January 23, 2003

January 23, 2003 | Commentary on Taxes

Just what our economy needs

President Bush's critics wasted no time denouncing his latest economic plan. "An irresponsible, ineffective, ideologically driven wish list," Sen. Joseph Lieberman, D-Conn., put it. "Too steeped in conservative ideology," The Washington Post said. The president is "going for broke - as in flat broke," according to the Los Angeles Times.

Predictably, many opponents indulged in old-fashioned class warfare. New York Times columnist Paul Krugman finds the plan "almost ludicrously tilted toward the very, very well off." The New York Times itself editorialized: "In a theoretical world, ending the dividend tax might make sense. Unfortunately we live in the real one, where it's the wrong move at the wrong time for the benefit of the wrong people."

Once you look closely at the plan, however - and the economic benefits likely to flow from a proposal that goes beyond the mere "stimulus" package the critics champion - you come away with a remarkably different impression.

Let's consider what the president has proposed:

1) Speed up and make permanent the 2001 tax cut. No wonder the critics are upset: This change would rob them of a handy rhetorical club - namely, the charge that we can't expect this tax proposal to do much good when the last one has done so little to boost the economy. But how could it, when most of its tax-rate changes aren't scheduled to take effect until 2004, 2006 and even later? And how much growth can it spark when the entire package is set to be repealed in 2011?

In short, the critics are trying to blame a sluggish economy on a tax cut that, in large measure, has yet to materialize. If we implement the whole package now, we can begin enjoying its intended benefits - higher levels of saving and investment, more jobs - sooner. And the benefits won't accrue solely to the rich: The 2001 tax bill will eventually lower every single tax rate, from the well-off to the not-so-well-off. If you pay taxes at all, your take-home pay will rise.

Tax-cut opponents sneer at this "supply-side" approach, insisting that tax cuts will depress the economy. But they ignore historical evidence that shows how tax cuts help the economy. It happened in the 1960s, when President Kennedy's plan to cut the top marginal tax rate from 91 percent to 70 percent took effect. Total tax revenues climbed 4 percent, despite predictions that the plan would plunge the country into debt. Taxpayers wound up with higher post-tax incomes, expanded economic opportunity and better financial security. The government got a faster-growing economy, more people working, more taxable earnings per worker and, thus, more revenue.

2) Reduce the tax penalty on new investment. Under a fairer tax system, companies would pay tax only on their net income - the difference, essentially, between how much they make and how much they spend. Under current law, however, businesses can deduct only a fraction of new investment expenses in the first year and must wait years to deduct the full cost. President Bush's plan would help reduce this anti-investment bias by increasing the amount of investment that can be immediately deducted (or "expensed") from $25,000 per year to $75,000 per year. Reducing this perverse bias in the tax code would bring obvious benefits, as rising investment brings more jobs and higher incomes.

3) Eliminate the taxation of dividends. President Bush considers this the centerpiece of his economic proposal. For starters, it would go a long way toward removing some inequities from our insanely complicated tax code. Basic fairness, after all, dictates that we tax income only once. Yet after corporations have paid on the income they earn and transfer some of the income to investors in the form of dividends, the government returns for another hit: This money is subject to another tax - this one paid by the investors. The practice of taxing business profits twice - once as corporate earnings and again as shareholder earnings - means the government can end up pocketing more than 50 cents of every dollar of distributed corporate profit.

But a dividend tax cut is more than just a matter of fairness. The double-taxation of dividends also may encourage companies to over-extend themselves by taking on too much debt, leading to some high-profile bankruptcies. The reason is simple: Investors don't want to pay the dividend tax, so they seek out companies that finance new investment with debt instead of equity. Inevitably, some companies wind up stretching themselves too far and collapse, dragging stockholders with them.

We should aim for a neutral tax code, as opposed to what we have now: one that encourages companies to incur debt to finance growth. The way we tax dividends contributes to numerous economic distortions. Congress needs to change this.

Congress could make the tax treatment of dividends more neutral by allowing corporations to deduct dividend payments from their taxes - just as they do with interest payments - or perhaps allow investors to receive tax credits on their individual returns to offset the dividends tax.

Critics claim that a dividend tax cut would benefit only the rich. Investing in the stock market has become far more widespread over the last two decades, with 84 million people - representing nearly half of all American households - owning stock. Tax-deferred investment tools such as 401(k) plans and individual retirement accounts (IRAs) have thrust millions of Americans who make $60,000 or less per year into the "investor class." (While these individuals are not currently paying any income tax on dividends into their tax-deferred accounts, they might benefit indirectly if the tax change causes overall stock prices to rise.)

IRS data show that 70 percent of the taxpayers who received dividends in 1998 earned less than $55,000 in wages and salary. By the end of 2000, 42 million workers who made less than $60,000 per year were participating in 401(k) plans, and by 2002, 40 percent of households with incomes of $55,000 or less owned IRAs. Of the $2.4 trillion in assets held in employer-sponsored retirement plans and IRAs in the country, nearly $1.5 trillion, about two-thirds, is invested in domestic stocks.

Perhaps most importantly, the re-composition of investments would produce higher levels of overall economic efficiency. Lower capital costs and more efficient equity and bond markets would give our economy long-term growth, as well as short-term "stimulus." Our research indicates that, if the income tax on dividends received is eliminated:

- Gross domestic product (GDP) would grow, increasing $22 billion next year and rising steadily to about $45 billion in 2012.

- Non-residential investment would rise about $253 billion over that 10-year period.

- Total employment would be higher in each of the next 10 years if dividend taxes were reduced. By 2012, the economy would have 325,000 more jobs than if the tax remained unchanged.

- Personal savings would increase by an average of $18 billion over the next decade.

"If tax relief is good enough for Americans three years from now, it is good enough for Americans today," President Bush said as he presented his economic plan. He's right. And if lawmakers adopt the kind of tax changes he's proposing, it's clear that economic growth will follow - today, three years from now, and beyond.

Beach is the director of Center for Data Analysis at The Heritage Foundation (www.heritage.org).

About the Author

William W. Beach Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis

Related Issues: Taxes

Originally appeared in the San Diego Union-Tribune