Ryan Plan Smartly Marries Tax Reform with Spending Reform

April 05, 2011

Today, House Budget Committee Chairman Paul Ryan released his budget plan for 2012 and beyond. Unlike the typical Congressional budget resolution, the Ryan plan (available here) is not only comprehensive in its scope but it is presented in a refreshingly transparent manner. Every proposal in this nearly 75 page document - from discretionary spending and Medicaid, to taxes and welfare spending - is explained and justified in a way that any taxpayer can understand.

While the press and critics will zero in on Ryan's bold proposals for reforming entitlements such as Medicaid and Medicare, serious attention should be given to the tax side of the plan because making the tax system conducive to long-term economic growth is just as critical to solving the nation's fiscal crisis as is reigning in uncontrolled spending.

There are three key elements to the plan that will greatly improve the economy's prospects for sustained long-term economic growth:

1.      The plan repeals the new taxes contained in President Obama's health care legislation and rejects the tax increases assumed in the President's 2012 budget.

The Ryan plan repeals the three major tax provisions in the health care legislation: (1) the tax penalties on businesses and individuals that don't sign up for the government plan; (2) the 0.9 percent surtax on wages and the new 3.8 percent tax on interest, dividends, and capital gains income; and, (3) the new taxes on so-called Cadillac health care plans.

While each of these tax increase would be a drag on the economy, the new 0.9 percent surtax on wages and the 3.8 percent tax on non-wage income would hit entrepreneurs and investors the hardest. For example, according to the OECD, the U.S. has the 4th highest combined rate on dividends among the 30 OECD nations at 49.5 percent. The new 3.8 percent tax will push the combined rate on dividends over 50 percent.

Similarly, the Obama budget called for raising the top tax bracket from 35 percent to 39.6 percent and raising the tax rate on capital gains and dividends to 20 percent. The U.S. already has the most progressive income tax system among OECD nations and these proposals would exacerbate the problem.

2.      The plan calls for cutting the top individual and corporate tax rates from 35 to 25 percent while ridding the tax code of the vast number of preferences and loopholes in the system.

Although the plan calls for the most sweeping tax reform since 1986 it does not cut revenues. Indeed, tax revenues will still double over the next ten years - from $2.2 trillion in 2011 to $4.1 trillion in 2020.  Thus the plan is more about producing a simpler, less economically damaging tax code than "cutting taxes."

For individuals, it consolidates the current six brackets while cutting the top individual rate from 35 to 25 percent. At the same time, it would broaden the tax base by eliminating many of the deductions and credits that now clutter the tax code.  

As is now well recognized, the U.S. tax system - especially our business taxes - is out of step with our major trading partners. For corporations, the plan also cuts the top rate from 35 percent to 25 percent, which would bring the overall corporate rate (including the average state rate) to roughly 30 percent - roughly equal to the weighted average of OECD nations. The 25 percent rate would also lower the U.S. ranking from 2nd highest overall among OECD nations to roughly 7th highest, a good first step.

Not only will these proposals improve U.S. competitiveness, they will boost the prospects for long-term economic growth. Economists at the OECD have identified high corporate and individual income tax rates as the most harmful taxes for long-term economic growth. Lowering both the top marginal tax rates for both businesses and individuals will put the economy on a strong growth path for the future.

3.      The plan averts massive tax increases on the next generation of American workers by reforming the major drivers of future deficits and the soaring national debt  - entitlement programs such as Medicare and Medicaid.

CBO's long-term forecasts show that if federal spending continues at its current pace, the federal deficit, and debt, will be so great that future tax rates would have to double or triple to raise sufficient revenues to close the budget gap.

The Ryan plan averts these massive tax hikes by proposing long-term reforms to the major entitlement programs that are now growing at unsustainable levels. For example, left unchecked, federal spending will top 32 percent of GDP by 2030 and 38 percent of GDP by 2040. According to CBO, the various spending reforms outlined by the Ryan budget will hold federal spending to roughly 20.75 percent by 2030 and 19.25 percent by 2040. In effect, this is like a 50 percent tax cut compared to what would be required to fill the long-term budget gap in the absence of any spending reforms.

Conclusion

There are two ways to solve the long-term budget crisis. It can be done in austere way that retards the economy's growth or it can be done in a dynamic way that boosts the economy's growth. The Ryan plan achieves the later by smartly marrying broad-based tax reform with substantive spending reforms. This will assure that government spending does not consume an increasing share of the private sector while making the tax code far more conducive to a growing economy.

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