Tax Aspects Of Paul Ryan's FY 2014 Republican Budget Proposal

Tony Nitti, Contributor

3/12/2013 @ 12:19PM |1,117 views

Earlier today, House Republican and budget chief Paul Ryan (Wisconsin) issued his fiscal year 2014 Budget Resolution, which, if enacted, promises to eliminate the federal deficit – expected to be around $850 billion in 2013 – by 2023.
Drawing much of the attention upon the budget’s release has been Ryan’s cuts to governmental spending. Ryan’s latest proposal would grow spending at 3.4% as opposed to the 5% rate currently scheduled, and as result, would decrease total spending over the next decade by $4.6 trillion, from the currently budgeted $46 trillion to $41 trillion.
To achieve the reduced spending, Ryan takes aim at many of the same programs targeted in his FY 2013 budget. Medicare and Medicaid spending is cut by $885 billion over the next decade. Adherence to and extension of the recent sequester saves another $1.2 trillion. And in what likely amounts to little more than a pipe dream, Ryan would save $1.8 trillion by repealing the President’s signature Obamacare legislation.
But analyzing spending isn’t my thing; I want to know what Ryan has to say about tax policy. And upon further review, it’s clear that Ryan’s current tax proposal has the same strengths – and glaring shortcomings – as his previously released budgets.
For starters, what’s in the plan? Ryan’s 2014 budget would enact the following changes:

• Do away with the current seven tax rate system applied to individual taxpayers, which currently ranges from 10% to 39.6%, and replace it with only two rates: 10% and 25%. While the budget doesn’t clarify this, in the past Ryan has stated that the 10% rate would apply to taxable income less than $100,000, with the 25% rate applying to all income in excess of that threshold.
• Repeal the alternative minimum tax as well as any and all taxes imposed by Obamacare, including the 3.8% tax on a taxpayer’s net investment income.
• Reduce the maximum corporate rate from 35% to 25%.
• Transition the international tax regime from the current “deferral” approach to a full territorial system.

That’s it; that’s all the budget says about tax reform.
So let’s start with the good.
The AMT has to go. As anyone who read my post from last night can attest, it reads as clear as Chinese arithmetic. This parallel tax has long since strayed from its original intention of ensuring that the nation’s wealthiest taxpayers pay some level of federal income tax and has evolved into the bane of the middle class. Even worse, it requires an amount of time and expertise to appropriately navigate that is unrealistic to expect from the average taxpayer.
I’m also in favor of Ryan’s proposed international reform. I discuss the merits of both territorial systems and worldwide systems, which President Obama favors, here, but in general, I believe a territorial system is the way of the modern international market, and would greatly reduce both the complexity and exploitations that plague the current system.
Now, let’s move on to Ryan’s proposal for individual reform. As a guy who makes his living in the nether regions of the Internal Revenue Code, I, like many Americans, crave simplicity from the tax law. And while both parties often speak longingly of simplifying the Code, recent legislation, from Obamacare to the fiscal cliff deal, has done anything but. The Code has only grown more convoluted and complex, and history has shown that when a law becomes overly complicated, it raises the cost of compliance, in both man hours and dollars, and invites abuse.
Any significant plan for tax reform would have to contain two of the premises embodied by Ryan’s proposal: lower rates and fewer deductions. Clearly, a two-rate system of 10% and 25% would be a radical departure from the seven-tier system we find ourselves stuck in today, and a major step towards a system where every American can quickly estimate their federal tax liability.
While the text in the current budget fails to shed light on the nuances of Ryan’s plan, much can be gleaned from the summary tables included with the budget.  Interestingly, Ryan’s proposal will raise the exact same amount of tax revenue over the next decade as would be raised under President Obama’s current policy. In other words, much like the proposal Mitt Romney’s embraced during his election campaign, Ryan’s plan would be revenue neutral: it would not add a single dollar to the deficit.
But obviously, a maximum rate of 25% would generate significantly less gross tax revenue than the current system, which contains a top rate of 39.6% (actually, over 44% when factoring in Obamacare and the repeal of the PEASE limitation on itemized deductions). So how can Ryan’s plan be revenue neutral?
Because accompanying the reduction in tax rates would be the much-discussed and rarely clarified “base broadening,” whereby the countless deductions and preferences contained in the current version of the Code would be limited or eliminated. The theory being, if you cut enough deductions, the same level of net tax revenue can be maintained despite a nearly 20% drop in the top rate.
And that is what I don’t like about Ryan’s plan.
For starters, eliminating anything from the Code has become an exercise in futility in light of the army of special interest groups and professional lobbyists who fight on behalf of even the most narrow, industry-specific provisions contained in the law. It is exceedingly hard to believe that House Representatives and Senators would be willing to look past their own self-interests (read: reelection) and willingly alienate even a small portion of their constituents by permitting, for example, the mortgage interest or charitable contribution deduction to be removed from the law.
But let’s ignore the implausibility of sweeping tax reform for a moment. Experts have shown that there are simply not enough deductions to remove from the Code to make up for the revenue lost by dropping the top rate to 25%. Or at least, not enough to recover that lost revenue from those who will benefit the most from such a reduction: the wealthy.
When Ryan introduced his FY 2013 budget, it contained an identical vision for tax reform. And in response, the Tax Policy Center crunched the numbers and determined that reducing the rates to 10% and 25%, as Ryan proposes, would cost the government $4.5 trillion in tax revenue over a 10 year period. Keep in mind, this was when the maximum rate was 35%; now that the top rate has climbed to 39.6%, the forgone revenue would be greater.
Keeping things simple, in order for Ryan’s plan to remain revenue neutral as promised, it must raise at least $4.5 trillion in additional tax revenue through the elimination of deductions and preferences. And as the TPC proved with Mitt Romney’s plan, it is simply a mathematic impossibility to accomplish this without heavily shifting the burden from the wealthy to the middle class.
To illustrate, under Ryan’s proposal — but before considering the effect of any base broadening –taxpayers earning in excess of $1,000,000 would enjoy an average tax cut of $265,000, those earning between $500,000 and $1,000,000 would experience an average $47,000 reduction in their tax bills, and those and those earning between $200,000 and $500,000 would see their average tax bill decrease by $120,000. To the contrary, taxpayers earning between $40,000 and $100,000 would enjoy an average cut of approximately $1,000.
And here’s the rub: as was proven with the Romney plan, there are simply not enough deductions to limit or eliminate to offset the tax cuts experienced by those earning more than $200,000. The benefit from the reduction in their top rate from 39.6% or even 35% or 33% to 25% far outweighs any damage that can be done by eliminating deductions. So if you believe in basic math, if those earning in excess of $200,000 are going to walk away with a net tax cut, and the plan is to be revenue neutral, then…Voila!… there must be an offsetting increase in the tax liability of those earning less than $200,000.
Now, there is one way you could drop the top rate to 25% (or perhaps 28%) and maintain progressivity, but it requires a step Ryan appears to have no appetite for: taxing long-term capital gains and qualified dividends as ordinary income. Start taxing the Warrant Buffetts of the world at 25% on every dollar of investment income they earn over $100,000, and suddenly the landscape changes, and Ryan’s proposal would represent more than merely a windfall for those who need it least.