raise revenue to fund public programs and that it was not the IRS’ job to administer social programs. Don argued with Milton Friedman about this when the EITC was first proposed in the 1970s – and lost when President Ford backed the EITC.

Perception matters.  Tax wonks can argue until they are blue in the face that these programs are spending and that recipients of these subsidies are really paying positive taxes before getting their benefits. I totally agree with this logic, but it is a tough sell.

I recall an equally tough sell when President Reagan greatly expanded investment tax incentives in the 1981 tax cut bill.  Some smart tax lawyers realized that corporations in a loss position could not use these benefits, so they persuaded Congress to enact a “safe harbor leasing” provision that effectively enabled these companies to sell their tax benefits to profitable corporations that could use them. The result that large profitable corporations ended up paying no income tax generated a public uproar, not unlike today’s, although it was driven by very different political forces and directed at a much different target. It did not matter how much Treasury tried to explain the logic of allowing these transactions. Nor did it matter that the sellers of the tax benefits, not the profitable companies buying them, reaped most of the benefits. Safe harbor leasing was repealed in 1982.

So we may have to reconsider how we provide benefits to low-income and other households. People will look at how much different taxpayers remit to the IRS – no matter how much we explain that some provisions are really spending, not taxes, or that the real beneficiaries are not always those who send a smaller check to the IRS.  As the behavioral economists now remind us, perception often counts as much or more than reality.

By the way, Don Alexander should be remembered mainly for his courageous efforts to resist efforts by the Nixon White House to use the tax agency to punish the president’s perceived enemies. Don reminded me that Nixon was not the first president to do this. But thanks to Don’s efforts, he may turn out to have been the last.

With great fanfare, the President in his 2010 State of the Union address announced a new small business tax credit that will go to “over one million small businesses who hire new workers or raise wages.” A White House fact sheet described the credit as a “powerful short term incentive to not only create good jobs but to increase wages and hours for Americans with jobs.”

Providing a credit to businesses that raise jobs or payrolls has been discussed over the past year as a possible anti-recession measure. My colleague Howard Gleckman has written several posts expressing skepticism of its effectiveness, while some academic economists have defended the idea. As with any other policy proposal, the devil is often in the details, so I eagerly awaited the release of the President’s budget and the Treasury Department's Green Book for a more complete description of the proposal and revenue estimates.

To my surprise, however, I could not find the proposal either in the Green Book or the chapter in the Analytical Perspectives volume of the budget that lists revenue proposals. Thanks to my more persistent and diligent colleagues, I can report that the category labeled “Allowances” in the list of revenue proposals on page 188 of “Analytical Perspectives” does contain a budget line item for “jobs initiatives.” This item will cost the Treasury $12 billion in fiscal year 2010, $25 billion in fiscal year 2011, and an additional $13 billion in fiscal years 2012-2014 - in the ballpark of what Administration spokespersons indicated the new jobs credit is likely to cost. There is, however, no description of the actual proposal in the budget documents, possibly because some details were resolved at the last minute or are still unresolved.

The alert reader of the Green Book would have been tipped off to this estimate by footnote #3 of the revenue table on page 150, which reads: "Table 14-3 in the Analytical Perspectives of the FY 2011 Budget includes the effects of a number of proposals that are not reflected here. These proposals include the making work pay credit, increase fees for Migratory Bird Hunting and Conservation stamps, change retention policy for consular fees, trade initiatives, integrate program integrity adjustments — IRS, revise terrorism risk insurance program, and the allowances of health insurance reforms and jobs initiatives."

My colleague Howard Gleckman has summarized the tax plan that Congressman Paul Ryan (R-WI) presented at the Tax Policy Center on October 29.  He describes it as a consumption tax, but that’s not what it is.  It is actually mostly a tax on wage income that would treat those who work for a living very differently from those living off the income from inherited wealth.

Many of the questions for Mr. Ryan at the October 29 event focused on one of the plan’s features – letting individuals choose between being taxed under a simple low rate schedule with a broader base or continuing to pay tax with the current rate schedule, while retaining tax preferences.  But my main concern is how the changes in the tax base would affect people differently, depending on their sources of income.

Mr. Ryan’s plan is modeled on the “flat tax” proposal of Professors Robert Hall and Alvin Rabushka, but with two key differences.  The flat tax is a tax on consumption because it taxes all receipts (either at the business or personal level) at the same rate, while exempting the return to saving.  But in Mr. Ryan’s plan, the business tax rate is only 8.5 percent, compared with a 25 percent top rate on earnings.  And Mr. Ryan’s business tax, unlike Hall-Rabushka, does not allow a deduction for wages, so it is identical to a separate VAT and works effectively as an additional tax on labor.

Let’s see how Mr. Ryan’s plan would work for someone who earns her bread by working – that is, most of us – and someone who lives off income from inherited wealth.  The worker bee would pay a 25 percent tax on her last dollar of earnings. And the VAT would raise prices or, if the Fed doesn’t allow that, force wages down. Either way, that’s another 6.4 percent hit on real wages (75 percent of the 8.5 percent tax because the VAT would be effectively deductible from the earnings tax).  The real total top marginal tax rate on earnings would be 31.4 percent – only a few points lower than the current 35 percent top income tax rate on earnings.  And if the worker chooses to retain her deductions and keep using the current system, she will see her top marginal income tax rate on earnings (excluding payroll tax) rise to 40.5 percent (35 percent plus 65 percent of the sales tax).

If you include state income taxes, the effective rate cut for the workers is even smaller because state income taxes are not deductible under Mr. Ryan’s alternative tax system. Suppose the state income tax rate is 6.75 percent (the current top rate in Wisconsin).  Then the combined state-federal marginal rate on wages is 37.6 percent under the Ryan plan, compared with 39.4 percent under current law.  (The 37.6 percent is the sum of the two income taxes, 31.75 percent plus 68.25 percent of the 8.5 percent sales tax.  The 39.4 percent figure is the sum of the 6.75 percent state tax and a federal tax of 35 percent of the 93.25 percent of earnings left in the base after deducting the state tax.)

The taxpayer living off income from her inheritance would be treated very differently..  She would absorb a one time and permanent hit to her wealth from the 8.5- percent business tax, which would reduce the value of her investments (though Mr. Ryan hinted in his speech at “transition” rules that could ease even this small burden).  That would be all the federal tax she would pay.  There would be no tax on her interest, dividends, and capital gains and no estate tax reducing the value of her inheritance.  (She would, in theory, still pay some state income tax on her investment income; but, in practice, states would find it hard to tax interest, dividends, and capital gains without the link to federal enforcement.)   

Under the Hall-Rabushka tax base, with Mr. Ryan’s individual rates, the worker would face a top rate of 25 percent (the wage tax rate) because the business-level tax would exempt wages.  The taxpayer living off inherited wealth would face the same one-time and permanent hit to her wealth from the business side of the consumption tax, but (absent favorable transition rules) that rate would now be 25 percent, the same rate as the wage earner.  Even though people would never report or remit tax on their interest, dividends, and capital gains, advocates of the Hall-Rabushka flat tax can claim that they “paid at the office” on their investments in businesses.  But supporters of Mr. Ryan’s plan can make no such claim.

Ronald Reagan was often accused of favoring the rich.  But his main beef about the federal tax seemed to be how high marginal rates affected work incentives -- a view informed by personal experience when taxes deterred him from making more movies.  He endorsed a major tax reform that reduced the top tax rate on income to 28 percent and equalized the taxation of capital gains and ordinary income.  But the tax reformers in his party seem to be moving in a very different direction now.  Don’t tax any income or consumption from wealth, they are saying, and shift the entire tax burden to wage-earners. 

In a famous campaign speech in the 1930s, FDR referred to his opponents as “economic royalists”.  Does this shoe fit now if virtually the entire federal tax base shifts to earnings?  The fictional Private Ryan in Steven Spielberg’s film may have been saved by a special order from the top military brass, but we grunts would bear the full weight of Representative Ryan’s plan.