Mitt Romney's recent announcement of Paul Ryan as his running mate makes this election even more about government spending, programs and taxes. Ryan is the primary author of the Republican-led House's 2013 budget proposal. Consider these five proposals to evaluate Romney's wisdom in selecting him.
Ryan would limit Medicare costs in two ways. First, he would allow private insurance to compete with traditional Medicare. Plans would have to be at least as good as Medicare, and premium support would be fixed at the second least expensive plan offered. Second, if competition did not control costs, per capita increases would be capped at 0.5% above total economic growth. This safety net would ensure that overly generous entitlements do not overburden the U.S. economy.
Ryan advocates a simpler tax code. Any changes in the tax code mean there will be "winners" and "losers." But the tax code is not static. Every change, no matter how small, also means a large number of people will behave differently. The Congressional Budget Office (CBO) is legally not permitted to consider these behavioral changes when it estimates how budget changes will impact revenue. Thus figures from the CBO are as useless as ignoring the principles of supply and demand.
For example, if you asked the CBO, "How much revenue would you collect if the tax rate were set to 100%?" they would have to answer, "You would collect the entire $15 trillion gross domestic product (GDP)." They are not allowed to take into account that none of us would work if the government took all our money. Similarly, they are not permitted to compute how much more productivity would be generated if tax rates were lowered.
The top U.S. corporate tax rate is currently 35%, scheduled to rise to 39.5% in 2013. This is now the highest corporate tax rate in the developed world. The average rate is only 23%.
The average effective rate for corporations is lower, about 27.7%. Some corporations don't have high profits and therefore do not pay a high tax rate. By the time corporations reach the 25% marginal rate, they have paid significant taxes in the lower tax brackets, making their effective average much lower. Corporations in some industries have sections of the tax code written specifically for them, translating into tax breaks that lower their burden.
Here is where understanding economics can help. Companies do not make decisions based on their effective tax rate. All decisions are made at the margin based on the top marginal tax rate. I wish voters understood that all decisions are made at the margin.
Imagine two identical companies in different countries that both have an effective tax rate of 25%. But the U.S. company is subject to a highly progressive tax code and its marginal rate is 35%, whereas the other company is subject to a flatter tax code and its rate is 25% no matter how much or little it makes. The foreign company has much more of an incentive for greater productivity.
To make the example even clearer, imagine there were only two tax rates, 10% and 100%. Once a company reached the edge of the 100% rate, it would stop bothering to earn any additional money. The top marginal rate would be 100%, but the effective tax rate would only be 10%. Changing the tax rate to a flat 20% might very well collect twice as much revenue, even though liberals would be blasting the plan as giving an 80% tax cut to the rich.
The fact that many companies pay a much lower effective rate is evidence of just how much the top marginal rate is keeping them from earning well into that rate. A flatter and lower tax that begins earlier would stimulate economic activity without necessarily changing tax revenues.
Ryan proposes just two rates: 10% and 25%. He would eliminate many of the tax loopholes that allow some companies to pay a lower rate.
The odd truth about corporate taxes is that while the rates have become more burdensome to those caught in the highest marginal rates, the taxes collected from corporations has been shrinking as a percentage of GDP.
Sound economics suggests that because decisions are made at the margin, the more corporations find themselves in a high marginal tax bracket, the lower the taxes that are collected. Flattening the tax and equalizing it among corporations by eliminating tax breaks and lowering the number of brackets might therefore have the opposite effect and increase tax revenue.
Ryan would regulate social programs. The states administer federally funded programs such as Medicaid and food stamps. They have an economic incentive to add people to these programs but little or no ability to reduce their costs. Conservatives support the types of incentives that produce self-regulating systems. Systems without this type of negative feedback ultimately explode in costs and numbers.
Ryan's solution is to cap federal spending to the states with block grants and allow states to tailor the enrollment criteria. This would permit states to require work or job training and thus help move people off welfare. Fewer people in need means the states could provide greater support with the same amount of money. With one in seven Americans receiving food stamps, the current system is exploding.
When I was studying engineering, I wired a circuit board incorrectly, and a small mushroom cloud of smoke rose from one of the components. Any system that lacks negative feedback to regulate it ultimately explodes. But systems with too much negative feedback won't perform at all. Conservatives claim the free market is overregulated and social entitlements are underregulated. From a systems point of view, I would have to agree.
Ryan would limit government spending as a percentage of the GDP. This is the right approach. Revenue has remained between 15% and 20% for years. Limiting spending to this range would ensure that spending doesn't overtake our ability to tax. The austerity it will take us to get there, however, will involve some political work.
Ryan may risk a value-added tax. Both Ryan and Romney are open to such a tax. I have always feared the country would add a sales tax without solving any of its spending problems. In that case we will continue to sink into a European-style of malaise where growth continues to slow to the point it starts contracting.
Ryan will compromise politically. Ryan is savvy about what is possible in Washington. In the past he has voted for programs that were not in line with conservative values. If you are worried he is too conservative, this record should reassure you. If you believe the country's situation calls for extreme measures, you may have doubts about what Ryan will actually be able to accomplish.
And this is probably Mitt Romney's purpose in selecting him. Ryan agrees with the principles of smaller government but also understands Washington politics. For those like Romney who seek to solve some of the country's economic woes with a compromised middle way while energizing the smaller government base, he is the perfect choice.