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.

 

 

In a blog post earlier this week, I concluded that whether a payment to government service is classified as a tax or a user fee is sometimes arbitrary and that how the payment is labeled is of secondary importance. Mike Udell of Ernst and Young, a former staffer on the Joint Committee on Taxation, reminds me, however, that labeling could have real consequences. Mike raises another example from the health reform legislation – the proposed “fee” on sales of pharmaceutical and medical device products. If the fee were an excise tax, it would be deductible and not included in the gross revenue of manufacturers of these products. But as a fee, it is not deductible, so income tax collections from these firms are higher than if they could exclude the payments from taxable income.

P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptWhat is a tax?SPAN style=mso-spacerun: yesnbsp; /SPANYou would think a senior economist at the ?xml:namespace prefix = st1 ns = urn:schemas-microsoft-com:office:smarttags /st1:place w:st=onst1:PlaceName w:st=onTax/st1:PlaceName st1:PlaceName w:st=onPolicy/st1:PlaceName st1:PlaceType w:st=onCenter/st1:PlaceType/st1:place would have no trouble answering that question. But it is not so simple./SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0pt?xml:namespace prefix = o ns = urn:schemas-microsoft-com:office:office /o:pnbsp;/o:p/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptThis question has come up in the debate over the proposal to require all Americans to have medical insurance—a provision in all of the major congressional health reform bills. If you must buy insurance, is the payment you make a tax or just a premium for insurance coverage?SPAN style=mso-spacerun: yesnbsp; /SPANIs the penalty imposed on those who don’t buy insurance a tax or a fine for failing to comply with the law?/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0pto:pnbsp;/o:p/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptOf course, we know taxes are what we pay to fund the general activities of the government. And for most taxes, including the individual income tax, what we pay bears little relationship to how much we benefit from government services.SPAN style=mso-spacerun: yesnbsp; /SPANBut not all payments to governments are for broad public services and some levies, such as airline ticket taxes, are associated with direct consumption of a service by the payer. SPAN style=mso-spacerun: yesnbsp;nbsp;/SPAN/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0pto:pnbsp;/o:p/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptPayments to governments that are analogous to commercial transactions are counted as user fees, not taxes, and reduce measured spending on the public activity. Examples include the fees I pay when I visit a National Park or for getting my car emissions tested. Getting the emission test gives me a lot less pleasure than hiking in st1:place w:st=onst1:PlaceName w:st=onShenandoah/st1:PlaceName st1:PlaceType w:st=onPark/st1:PlaceType/st1:place, but it is a requirement I must meet for the privilege of driving. And since I am the potential polluter, the state requires me to bear the cost./SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0pto:pnbsp;/o:p/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptSo when is a payment to government by users of a service a tax and when is it a fee?SPAN style=mso-spacerun: yesnbsp; /SPANA 1993 A href=http://www.cbo.gov/ftpdocs/104xx/doc10417/1993_08_growthofuserchargesa)taxes.pdfFONT color=#800080CBO report/FONT/A cited Malcolm Baldrige, a Commerce Secretary during the Reagan Administration. “I think it is simple,” Baldrige commented.SPAN style=mso-spacerun: yesnbsp; /SPAN“If it is a Democratic proposal, it is a tax; if it is Republican, it is a user fee.”SPAN style=mso-spacerun: yesnbsp; /SPANOf course, Baldrige was joking, but nonetheless user-related taxes are often hard to distinguish from user fees.SPAN style=mso-spacerun: yesnbsp; /SPANIf my local community funds trash collection out of property tax revenues, total tax collections look higher than if they charge me a separate fee for trash collection (even if the fee is collected when I pay my property tax).SPAN style=mso-spacerun: yesnbsp; /SPANUsing federal gasoline taxes to finance interstate highways makes the tax burden look higher than if those roads, like some older state highways, were paid for by tolls./SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0pto:pnbsp;/o:p/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptThe 1993 CBO report cites four categories of user-related charges:SPAN style=mso-spacerun: yesnbsp; /SPANuser fees, regulatory fees, beneficiary-based taxes, and liability-based taxes. SPAN style=mso-spacerun: yesnbsp;/SPANIn general, fees are distinguished from taxes by the degree of connection between the payment and the service received or social cost imposed by the payer. Thus, payments to the black lung fund are considered a liability-based tax because, although payments to miners result from past activities of the coal industry, they are not closely linked to the current actions of any firm on which the impost is based. In contrast, charges for food safety inspections are a regulatory fee, because (assuming the cost is passed forward) food consumers who are the beneficiaries of the inspection activities are paying for it. Often, however, a particular levy can be classified on either side of the tax/fee line./SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0pto:pnbsp;/o:p/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptSo what are payments for mandatory health insurance?SPAN style=mso-spacerun: yesnbsp; /SPANThey are involuntary and not based on something the person chooses to do, which makes them look like a tax.SPAN style=mso-spacerun: yesnbsp; /SPANHowever, the individual gets a benefit –insurance coverage – in exchange for the payment, which sounds like a fee. Because of subsidies, some individuals will pay more than others for the same coverage (tax).SPAN style=mso-spacerun: yesnbsp; /SPANAnd if the individual fails to buy insurance, she must make a payment to the IRS, for which she will get nothing directly in exchange (tax). But the payment can be viewed as a regulatory fine for failing to meet a public responsibility (fee).SPAN style=mso-spacerun: yesnbsp; /SPANFinally, because the IRS is administering these payments, it looks very much like (and will likely be scored as) a tax./SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0pto:pnbsp;/o:p/SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=FONT-SIZE: 9pt; FONT-FAMILY: Verdana; mso-bidi-font-size: 12.0ptAs a tax economist, parsing these questions is fascinating. But I’m not sure it is very important to the health debate. Instead, we’d be better off asking a different set of questions: Who would bear the net costs of this mandate by paying more than the value of insurance they receive?SPAN style=mso-spacerun: yesnbsp; /SPANWho would benefit by receiving insurance in excess of the amount they pay?SPAN style=mso-spacerun: yesnbsp; /SPANIs this income redistribution desirable?SPAN style=mso-spacerun: yesnbsp; /SPANIs it the best way to pay for (near) universal coverage?SPAN style=mso-spacerun: yesnbsp; /SPANAnd is that goal worth the cost?SPAN style=mso-spacerun: yesnbsp; /SPANIf we like the answers, we should support reform and if we don’t we should oppose it, regardless of whether we label the payments “tax” or “fee”./SPAN/P P class=MsoNormal style=MARGIN: 0in 0in 0pto:pnbsp;/o:p/P P class=MsoNormal style=MARGIN: 0in 0in 0ptSPAN style=mso-spacerun: yesnbsp; /SPAN/P