Nine Simple Guidelines for Pro-Growth Tax Policy

By Daniel J. Mitchell, Ph.D.

Economic growth occurs when people work more, save more, and invest more. These are the behaviors that increase national income and boost the nation's wealth. People do not produce more simply because the government has a balanced budget. Nor do they increase their levels of work, saving, or investment just because the government gives them a check, even if it is in the form of a tax rebate. To ensure that national income increases and to encourage the efficient use of national resources, lawmakers should focus on fiscal policy options that improve incentives to engage in productive behavior, recognizing the following facts.

1. Not all tax cuts are created equal
   Certain tax cuts help the economy, because they improve incentives to earn more income and create wealth. Lowering tax rates on productive behavior is the key to good tax policy. Taxes are essentially a "price" imposed on different activities. When the cost is prohibitive (that is, when tax rates are high), the activity being taxed is discouraged. Lower tax rates on work, saving, and investment encourage additional economic growth. By contrast, other tax cuts may have no effect on growth. Giving all taxpayers $500, for instance, does not increase their incentives to earn more income or engage in productive behavior and will thus do nothing to increase national income.
2. The change in tax rates matters, not the size of a tax cut
   Public policy debate frequently focuses on the size of a tax package, but this can be very misleading. Providing an annual "rebate" to every taxpayer in the country, for instance, would involve a significant reduction in tax revenue but would have no impact on economic growth. By contrast, a small reduction in the capital gains tax would encourage more investment and boost the economy's performance--even though this tax relief would be tiny compared to the tax rebate. Some tax policies can boost growth even without lowering the overall tax burden. A revenue-neutral flat tax, for example, would increase national economic output significantly even though taxpayers as a group have no additional money in their pockets.
3. Good tax policy leads to a "revenue feedback" as a result of better economic performance
   With good tax p olicy, the actual reduction in tax revenue is always smaller than the projections produced by static revenue-estimation models. Lower tax rates encourage taxpayers to work more, save more, and invest more. As a result, the national income increases, and the tax base becomes concomitantly larger. This does not mean that all tax cuts pay for themselves. Only in select instances (such as the 1997 capital gains tax-rate reduction) does a tax rate reduction generate a big enough increase in taxable income to offset the revenue loss associated with a lower tax rate.
4. Tax cuts do not help the economy by "giving people money to spend"
   Although tax cuts allow taxpayers to keep more of their money, this extra money does not materialize out of thin air: The government must borrow it from private credit markets (or, if there is a surplus, return less money to private credit markets). Any increase in private consumer spending generated by a tax cut is offset by a reduction in private investment spending. Thus, there is no increase in total spending, national income, or economic growth.
5. Consumer spending is a consequence of growth, not a cause of growth
   Some politicians argue that encouraging consumer spending will spur growth. This puts the cart before the horse. Consumers spend when they have disposable income, and faster growth is the only permanent way to increase the level of disposable income.
6. Good long-term tax policy is the best short-term "stimulus"
   Some policymakers claim that good tax policy should be postponed in order to focus on "stimulus." This assumes that consumer spending drives the economy. In fact, the only tax policies that create short-run growth are the ones that also improve long-run growth. Some of these policies (such as tax cuts that attract capital from other nations) can have a pronounced immediate impact. The economic benefits of other equally desirable policies (such as personal income tax-rate reductions) may take effect over a longer period of time.
7. The size of government matters, not deficits
   So-called deficit hawks mistakenly focus on the symptom of bad fiscal policy and ignore the underlying cause. Taxing and borrowing are two ways to finance government, and both have adverse consequences, as resources are transferred from the productive sector to government. Although some government expenditures, such as providing national security or maintaining a well-functioning legal system, bring societal benefits that compensate for the economy's forgone growth, in many cases, the rate of return on government spending is very low--or even negative.
8. Supply-side tax cuts lower interest rates
   Financial institutions and other lenders make funds available to borrowers because that is how they make money. But in order to earn a profit, the interest rate charged on loans and other investments must be high enough to compensate for factors such as projected inflation rates and likelihood of default. Taxes also affect interest rates. When tax rates are high, investors must charge a higher interest rate. This explains why interest rates for "tax-free" municipal bonds are about 150 basis points lower than interest rates for comparable debt instruments that are taxable. Reducing the multiple layers of taxation on income that is saved and invested will lower interest rates.
9. Deficits do not have a significant impact on interest rates
   Interest rates are determined in world capital markets where trillions of dollars change hands every day. Even a large shift in the U.S. government's fiscal balance is unlikely to have a noticeable impact on interest rates. Indeed, interest rates have fallen in the past three years even though the federal government now has a $200+ billion deficit instead of a $200+ billion surplus. This does not mean that higher deficits lead to lower interest rates. Instead, it shows that other factors have a greater impact than deficits. Academic studies have confirmed that there is no significant relationship between fiscal balance and interest rates.

If policymakers want to boost the economy's performance, they should reject big-government policies and, using these nine guidelines, work to lower tax rates on productive activity.

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.