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.