The House leadership seems convinced that a relative handful of people should pay for health reform. In the plan released yesterday by Speaker Nancy Pelosi, Democrats would fund most of the cost of insuring millions more people in two ways: cutting subsidies to Medicare Advantage plans and imposing a stiff 5.4 percent surtax on individuals making $500,000 and couples making more than $1 million.

TPC figures that just 400,000 taxpayers will pay that increase in 2011, less than three-tenths of one percent of all taxpayers. However, because the millionaire’s surtax is not adjusted for inflation (at least not yet), within a decade many more are scheduled to fall victim to the tax hike. By 2019, TPC figures nearly 800,000 would be in the bulls-eye, although that is still fewer than 1 percent of all taxpayers. Over the decade, the surtax is projected to raise nearly a half-trillion dollars. But because income subject to the surtax does not increase with inflation, annual tax revenues would grow from about $30 billion in 2011 to $70 billion in 2019

I am bothered by two elements of this. First, do we really want to put most of the cost of a national priority such as health care on the backs of a relatively few people? My concern has more to do with our social compact than economics, but wouldn’t it make more sense if we all had a horse in this race?  I know, those hit by the surtax are the same people who benefitted most from the Bush tax cuts in 2001 and 2003. But there is still something wrong with pretending that health reform is a free lunch for 99.7 percent of us. 

And I have another problem. My guess is the levy would become another Alternative Minimum Tax deal. That is, despite what looks like surtax-creep, there is a pretty good chance Congress would get cold feet somewhere along the way and protect many of those who would otherwise face the extra tax over the next decade. This would add tens of billions more to the deficit. 

I can hear lawmakers now. “This tax was never intended to hit these hard-working Americans earning just $500,000,” some pol will thunder in the run up to the 2014 elections. And on some level, I fear, that will be quite right.

By the conventions of budget scoring, of course, it doesn’t matter if many never pay the tax. The scorekeepers (JCT in this case) must assume the law will apply for 10 years. So, if this provision survives the next few months of congressional debate, Congress will be able to give itself credit for paying for health reform, never mind that would do so in a way that is irresponsible and very likely phony.  

Representative Paul Ryan (R-WI), one of Congress’ most interesting members, was the guest at this morning’s session of TPC’s Tax Reform 2.0 series. He came to talk about his Roadmap for America’s Future—a comprehensive plan for dramatically restructuring both entitlement spending and the tax code. Ryan is nothing if not ambitious.

I’ll leave his proposals for Medicare, Medicaid, and Social Security for another day. But on revenues, Ryan has embraced the idea of a consumption levy to replace the current income tax. (which is really a clumsy hybrid of both).

On the business side, Ryan goes for the Full Monty. He'd dump the corporate income tax for a subtraction method value-added tax. As in similar models, he’d allow businesses to fully expense all capital investment, but firms would no longer deduct their interest costs. The tax, which he’d set at a very low 8.5 percent, would be border adjustable so it wouldn't affect exports. Ryan is hardly the first person to come up with such a tax structure. Years ago, Rudy Penner and others proposed the very similar USA Tax. 

But Ryan gets credit for taking the leap on any form of VAT, usually anathema to his fellow Republicans and much of the business community. Bruce Bartlett, another often-heretical Republican, also endorses the VAT in a recent Forbes piece.

When it comes to individuals, however, Ryan loses his nerve. He proposes a full-blown consumption tax, all right, but then makes it voluntary. This is similar to what GOP presidential hopeful Fred Thompson talked about in the 2007-2008 primaries. Taxpayers would be given a choice: They could switch to a simplified income tax with almost no credits, deductions, or exclusions or keep today’s system with all its subsidies and complexity.

Ryan is convinced that taxpayers would flock to the new tax. It would have two rates—10 percent for income up to $100,000 and 25 percent on earnings above that level. It would include a big standard deduction and personal exemption ($39,000 for a family of four). Interest, capital gains, and dividends would be tax free. So would all estates.

The problem, as Rudy noted this morning, is that the wealthy would avoid taxes on their investments by migrating to the new system while middle-class itemizers (many of whom are hooked on their deductions for mortgage interest and the like) would stick with the current mess. The result: A huge revenue sink.

Ryan believes his new system would generate federal revenues of about 18.5 percent of   GDP—close to the post World War II average. But TPC found the Thompson plan would cut federal revenues by a staggering $6 trillion to $7 trillion over 10 years, assuming everyone chose the version that most minimized their tax bill. The biggest benefit would go to those making between $100,000 and $500,000. The TPC estimate was static, so actual revenue losses might be more moderate, but still…

In the longer run, young people might go for simplicity before they get hooked on tax preferences and may end up on the consumption tax. But in the long run, as they say, we are all dead.

Ryan’s reason for giving people the choice seems more political than economic. He understands that tax reform usually creates losers as well as winners. So he figures his winners-only option may make a consumption tax more appealing to voters. Still, it is too bad he blinked. But give Ryan credit for at least confronting the failure of the income tax. It is a lot more than most of his colleagues are willing to do.
 

Suppose that a taxpayer earns an additional dollar of income. How much tax would she owe on that dollar? A natural way to answer this question would be to look up the taxpayer’s statutory tax rate – the rate corresponding to her tax bracket and filing status.

But that approach often gives the wrong answer and can mislead not only taxpayers but policymakers. Many tax preferences are phased in or out according to income, and as a result, those who earn extra income may face either a hidden tax or a subsidy as their tax benefits change in value. For example, for those in the phase-in range of the earned income credit earning an extra dollar increases the credit and reduces their tax liability, driving their actual rate below their statutory rate. But once they make enough so the EITC begins to phase out, the opposite happens and the rate they actually pay climbs.

Altogether, half of taxpayers in 2009 face actual tax rates on additional earnings that differ substantially from their statutory rates. The tax on that last dollar –  what economists call the effective marginal tax rate – is higher than the statutory rate for 32 percent of taxpayers and lower for almost 18 percent. Moreover, the difference between the two rates can be huge. For taxpayers whose effective rate is higher, the average discrepancy is almost 6 percentage points. For those with lower effective rates, the difference averages 11 percentage points (we pointed out these differences in this week’s Tax Fact column in Tax Notes).

This distinction between effective and marginal rates sounds like the kind of technical mumbo-jumbo only economists can love, but it is a very big deal. It changes – or at least it should change – the way lawmakers look at how tax policy affects economic behavior. Take, for instance, President Obama’s proposal to restore some of the pre-Bush tax rates. Simply looking at the change in the statutory rates may not tell a very accurate story. The effective marginal tax rate is what should shape incentives to work, save, and comply with the tax system.

Although differences between effective and statutory rates are significant for all groups, the discrepancy is especially striking for those subject to the Alternative Minimum Tax (AMT). More than 80 percent of AMT taxpayers face an effective rate above their statutory rate because they gradually lose the full benefit of their personal exemptions. The statutory rates for the AMT are 26 and 28 percent. But the phaseout of the personal exemptions raises the effective marginal rate to 32.5 and 35 percent. So while the AMT is an unpleasant surprise for many, this higher effective rate is the real shock. AMT taxpayers making between $200,000 and $500,000 (about two-thirds of all AMT taxpayers in 2009), are socked, on average, with a whopping effective rate of 34 percent. Ouch.

Yet many don’t even know it. Statutory and effective rates differ so haphazardly that most taxpayers probably have no idea how much tax they owe on an additional dollar of income. What does this say about our current tax system? First, the phase-in and phase-outs of provisions really do bite. Second, in case you needed more proof that our current system is complex, here you have it.  Finally, it suggests that many individuals are making decisions based on incorrect notions about the tax consequences of their behavior.

People lose confidence in a system that leaves them in a fog about the tax rates they face. And considering that we are going to have to rely on this revenue-raising structure more than ever in the coming years, that it not a good thing at all.

The congressional fog is slowly parting and the fundamental issues of health reform are coming clear. And perhaps most controversial is the question of how Congress will pay for it all. Somebody’s taxes are going to be raised. But whose? And by how much? Despite the whining about 1000-page bills, there are only a few big moving parts to health insurance reform. It will require insurance companies to sell to all, regardless of their health. It will mandate that everyone purchase coverage (a trade-off rightly insisted upon by the insurers). It will create exchanges to make it easier for people to buy in the non-employer market. And it will create subsidies to help make those policies affordable. Finally, Congress has to pay for those subsidies.    more »

It is interesting, and perhaps worth noting, that while political opposition seems to be hardening against the $1 trillion, ten-year cost of the early versions of health reform, barely a peep of concern has been raised about the $3 trillion price tag for President Obama’s plan to extend most of the Bush-era tax cuts.    more »

Many people who have failed to pay taxes on funds stashed in overseas bank accounts will likely toss and turn during coming nights, worried that the tax man will soon come knocking at the door. Will they be among the nearly 4,500 account holders whose names Swiss bank UBS has agreed to give to the IRS? And even if their names aren’t on the list, will the IRS learn about them from others seeking amnesty? Should they apply for amnesty themselves, paying large tax bills but at least staying out of jail? Or lie low for fear the IRS will find other problems if they draw attention to their returns?   more »

Last week the Congressional Budget Office issued a new edition of Budget Options, its biennial publication detailing hundreds of proposals that would raise or lower taxes and spending. Numbers in the revenue chapter of the nearly-300-page book show just how difficult it will be to raise the taxes needed to fill the huge deficit hole that we’ve dug for ourselves.    more »

What would I do without The Wall Street Journal editorial page? I come to work on a slow summer’s day, not sure what I’m going to blog about, when I find this in the morning Journal: “A piece in The New York Times over the weekend declared in a headline that ‘the Rich Can’t Pay for Everything, Analysts Say.’ And it quoted Leonard Burman, a veteran of the Clinton Treasury who now runs the Brookings Tax Policy Center, as saying that ‘This idea that everything new that government provides ought to be paid for by the top 5%, that’s a basically unstable way of governing.’ They’re right, but where were they during the campaign?”    more »

As Congress and the administration grope their way toward healthcare reform, a major obstacle is financing: how do we pay the $1 trillion cost over the next decade? Many economists and members of Congress favor reducing or eliminating the tax exclusion of premiums paid for employment-based health insurance (ESI). We owe no income or payroll tax on the premiums our employers pay. The exclusion will cut an estimated $240 billion from federal revenues next year and $3.5 trillion over ten years. And it hits state tax collections too.    more »

A few thoughts on the House Democrats’ still-evolving plan to pay for close to half of health reform by raising marginal rates on the highest earning taxpayers: *By allowing the Bush tax cuts to expire, restoring the phase-outs of the personal exemption (PEP) and itemized deductions (Pease), and now by proposing a ‘surcharge” of 2 percent or more, Democrats would be boosting the top individual tax rate from the Bush-era 35 percent to nearly 45 percent, ever-closer to the 50 percent top rate of 1985.    more »

As I promised in last Friday’s TaxVox post, here is TPC’s estimate of the 2012 distribution of President Obama’s tax proposals in the 2009 budget, measured against the administration’s chosen baseline. That baseline looks a lot like current policy: extend the Bush tax cuts, index and make permanent the 2009 estate tax, and permanently patch the alternative minimum tax by indexing forward the 2009 parameters.    more »

Following last month’s release of the Treasury Green Book, the Tax Policy Center reworked its distributional analysis of the tax proposals in President Obama’s 2010 budget. We learned many new details about specific tax provisions, including the practical definition of who has enough income to face higher taxes. The bottom line? You have to have a lot of income to be in Obama’s crosshairs.    more »

A basic tenet of public finance holds that people tend to do less of something when it is taxed. Raise income tax rates and some people will work less. Boost the gas tax and people will drive less. Hike the cigarette tax and people will smoke less. That inexorable law of demand poses two problems for the taxman. First, taxes distort behavior as people move from taxed activities to those that are taxed less or not at all. Sometimes, as in the case of cigarette taxes, we want to discourage the taxed activity. In other cases, the tax only makes the economy less efficient. Second, tax avoidance may reduce the revenue gained from a tax increase—or even negate it entirely. For example, if gasoline sales plummet when gas taxes rise, we get less revenue to build and maintain roads.    more »

During the 2008 presidential campaign, much was made of candidate Obama’s proposal to boost taxes on “high-income” taxpayers. Campaign attack ads warned those folks—couples with income over $250,000 and others with income over $200,000—that a big tax increase was on the way. Joe the Plumber complained that the tax increases would stifle his unborn entrepreneurial dreams.    more »

Tax Day has come and gone and IRS commissioner Doug Shulman says refunds this year will total roughly $300 billion. About two-thirds of that amount had already gone out to early tax filers by the beginning of this month. That’s a significant amount of money and it could boost the economy—if recipients spend it. In today’s economic environment, that’s a big if.   more »