April 24, 2003

April 24, 2003 | Commentary on Taxes

The Right Kind of Tax Cut

Listening to Washington policy-makers haggle over the size of President Bush's proposed tax cut -- $350 billion over the next decade? $550 billion? $726 billion? -- you would think nothing matters much beyond the price tag.

Just as important, though, is the type of tax cut they approve. Not all tax cuts are created equal. The wrong kind will do little to boost economic growth and create jobs.

Providing a $500 annual "rebate" to every taxpayer in the country, for instance, would reduce tax revenue significantly. But it wouldn't help the economy because rebates don't change incentives to work, save and invest. By contrast, eliminating -- or even reducing -- the "double taxation" of dividends would encourage more investment and boost the economy's performance, even though the amount of tax relief might be small compared to a universal rebate.

When designing the tax cut, lawmakers should consider the following questions:

Will it lower the cost of productive behavior?
To encourage growth, a tax cut should reduce the tax rate on work, saving, investment, risk-taking and entrepreneurship. These are the activities that increase national income. As a rule, credits, deductions, preferences and exemptions don't help the economy grow faster.

Will it help America compete in the global market?
It's increasingly easy for jobs and capital to migrate from high-tax countries like France to ones with relatively low taxes, such as the United States. The process, known as tax competition, enhances the rewards for nations with pro-growth tax policies.

Will it encourage job creation?
Companies don't hire workers because they feel sorry for them or because they have a social conscience. They hire workers in the expectation of making a profit. High tax rates make labor more expensive and make it harder to fund the kind of improvements that boost worker productivity.

Will it reduce the bias against saving and investment? Between the capital gains tax, the corporate income tax, the personal income tax and the death tax, we impose up to four layers of tax on income that is saved and invested. Reducing or eliminating any of these layers gives entrepreneurs added incentives to invest in our economy.

Will it move us closer to a flat tax?
Any cut that shifts the tax code closer to a system that taxes income only once and imposes just one low rate -- with no special favors -- will benefit the economy.

Under these criteria, three components of the president's tax plan should be preserved:

  1. Eliminate the double-tax on dividends.
    Taxing dividends only once will make America more competitive and increase investment, making it easier for workers to get good jobs at good wages.

  2. Put lower tax rates into effect immediately.
    Some of the tax cuts approved in 2001 don't take effect until 2004 and 2006. This is absurd. The economy needs help today.

  3. Reduce the "depreciation" tax on small business.
    The tax code treats some business investment expenses as if they were taxable income. The president's plan would help us begin fixing this bizarre bias against new investment.

This short list of reforms doesn't mean that other tax cuts are misguided. Other elements of the president's tax package make good sense, such as a reduction in the "marriage penalty," that quirk of the tax code that forces many married couples to pay more than unmarried couples. But in a sluggish economy, pro-growth provisions should come first.

But, some will ask, what about the deficit? This is a legitimate concern, but pro-growth tax cuts never reduce tax revenues nearly as much as the critics predict they will. That's because lower tax rates encourage taxpayers to work more, save more and invest more. As a result, national income increases and the tax base grows larger. One example: Tax revenues doubled during the 1980s because Ronald Reagan's tax cuts triggered an economic boom.

Lawmakers frequently talk of their desire to "stimulate" the economy. With the right kind of tax cut, they can do a lot more than that. They can put us on the path to sustainable, long-term growth. You can't put a price tag on that.


-Daniel Mitchell is the McKenna senior fellow in political economy at The Heritage Foundation (www.heritage.org), a Washington-based public policy research institute.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy