Congressional Rep. Paul Ryan (R-Wisconsin) unleashed the first version of his U.S. budget proposal (HR 6110, “A Roadmap for America’s Future”) in 2008.  His latest proposal has been passed by the House but will not even come to a vote in the Senate.  (Why should they pass a budget this year?  The U.S. Senate has not passed a budget for the previous three years.  There is no reason to believe this fiscal year will be any different.)

A thoughtful commentary by columnist James R. Stewart in the March 24 New York Times (page B-1).  Mr. Stewart points out many of the “tax expenditures” that would need to be repealed under the Ryan budget.  Stewart concludes that “nearly all” the current tax breaks would need to be repealed. The total amount of these “preferential tax treatments” is a staggering $1 trillion per year according to Rep. Ryan’s document which continues, “these tax preferences are disproportionately used by upper-income individuals. …There’s nothing fair about that.”

Mr. Stewart specifically mentions deductions for mortgage interest, charitable contributions, state and local taxes, interest paid, and employer-provided health care benefits (which are paid out of before-tax income). He also notes that capital gains, carried interest, and dividend income are taxed at lower rates than ordinary income.  But economists know that dividends are taxed twice because they are paid out of after-tax profits.  I believe dividends should be treated the same as interest payments, with businesses allowed to deduct both as expenses.  In return, it seems reasonable to then tax dividends at ordinary income rates.  Regarding the capital gains tax, the lower rate provides at least some incentive to purchase equity.  I favor taxing capital gains at ordinary income rates unless the asset being sold was held longer than five years.  After a five year holding period, the capital gains tax would drop to zero.  This adds an incentive to think at least a little beyond the current quarter’s numbers when planning a portfolio.

Actually, the Ryan proposal goes even further.  It proposes complete repeal of the Alternative Minimum Tax (AMT) and elimination of all taxes on capital gains and other forms of capital income.  I’ll stick with my idea instead.  The U.S. needs to encourage long-term thinking and planning.  But getting rid of the AMT is essential to any tax reform.  (I speak as someone who actually was forced to pay the AMT a few tax cycles back.)  There would be two tax brackets for households.  Joint filers with total income under $100,000 will be taxed at a 10 percent rate and income over that amount takes a 25 percent hit.  The standard deduction and personal deductions would be raised to $25,000 and $3,500 per person.  Rep. Ryan also proposes a value-added tax (VAT) which is called a Business Consumption Tax (BCT).  A quick glance at the BCT tells me that it’s pretty darn close to a VAT (if not identical).

One item not mentioned by either Mr. Stewart or Rep. Ryan is municipal bond (muni) interest.  Under current law interest paid on qualifying municipal bonds is exempt from federal income taxes.  If you pay taxes in the state in which the munis were issued, most states also exempt the interest from state taxes.*  Frankly, this is a terrific tax shelter.  We’re fortunate enough to be able to take advantage of it.  (Those interested should look up “taxable equivalent yield” to determine whether munis are a good idea for you.)  And, while muni interest is a great tax shelter, it’s hard for me to believe that the tax expenditures created don’t mostly go to high-income and/or high-wealth households. A Google search of the “Roadmap” website turns up one hit on “municipal” — an article in the New York Times about the state of New York’s budget woes.

So, Rep. Ryan, I ask a simple question: what do you propose to do about municipal bond interest?  If that interest remains tax exempt, your proposal will cause wealth to flood into the muni market, driving interest rates being paid by state and local governments down sharply.  The portfolio shift will be caused by — what else? — wealthy people trying to escape taxes.

*For years I’ve proposed studying how muni interest rates vary among states with respect to the state income tax rates.  After all, Texas, Florida, Oregon, Arizona, New Hampshire and a few other states have no state income tax at all.  Anyone with time on their hands is invited to do this research — assuming it hasn’t already been done in which case I expect to hear from my fellow economists in short order.