The Heritage Foundation

Executive Memorandum #316 on Taxes

November 20, 1991

November 20, 1991 | Executive Memorandum on Taxes

How the Kasten-Weber Tax Cut will Spur Economic Growth

(Archived document, may contain errors)

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The deep and painful recession afflicting America is the result of seriously flawed economic policies sup- ported by George Bush and Congress. Record tax increases, costly new regulator y burdens, and unprecedented in- cre,ases in federal spending all have combined to discourage job creation and entrepreneurship. Even though the evidence is clear that the economy remains stagnant, Bush Administration economic advisors actively am oppos- i ng growth legislation. And Bush apparently is following their bad advice. Warned The Wall Street Journal this week in an editorial: "Even as lusty a beast as the U.S. economy can take only so much punishment from its political masters in Washington. The l o ng and short of it is: The world's most important economy is in the grip of economic incompetents." As long as it remains in their grip, American workers and families will remain con- demned to lower living standards and rising unemployment. Yet the econo m y can grow again if policy makers remove the shackles placed on it last year by the tax and spending increase. To do so, lawmakers must reverse course and correct the mistakes that are causing the reces- sion and adopt policies that encourage job creation and increase incentives to work, save, and invest. A good s tan is the Economic Growth and Family Tax Freedom Act of 1991 (S. 1920, H.R. 3744) mitroduced by Senator Robert Kasten of Wisconsin and Representative Vin Weber of Minnesota, both Republicans. Th e Kas- ten-Weber growth package cuts the tax on savings and investment, technically known as the "capital gains tax," lowers taxes on business investment, expands Individual Retirement Accounts (IRAs), offers real estate tax relief, and establishes enterpr i se zones. Kasten-Weber also relieves the tax burden on families by granting a $ 1,000 non- refundable tax credit for children under age 6 and a similar credit of $300 for children age 6 to 18. The creft sig- nificantly would reverse the rising tax burden o n families caused by inflation's- erosion of the dependent exemp- tion over the past four decades. With the economy mired in recession, the portion of the Kasten-Weber package designed to promote economic growth is particularly critical. Its key features: 15 Percent Capital Gains Tax-Germany, Hong Kong, the Republic of China on Taiwan, and South Korea do not tax long-term capital gains, the difference between an asset's purchase and sale price. In Japan, the maxi- mum tax on capital gains is a mere 5 perce n t. In the United States, by contrast, capital gains are subject to a 28 percent tax. To make matters worse, the tax code ignores the fact that much of the higher sales prices and profits on savings and investments are due to inflation. American investors c annot use indexing to ensure that taxes only are paid on actual gains rather than changes in asset value caused by inflation. The Kasten-Weber proposal would cut to 15 percent the capital gains tax for savers and investors in the upper tax brackets and to 7.5 percent for those in the lower bracket. To prevent the unfair taxing of gains that reflect only inflation, the legislation also permits indexing. By calling for a lower rate and including indexation, the Kas- ten-Weber capital gains proposal goes well beyond the anemic proposal endorsed by the White House and would provide a much stronger stimulus to the economy.

Washington-based economists Gary Robbins. and Aldona Robbins. of Fiscal: Associates, Inc., estimate that lowering the tax to 15 percent woul d create more than 900,000 over ten years. and boost gross national. product growth by an average of 0.36 percent for. each year over the ten-year period. Other economists find similg impact from a capital gains. tax cut. Allen Sinai, Chief Econo m ist of The Boston Company, estimates that a 15 percent capital gains tax would boost employment by 600,009 within five years and increase, the gross qa- tional product by 0.2 percent annually. Reducing the capital gains. tax also would boost asset .values , thus strengthening American banks and homeowners as. well as reducing the cost of bailing out the federal gove.rnment's savings and loan deposit insurance scheme.. Neutral Capital Cost Recovery-Kasten-Weber increases the. amount of deductions businesses c an take for. investment expenses by adjusting "depreciation!' schedules for inflation and the value of money. This refiorm'sub- A :i S;antially wo4ld boost capital formation by reducing the after-tax cost of investment. Under current tax law, b i Msi- nes s es cannot deduct the cost of investments. in the year when they are incurred. Instead,-these costs must be "dqprcciated7' over time, up to 31 years. Eventually, of course, the business is permitted to. deduct the entire. nominal amount invested. But the t r ue value of this deduction is eroded enormousl by inflation. y The Kasten-Weber neutral capital cost recovery approach would address the tax code's bias against busines in s in- vestment. If a business originally was supposed. to depreciate $10 million of an investment in the second yea.'r, for instance, Kasten-Weber might increase that depreciation to $10.8 million, with similar adjustments M4 followin years so that the value of the deduction would keep pace with inflation and the cost of funds. Correctly struc- tured, neutral capital cost recovery would provide the same incentive for increased investment as plans permitting immediate deductibility of business investment in the first year. This would remove some of the current penalty on productive investm e nt. IRA-Plus--Kasten-Weber expands upon current IRAs by giving all taxpayers the option to invest in In-. dividual Retirement Accounts. Savers, moreover, would get the option of investing in IRAs that would allow for. tax-free withdrawal of both principal and interest income upon retirement. Taxpayers taking advantage of this @'back`-ended!'IRA, however, would not be able to ded .uct contributions in the year they are made. In addition'to allowing tax-free withdrawals upon retirement, Kasten-Weber would pe r mit 25 percent of the IRA Ito'be withdrawn before retirement for initial home purchases, education, and medical emergencies. Passive Loss Reform-As part of the 1986 Tax Reform Act, so-called passive investors in real estate, those d.qfined as not principa l ly engaged in the business, cannot use rental propei-des lossesio, offset other income. Many experts say that this provision has helped trigger. the decline in American real estate values and thus has in- creased the cost'6f the savings and loan deposit i n surance bailout. Kasten-Weber would reform passive .loss rules for real estate so they more closely resemble guidelines for other business investments. Enterprise Zones-To encourage economic growth in impoverished urban centers and other particularly depr e ssed sectors of the country, Kasten-Weber would allow the creation of 50 enterprise zones. Employers open- ing operations in the zone would receive a tax credit for workers in the zone. No taxes would be levied on cgp@tal i the year they are in gains in t h e zone, and investments in zones could be immediately deducted from taxes n curred. These zones especially would help create jobs in inner cities. Bush Administration and congressional policies have made it unprofitable for businesses to hire new workers a nd for investors to put their money at risk. Excessive taxation and overregulation have. ground the economy to a halt and pushed nearly two million additional Americans into unemployment lines. Meanwhile, Washington policy makers seek not answers, but how to assign blame elsewhere. Bush clumsily blames credit card issuers for high interest rates, while liberals in Congress think higheitaxes on the "rich" will spur growth. There is no mystery about how to restore growth: simply reduce or remove govenurient p enalties on job crea-' #on, savings, and investment. The Kasten-Weber bill will not solve every economic problem created by policy' mistakes, but enactment of the pro-growth legislation would stimulate increased economic.aFtivity and reduce the tax burden on families. Daniel J. M tchell John NL Olin Senior Fellow


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