Heritage Foundation Leadership for America

Senator John F. Kerry, the presumptive presidential nominee of the Democratic Party, has proposed a number of changes to U.S. tax policy that he argues will boost the economy’s performance and increase jobs. However, an econometric analysis of his plan shows that the negative effects of an increase in taxes for high-income taxpayers overwhelm the positive effects of making key elements of the Bush tax plan permanent for taxpayers with incomes under $200,000. The net effect is a slower economy and job creation significantly below potential.[1] 

Our preliminary analysis estimates the effects of the Kerry tax plan using a standard macroeconomic model of the U.S. economy. This analysis shows that: 

• Employment growth recedes.  Employment growth reflects the slower pace of economic activity. The annual rate of non-farm employment growth will be consistently below-forecast each quarter for the 10 years following January of 2005. By 2006 there will be 225,000 fewer jobs created per year due to the Kerry tax plan than in the baseline scenario, and by 2013 there will be 404,000 fewer jobs created per quarter. The unemployment rate also is consistently higher than in the baseline scenario through the forecast period.
• GDP slows.  The nation’s output of goods and services quickly drops below current forecasts, and growth remains slower throughout the next 10 years. Gross Domestic Product, after adjustments for inflation, drops an average of nearly $20 billion below baseline for each of the first five years and $30 billion below baseline for each of the last five years. 
• After-tax income shrinks.  Income after taxes, or inflation-adjusted disposable personal income, is below baseline in each year of the forecast. It begins $43 billion lower than baseline in 2005 and continues to drop to $240 billion below forecast in 2014.
• Savings plummet.  Lower disposable personal income means lower personal savings. The personal savings rate averages 17 percent less during the first year of the Kerry plan (2005) and is 43 percent below baseline by 2014. By 2014, personal savings are $193 billion below baseline.

The Kerry Tax Plan

Senator Kerry mixes tax cuts with tax increases in his proposed tax plan.[2] Though many details remain to be announced by the Senator’s tax team, the following appear to be principal, well-developed elements of his plan and were incorporated in our economic analysis of his proposals:

1. For taxpayers with incomes above $200,000, the tax benefits of policy changes from 2001 and 2003 no longer apply. Their first dollar is taxed at 15 percent rather than 10 percent, and their last dollar is taxed at 39.6 percent rather than 35 percent. They lose the benefit of lower taxes on capital gains and dividend income. These income streams currently are taxed at a 15 percent rate, and Senator Kerry’s plan calls for the rate to jump to 20 percent for capital gains and to the pre-2001 ordinary income tax rates of 36 and 39.6 percent for dividend income. Taxpayers earning above $200,000 also lose the expanded child tax credit and marriage penalty relief and would once again be subject to the phase-out of personal exemptions and itemized deductions.
2. While Senator Kerry’s campaign has been relatively silent on federal estate and gift taxes, we assume that the Senator will propose a halt to both expansion of the estate tax exemption amount and reduction of the estate and gift tax rates, as well as the repeal of the estate tax in 2010. 
3. For individually filing taxpayers with incomes below $200,000, Senator Kerry proposes to make several of the Bush tax cuts permanent. The Senator would keep the 10 percent tax rate and the expanded tax bracket. He would make permanent marriage penalty reforms. And, he would permit taxpayers earning less than $200,000 to keep the $1,000 per child tax credit. Insufficient detail exists, however, to permit us to assume that Senator Kerry will retain the small business expensing provisions that benefit taxpayers who report business income on the 1040 form.
4. The Senator provides additional tax cuts to cover health care costs. For taxpayers with incomes below $200,000, Senator Kerry proposes a health care tax credit for those who retire early and for those who are between jobs. He also proposes a tax credit for small businesses that purchase health plans for their employees. 
5. The statutory tax rate on corporate profits would fall from 35 percent to 33.25 percent. Senator Kerry proposes to pay for this tax reduction by ending the current practice of allowing corporations with foreign sourced income to defer paying the U.S. profits tax on that income. 

The net effect of these tax policy changes—not counting the negative economic feedback they would cause—is a net tax increase of $609 billion over the ten-year period beginning January 1, 2005.[3]

Conclusion

While these economic estimates are likely to change as Senator Kerry announces more details about his tax plan, they strongly indicate the weakness of his current approach. Raising taxes on high-income taxpayers to cover budget shortfalls may make political sense, but it is not the right move to encourage economic growth. Senator Kerry’s new tax revenues divert capital from better economic uses, which slows the growth in productivity that usually stems from new investment. Job and income growth suffer as a consequence.

What Senator Kerry should do is embrace the goal of faster economic growth and endorse the objective of making every one of the 2001 and 2003 tax cuts permanent. The Senator is halfway toward this objective now with his proposal to secure the middle-class tax cuts. However, the Senator is missing an opportunity to transcend the politics of economic policy with a vision for a real pro-growth tax policy. Taking the next step and making all of the 2001 and 2003 tax cuts permanent may be politically difficult, but it would be a sensible step for any candidate concerned about economic growth.