The Heritage Foundation

Backgrounder #1478 on Taxes

September 25, 2001

September 25, 2001 | Backgrounder on Taxes

Promoting Growth to Protect Security

Prior to September 11, America's economy was stagnant. The economic slowdown, which had begun in the middle of 2000, was perilously close to becoming a recession. But the events two weeks ago in New York City and at the Pentagon changed a cause for concern into a threat to national security.

The terrorist attacks destroyed a significant amount of wealth and damaged the short-term productive capacity of key sectors of America's economy. Recovering from these despicable assaults will be a tremendous ordeal, but that challenge is only part of the problem. Equally important is the need to restore the economy's overall performance. If America is to wage war on terrorism, the nation will need the resources that can be generated only by an economy firing on all eight cylinders.

This type of growth will require substantial tax reform and significant tax rate reduction. For example, Congress will need to:

  1. Repeal provisions of the tax code that penalize capital formation and wealth creation--particularly "depreciation" rules that force businesses to pay tax on new investment--as soon as possible. This is good long-run tax policy, but it also is critical in the short run because of the enormous need to put money to work for the nation.

  2. Accelerate the pro-growth elements of the Bush tax cut so they take place right away, not in 2004, 2006, and 2010. Once again, this is good long-run tax policy, but that is a secondary concern compared to the need to unleash the talents, ability, and money of America's investors and entrepreneurs.

LESSONS TO REMEMBER
America needs to rebuild, and yesterday's debates about "distribution tables" and "lock boxes" are moot. What matters today is getting the economy back on its feet, which will require investment, risk-taking, and entrepreneurship. As lawmakers consider emergency legislation to help stimulate the economy, they should be guided by certain well-established, time-tested principles.

  • Government spending may be necessary and desirable, but it does not stimulate an economy. Congress already has approved a substantial amount of new spending and will be enacting more spending measures in the near future. Some of this spending will fund a long-overdue restoration of national defense and intelligence capability. This is a proper function of government and helps to protect the nation's interests. Some of the money, of course, will be used for misguided domestic spending programs. But in neither case will the new spending boost the economy. Every dollar the government spends--whether prudently or foolishly--is a dollar that is diverted from the private sector. This is bad for the economy since families, entrepreneurs, and businesses, unlike government, have a strong bottom-line incentive to use money wisely.

    In addition, it is important to remember that government spending means the political process is allocating America's capital. And when government spends money, political factors and bureaucratic inefficiencies often cause the money to be allocated inefficiently. Controlling the size of government therefore helps to ensure more growth and also explains why the U.S. economy has outperformed the economies of welfare states burdened by high levels of taxes and spending.

  • Lowering tax rates on productive behavior, not giving rebates to "put money in people's pockets," will stimulate growth. Taxes are a cost imposed on productive behavior. Work hard and the government hits you with higher income tax rates. Take risks and the government hits you with a capital gains tax. Now more than ever, perhaps, America needs savers and investors who are willing to take risks to provide the seed corn that finances growth. Yet they often are hit with three or four layers of taxation.

    Lower tax rates will improve economic performance by reducing tax penalties on these types of productive behavior. More people will put their money at risk, work harder and longer, and invest in the future. This is why lower marginal tax rates and reductions in the tax code's bias against savings and investment are essential features of pro-growth tax legislation. Keynesian-style rebates, by contrast, simply put money in the pockets of some people that otherwise would have been in the pockets of other people. If lawmakers feel compelled to approve rebates, refundable credits, and other similar money transfers, they should make sure that these are one-time measures and not permanent changes in law. This will prevent bad tax policy from crowding out good tax policy in the long run.

  • Tax cuts that take effect sometime in the future will not yield benefits today. America needs tax relief now, not tomorrow or sometime in the future. The President's tax cut enacted earlier this year represents constructive tax policy. Unfortunately, however, many of the tax rate reductions will not take effect until 2004 and beyond. This means that the pro-growth impact of those changes also will not occur until 2004 and beyond. If lawmakers want to stimulate additional work, saving, and investment today, they should make tax rate reductions effective immediately.

  • Rebuilding America means ending the tax bias against investment. The tax code subjects income that is saved and invested to as many as four separate layers of taxation. Capital gains taxes, corporate income taxes, personal income taxes, and death taxes combine to impose a heavy burden on investors and entrepreneurs. A neutral, pro-growth system would tax income no more than one time. This is good tax policy, but it is especially important to avert or minimize an economic slowdown.

  • The mythical "lock box" should be buried and the worship of surpluses and debt reduction discarded. Budget surpluses and debt reduction have very little, if any, impact on the economy's performance. Contrary to conventional wisdom, interest rates are not noticeably affected by changes in government's fiscal balance. World capital markets are too big for changes in the U.S. budget surplus to have an effect. Moreover, interest rates are not a key determinant of economic growth. People invest in the hopes of earning an after-tax return, and interest rates are only a small part of that equation. If lawmakers want to boost economic growth, "protecting" some of the surplus is the wrong approach; appropriate fiscal policy reforms include lower tax rates, eliminating the tax bias against capital, and reducing the size of government.

  • Loose monetary policy does not solve problems caused by bad tax policy. A knee-jerk reaction in Washington is that economic problems could be solved if the Federal Reserve Board would "lower" interest rates. An easy-money policy is appropriate, however, only if there is evidence that monetary policy in the preceding period has been too tight. Loose monetary policy when an economy is burdened by excessive taxation is a recipe for stagflation, not growth.

ACTIONS TO TAKE
The principles listed above suggest the types of policies that will boost economic growth and rebuild America's wealth. In the fiscal policy arena, this means enacting substantial tax reform and significant tax rate reductions. Lawmakers seeking to put together an economic rebuilding and recovery package should:

  • Replace "depreciation" with "expensing" of business investment. It is bad policy not to allow companies to deduct fully the expense of investments in new factories, machines, and structures. Replacing the current depreciation rules with immediate expensing of those investment costs--or at least implementing a significant shift in that direction--will boost capital formation and help rebuild the wealth destroyed by the terrorists.

  • Accelerate implementation of the Bush tax rate reductions. Many of the pro-growth elements of the tax cut will not take effect until 2004, 2006, and 2010. This means that the additional growth also will not take effect until after that time. The tax rate reductions, IRA expansions, and death tax repeal should be made effective as of September 11, 2001.

  • Reduce the capital gains tax rate. The capital gains tax is a form of double taxation that penalizes risk-taking and entrepreneurship. This tax should not exist; it discourages citizens from reinvesting in America, especially during today's uncertain environment. A large reduction in the capital gains tax would stimulate new investment and more productive use of capital. Such a reduction should be made permanent, however, since a temporary reduction in the capital gains tax rate would have its largest effect on the timing of stock sales when the real focus should be on boosting new investment.

CONCLUSION
Economic growth is no longer just a matter of better jobs and higher incomes. It is now a national security issue. The terrorists have inflicted damage on lives and property. To recover, America needs a strong economy, and this means enacting tax cuts that will boost capital formation and improve incentives for investors and entrepreneurs.

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.

About the Author

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

Related Issues: Taxes