What Happened in 2002

While many tax reform issues were addressed in the House of Representatives during 2002, the Senate leadership blocked any opportunity to make real progress. The House voted (H.R. 586) to make the 2001 tax rate reductions permanent, but the Senate did not consider similar legislation. The chairman of the House Ways and Means Committee introduced legislation (H.R. 5095) to help U.S. companies compete overseas, but there was no movement in the Senate--even though the World Trade Organization (WTO) had ruled against America for a fifth time and several companies were forced to re-charter in other jurisdictions in order to compete on a level playing field.

At the request of the Ways and Means Committee chairman, the Joint Committee on Taxation has begun to address concerns about the shortcomings of using the current "static" methodology. The committee even appointed a blue-ribbon panel to study ways of improving the revenue-estimate process to take into account the effects of tax policy changes on such things as savings, investment, and jobs; and many lawmakers expressed interest in modernizing the system. The Administration began an analysis of fundamental tax reform in 2002, and there appears to be substantial support both in the White House and on Capitol Hill for policies that will reduce the tax bias against saving and investment.

What to Do in 2003

To boost the economy's recovery in 2003 and make America more competitive in the global market, Congress and the Administration should:

• Make the 2001 tax rate cuts permanent. The income tax rate reductions approved in 2001 will take full effect in 2006 but then disappear on January 1, 2011, when the Clinton-era tax rates will return. Likewise, the death tax will be repealed in 2010 but then fully reappear in 2011. Such bizarre tax policy, the result of arcane budget rules, will cause significant long-run damage to the economy. Simply stated, workers, investors, and entrepreneurs will not engage in nearly as much additional productive behavior if there is a substantial possibility that their tax rates will jump back up in 2011. Even the short-term impact of the current policy will be muted, since many decisions to work, save, invest, or expand a business will result in higher long-run tax liabilities.
• Accelerate the planned tax rate reductions. Because of inappropriate fixation on annual budget estimates, the 2001 tax cut plan is being implemented over a 10-year period. The income tax rate reductions take effect in 2004 and 2006, and death tax repeal is not effective until 2010. These delays undermine the pro-growth impact of these tax cuts, since taxpayers have an incentive to hold off on activities that will generate taxable income. Lawmakers should accelerate these tax cuts so that they take effect in 2003. This will improve incentives to work, save, and invest, thereby increasing both short-term and long-term economic growth.
• Fix the tax code's treatment of income earned overseas. Unlike most other nations, the United States has a "worldwide" system of taxation, forcing U.S.-chartered companies to pay tax to the IRS on income earned in other nations. This is a very anti-competitive policy, particularly since the United States now has the developed world's fourth highest corporate tax rate and will soon have the second highest if Italy and Belgium proceed with their planned tax rate reductions. The combination of high tax rates and worldwide taxation makes it very difficult for American-based companies to compete overseas--particularly since foreign governments already subject the overseas income of American companies to all applicable foreign taxes.

Lawmakers have tried to ameliorate the damage with preferential rates for export-oriented income, but the WTO has ruled that this policy is an illegal export subsidy. In an effort to protect their workers and shareholders, some companies have re-chartered in places like Bermuda and the Cayman Islands that have better tax laws. But this is a second-best option. Lawmakers should shift toward a "territorial" system, meaning that the United States no longer would tax foreign-source income. This policy would enable U.S.-based companies to compete on a level playing field with their foreign competitors.

• Add economic analysis to revenue estimates of tax policy changes. Congress routinely debates changes in tax policy largely without considering their economic or dynamic effects. Absent an understanding of how tax and fiscal policy influences economic behavior, the static "cost" estimates produced by the official revenue estimators (the staff of the Joint Committee on Taxation, the Congressional Budget Office, and the Treasury Department's Office of Tax Analysis) often are shockingly wrong and nearly always misleading. The current static approach creates an artificial and incorrect bias in favor of tax rate increases and against pro-growth tax rate reductions. Without a change in this policy, that bias will persist and meaningful tax reform will be much more difficult. Clearly, Congress and the Administration would do a better job of enacting pro-growth tax legislation if they routinely and seriously considered the economic effects of their actions. (For more on dynamic revenue estimates, see the chapter on "Reality-Based Scoring.")
• Reject international tax harmonization schemes. The European Union (EU) has proposed a "savings tax directive" that would require nations to collect private financial information about non-resident investors and share that information with tax authorities in other nations, and it wants the United States to participate in the proposed cartel. In an effort to preserve bad tax policy, this approach would make it easier for high-tax nations to tax income earned outside their borders. It violates the principle of territorial taxation and inevitably will create conflict with jurisdictions that do not want to become vassal tax collectors for high-tax nations. It also would make it easier for nations to impose a second layer of tax on income that is saved and invested, violating the principle of neutrality and depressing capital formation, which hinders economic growth and job creation. The Bush Administration already has rejected this scheme, but career bureaucrats at the IRS and Treasury Department appear to want to undermine that position. Congress should encourage the White House to reject all tax harmonization schemes, particularly the EU's savings tax directive. In addition, lawmakers should prohibit the IRS from usurping the policymaking process with pro-tax harmonization initiatives, such as the proposed regulation to require the reporting of bank deposit interest paid to nonresident aliens.1
• Begin fundamental tax reform. Such reform should include promoting universal IRAs, eliminating the capital gains tax, and integrating personal and corporate income taxes so that dividend income no longer is taxed twice. The Internal Revenue Code has a pervasive bias against saving that can be addressed in two ways. Option one would be to expand traditional (or front-ended) IRAs. In this scenario, the money that an individual deposits in an IRA would not be subject to tax; the principal and interest, however, would be subject to a single layer of tax when the money is withdrawn. Option two is to promote the back-ended (or Roth) IRA. In this scenario, individuals pay their single layer of tax the year income is earned, but any after-tax money placed in the back-ended IRA and the returns to that money are protected from any additional layers of taxation. Both options would yield the same long-term result. The back-ended IRA sometimes is seen as a more attractive approach since it minimizes short-run revenue losses.

The capital gains tax is a second layer of tax that has a pernicious effect in that it penalizes risk-taking and entrepreneurship. Many nations do not tax capital gains, and those that do impose the tax often provide widespread exemptions and exclusions; others protect taxpayers by indexing the tax to ensure that only inflation-adjusted gains are taxed. A capital gain occurs when an asset climbs in value because there is a market expectation that it will provide a larger stream of after-tax income in the future. This future income, of course, will be subject to tax when it materializes. Indeed, current tax law sometimes will subject that income to two layers of tax. To tax a capital gain, therefore, is to impose preemptively a second or third layer of tax--an approach that magnifies the tax code's bias against savings and investment and is therefore completely inconsistent with pro-growth tax policy.

Corporate investors must pay at least two layers of tax to the federal government. First, the income is subject to corporate income tax; the income that is left after paying the tax is distributed to the shareholder and then subject to the personal income tax. The combination of these two taxes (with maximum rates of 35 percent and 38.6 percent) means that equity investment is routinely subject to effective tax rates of approximately 60 percent. Such double taxation of income reduces investment, which means in turn a lower capital stock and wages.

Eliminating the double taxation can be accomplished in three different ways. Option one is to remove dividends from the base of the individual income tax. Option two is to make dividend payments deductible for the business, which has the effect of eliminating the layer of tax that exists at the corporate level. Option three is to lower the tax rate on corporate income and to provide a preferential tax rate for dividends at the individual level.

--Daniel J. Mitchell, Ph.D., is McKenna Senior Fellow in Political Economy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

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