Paul Ryan’s tax plan is just a shift toward less obvious tax breaks for the rich

Posted July 1, 2016 at 2:27 pm by Hunter Blair

Paul Ryan’s tax plan is just a shift toward less obvious tax breaks for the rich

Paul Ryan’s election-year tax reform agenda shocked some people with its 33 percent top marginal income tax rate on earned income. This is much lower than today’s rates—or even what prevailed after the George W. Bush tax cuts—but at the same time, it’s high relative to the world of wildly unrealistic Republican tax plans. Have Republicans realized that slashing taxes on the rich won’t lead to booming growth and hence be self-financing? Or have they realized that they shouldn’t exacerbate inequality by continuing to fight tooth and nail for enormous tax cuts for the rich? Sadly, no, they are still fighting for enormous tax cuts for the rich—they’re just being a bit more subtle about it now. One example of this subtlety was detailed in my previous post: the 33 percent statutory rate masks the fact that high-income individuals could easily pay a top rate of 25 percent under Ryan’s plan by simply reclassifying their income as pass-through income. So the extent to which the House Republican caucus is no longer calling for drastic cuts to top marginal income tax rates is highly exaggerated. They’ve simply traded in their very-apparent tax reductions for less-obvious tax loopholes.

Another example highlights how House Republicans are doubling down on tax breaks for an even-richer subset of high income individuals—people who make their income from capital earnings instead of working.

The Ryan tax plan drastically slashes taxes on both corporate income and income from capital gains, dividends, and interest. It cuts the corporate income tax to 20 percent and shifts the United States to a territorial system that would spur income shifting and tax avoidance. I’ll discuss the effects of those proposals in a later post, but for now I want to focus on Ryan and the House GOP’s 50 percent exclusion on income earned from capital gains, dividends, and interest.

What would a 50 percent tax exclusion on capital gains, dividends, and interest do? As the Tax Policy Center and Citizens for Tax Justice note, this 50 percent exclusion effectively sets a top rate on capital gains, dividends, and interest at 16.5 percent. Because you can exempt 50 percent of your capital income, you have to make more than twice the cutoff to have anything fall in top bracket. At that point, half of the next dollar accruing through capital returns is excluded from taxation, and the other half is taxed at 33 percent, meaning that the whole dollar is taxed at a top rate of 16.5 percent.

The effect of the new 50 percent exclusion on capital income is a little less straightforward for households not in the top marginal tax bracket. The marginal rates on capital income in lower brackets won’t be exactly half the rates faced by earned income, but close. Regardless, the 50 percent exclusion results in the effective rate on capital income being lower then it would be if Ryan simply cut the marginal rates on capital gains, dividends, and interest by half of the marginal earned income rates. The details are admittedly complex and have confused even some analysts, but I provided an example in the following footnote.[i]

Overall, given the new tax brackets introduced by Ryan on earned income and his 50 percent exclusion for capital income, Ryan’s tax reform plan would slash the current top marginal tax rate on capital income from 23.8 percent to 16.5 percent. It’s worth noting how steeply regressive this tax cut would be. Capital income is a remarkably unequally held form of income, and this tax cut would worsen the already preferential tax treatment of capital gains and dividends, which are currently taxed at a top marginal rate of 23.8 percent, compared to the top marginal rate of 43.4 percent on earned income.

The Congressional Budget Office estimated that the preferential rate on dividends and capital gains provides “almost no benefit” to the bottom 80 percent of households. And the benefit of preferential rates on dividends and capital gains is heavily concentrated at the very top of the income distribution, with 68 percent of the benefit going to the top 1 percent of households.

As Politico notes, it appears this shift towards capital and corporate income taxes is driven in part by the desire to move away from the fight to lower the top marginal earned income tax rate. But the outcomes of Republican tax proposals are the same in the end. Because labor income is less unequally distributed than capital income, tax cuts for capital income would dramatically exacerbate inequality. All that has really changed is the details on how this happens.

Endnote

[i] The Tax Foundation claims that the 50 percent exclusion is equivalent to setting the marginal tax rate on capital gains, dividends, and interest at half of the earned income rate. But while this may approximate the rates on capital gains, dividends, and interest, it isn’t exactly equivalent. To see this, consider the effective rate on capital gains, dividends, and interest from a simple example using the Tax Foundation’s assumptions on the Ryan plan.

Extended endnote

That is, assume that Ryan’s 12 percent bracket would replace the current 10 and 15 percent brackets, the new 25 percent bracket would replace the current 25 and 28 percent bracket, and the top bracket of 33 percent would replace the current 33, 35, and 39.6 percent brackets. Let’s consider three ways a single individual could be taxed while making $250,000 in taxable income (after taking into account the standard deduction). Under the Ryan plan, if the income is all earned income, the individual is taxed at marginal rates of 12/25/33, if the income comes from capital they get to exclude 50 percent of the income from taxation but are then taxed at rates of 12/25/33. The final option is the Tax Foundation’s version, where the income from capital is taxed at half the earned income rates, so the marginal rates would be 6/12.5/16.5. What we will see is that the Ryan plan is actually even more of a tax break for the rich than the Tax Foundation’s version.

Consider what actual effective tax rate each of these options implies. The first would pay an effective rate of 25 percent, the second would pay an effective rate of 10.5 percent, and the third would pay an effective rate of 12.5 percent. So that while, yes, the bulk of the tax breaks for capital income could be approximated by the Tax Foundations marginal rates, doing so would miss that under Ryan’s tax plan capital income will actually be taxed at an effective rate 2 percentage points lower. And while the difference between those percentages will decrease as the taxable income in this comparison increases, the Ryan tax plan will always be more beneficial to the taxpayer in absolute terms. By $10,000 at the increasingly higher income levels that bring about the percentage effective rates’ convergence.

Why is this the case? Because of the interaction that occurs with the bracket cutoffs when half of income can be excluded. In the case of the 6/12.5/16.5 marginal tax rates, the individual’s income is taxed in all three brackets. However, with an exclusion of 50 percent, while that capital income may be taxed at higher rates, less of it is taxed and more importantly for this particular example, none of their income is ever taxed in the highest tax bracket. To put it another way, with an exclusion of 50 percent of capital income, an individual needs to make more than $380,300 in capital income before a single dollar of their taxable capital income is subject to the top marginal tax rate.

Tagged Budget, Taxes, and Public Investment Taxes

Paul Ryan’s tax plan is just a shift toward less obvious tax breaks for the rich

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