The Heritage Foundation

Executive Summary #1614 on Taxes

November 22, 2002

November 22, 2002 | Executive Summary on Taxes

Executive Summary: Making the Tax Cuts Permanent and Fully Effective Now

The Senate's failure to make last year's tax rate cuts permanent and fully in effect now is hurting America's workers and families, the economy, and the stock market. By fostering uncertainty, the current policy is reducing investment, limiting job growth, slowing the economy, and depressing the stock market. Specifically, the 2001 tax cut legislation--which lowered tax rates by one percentage point immediately and reduces them further over the next few years--expires in 2011, allowing most tax rates to return to pre-2001 levels and imposing probably the largest tax increase in history on workers and families. The temporary and delayed structure of this policy is wrong. The President should demand that Congress make the tax rate reductions permanent and fully effective now for four reasons.

Reason #1: Certainty about tax rates improves general incentives to work, save, and invest.

In tax policy, certainty, immediacy, and permanence are commonsense principles that lead to positive results, while uncertainty breeds caution and makes it much more difficult for people and businesses to plan properly. In particular, uncertainty about how much the government will punish success--that is, how much of additional income it will take in taxes--in the future discourages people and businesses from saving and investing today.

Because temporary tax rate cuts do not fundamentally lower government-imposed barriers (such as high tax rates) to working, saving, investing, or developing a business, they prompt people merely to shift the timing of those activities. Some policymakers suggest preventing the tax rate cuts from becoming permanent; workers, investors, and entrepreneurs understand this risk and discount the likelihood that the tax rate cuts will last. Making the tax rate reductions permanent and fully in place now would remedy this problem, bringing the benefits of those tax rate cuts forward to today, providing greater certainty about future tax rates, and increasing incentives to work, save, and invest today.

Reason #2: Making the tax rate cuts permanent and fully effective now would especially help small businesses and workers.

Small businesses are the engine of the economy, creating countless jobs. Many small-business owners pay the top individual tax rate. They make decisions about investing, expanding operations, and hiring based on anticipated future after-tax profits, thus making the top tax rate critical to job creation. If they are uncertain about how much the government will punish their success--that is, take in taxes--or if they are certain that tax rates will rise in the future, then they will resist expanding their operations now. After-tax profits likely will not exist in the future to support that growth. Small firms, then, are particularly sensitive to tax rates. Therefore, making the tax rate reductions permanent and fully effective now would help workers and families and spur small business growth immediately, prompting higher wages and lower unemployment.

Failing to make the tax rate cuts permanent not only harms workers and small businesses now, but also would dramatically hurt people in the future. Policymakers must remember that they cannot help employees by punishing employers. Clearly, repealing the tax rate cuts would even more severely harm both small businesses and workers.

Reason #3: Making the tax cuts permanent and fully effective immediately would bolster the recovery now and foster greater growth over time.

The economy is an aggregation of the actions of people in their roles as producers (particularly small business owners) and consumers. Though the economy is rebounding from a recession, it could perform better. Making the tax rate cuts permanent and fully effective now would lower government obstacles and increase the rewards for working, saving, investing, and developing a business. In the long run it also would create more jobs, increase wages, expand prosperity, and decrease poverty.

Reason #4: Making the tax rate cuts permanent and fully effective now would improve the stock market.

The stock market, which represents people's current collective view of future conditions, has fallen sharply since its peak in 2000. Uncertainty exists regarding the war on terrorism, war with Iraq, the health of the economy, and the promise of lower tax rates. Investors, like business owners, make decisions based on anticipated after-tax returns. Because financial markets look forward and are sensitive to unknowns, building confidence in the future would lead to more investment and higher stock prices now. By reducing government's multiple taxation of investment, making the 2001 tax rate cuts permanent and fully effective now would increase incentives to invest in stocks, improving stock market conditions now.

The Federal Budget
Making the tax rate cuts permanent and fully effective now would likely lead to more, not less, tax revenue than government collects now. A more robust economy--particularly in the long run--would increase incomes and thus federal tax revenue (though the latter should not, in itself, be a policy goal). Yet tax cut opponents still cite concerns about the budget. Some even mistakenly advocate postponing or repealing parts of the tax cut as a way to balance the budget. Either policy would harm people, the economy, and the stock market but not improve the government's budgetary situation. The economy drives the federal budget, not the other way around. The keys to balancing the budget are economic growth and restraining government spending, not higher tax rates on people.

Government should not act like a business and try to bring in as much money as possible. In fact, it should take from people only as much money as it needs to fund truly essential functions in the most efficient--that is, economically least destructive--way possible. Policymakers should move away from the flawed goal of maximizing government tax revenue and toward the correct goal of maximizing economic growth by limiting the size of government and lowering tax rates on working, saving, investing, and developing a business.

Conclusion
President George W. Bush should demand that Congress make the entire 2001 tax cut package--particularly the rate cuts and death tax repeal--permanent and fully effective immediately. Such a policy would remove economically damaging uncertainty about tax rates and instantly improve incentives and lower government barriers to working, saving, investing, and developing a business. Workers, families, the economy, and the stock market would benefit from this wise policy.

Lawrence Whitman is a former director of the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Lawrence Whitman Director
Thomas A. Roe Institute for Economic Policy Studies