The Heritage Foundation

WebMemo #268 on Taxes

April 30, 2003

April 30, 2003 | WebMemo on Taxes

Creating the Most Growth: Picking the Right Tax Cuts

As the tax package becomes smaller, it is imperative that Congress focuses on those provisions that cause the most economic growth. While a tax bill at only $350 billion greatly reduces the potential for economic growth under the President's original plan, higher levels of economic growth can still be achieved if Congress enacts the best provisions of the President's plan.

 

Tax measures, which increase people's incentive to work, invest and save, contribute the most to economic growth[2]. Hence, certain types of tax measures, no matter the size, could generate much more growth than larger provisions, which fail to encourage investment or work.

 

The best tax cut for the money, listed in order of creating the most growth:

  1. Complete elimination of the individual tax on dividends
  2. Setting the dividend and capital gains tax rate at 5/15 percent
  3. Increase bonus depreciation to 50 percent and extend through 2005
  4. Accelerate the marginal rate reductions and expand the 10% bracket
  5. Marriage penalty reform
  6. Increase of the child tax credit

For more see attached:

Table: Comparison of the Economic Effects of the Components of the President's Economic Growth Package

Chart: New Jobs Created by Each Component of the President's Economic Plan

Chart: Increase in Gross Domestic Product Produced by Components of the President's Economic Plan

 

Background

In January, President Bush asked Congress to pass a tax cut over the next ten years worth $726 billion.[1] Congress responded by passing a budget resolution calling for $550 billion in tax relief. While Congress's response fails to address the heavy burden of taxation borne by taxpayers as aggressively as the President's plan, the passage of $550 billion in tax cuts would still constitute one of the largest tax relief packages in recent history. However, the chairman of the Senate Finance Committee, Senator Chuck Grassley (R-IA), vowed that the Senate would pass only $350 billion in tax relief unless reductions in spending were made to pay for more tax relief.

 

Action

In this report, we model the President's tax provisions and some other tax proposals to show their separate effects on the economy. The tax provisions we analyze differ based on their total savings to taxpayers and how they change incentives to work, invest and save. The report focuses on these specific components' effects on GDP growth, job growth, budget cost, and their impact on American families.

 

Complete Elimination of the Individual Tax on Dividends
This provision will cause the most growth.

 

President Bush took another bold step towards fundamental tax reform by proposing the end to the double taxation of dividends. Currently, dividends are taxed once at the corporate level and again at the individual level when dividends are paid to investors. The President's plan would end the taxation at the individual level. This tax relief lowers the cost of capital on businesses, which makes it easier for businesses to expand their operations and for entrepreneurs to open new businesses.[3]

 

The CDA estimates that on average from 2004-2008 eliminating the double taxation of dividends would create 498,000 new jobs, $44.6 billion in real GDP and increase disposable income by $72 billion. For every dollar of additional debt, this tax reform produces $5.84 in additional income.

 

Setting the Dividend and Capital Gains Tax rate at 5/15 Percent

This provision will encourage growth for many of the same reasons of complete repeal: the tax rate on capital investment declines spurring new business investment. However it will not generate as much economic growth as the President's plan because it does not eliminate the double tax on dividends.


Because of budget constraints, other options have been proposed to reduce the taxation of dividends. One of the ideas, promoted by House Ways and Means Chairman Bill Thomas (R-CA), is to tax dividends and capital gains at the same rate; 5 percent for those who pay individual income taxes at the 10 or 15 percent bracket and 15 percent for those in all other brackets. While this does not end the double taxation of dividends, it does reduce the top tax rate on capital gains by twenty-five percent and substantially reduce the taxes that investors must pay on dividends.

 

The CDA estimates that on average from 2004-2008 eliminating the double taxation of dividends would create 367,600 new jobs, $30.9 billion in real GDP and increase disposable income by $38.7 billion. . The total savings for this proposal are estimated at $277billion from 2003 to 2013.

 

Increase Bonus Depreciation to 50 Percent and Extend Through 2005
This provision expands the depreciation deduction enacted in 2002 that allowed businesses to deduct up to 30 percent of the cost of qualified property[4] used for business purposes. Economists estimate that this could reduce the cost of capital by four percent a year for businesses[5]. In turn, this reduction would cause businesses to invest more, thus growing the economy.

 

The increase and extension in the House bill would increase the deduction to 50 percent of the cost of qualified property and extend the provision by one year (to 2005). The Joint Tax Committee estimates that the static cost of this provision is $21 billion over ten years and $78 billion from 2004 to 2008. CDA economists estimate that on average, from 2004 to 2008, the bonus depreciation would create 93,400 new jobs, $8.6 Billion in real GDP and boost disposable personal income by $14.5 Billion.

 

Accelerate the Marginal Rate Reductions and Expand the 10% bracket

This provision would reduce the income tax for millions of tax filers. It provides strong economic growth because working Americans get to keep more of what they earn.

 

Marginal rate reductions, originally scheduled for 2004 and 2006, would be fully implemented in 2003 under the President's budget. The 38.6 percent rate drops to 35 percent, the 35 percent rate drops to 33 percent, the 30 percent rate drops to 28 percent and the 27 percent drops to 25 percent. The tax bill also helps those in lower income groups by expanding the 10 percent bracket. More of these taxpayers' income will be taxed at 10 percent instead of 15 percent, thus they would keep more of what they earn.

 

The CDA estimates that on average from 2004 to 2008 accelerating the rate reductions and bracket expansion would create 130,000 new jobs, $12.6 billion in real GDP and increase disposable income by $31.6 billion. For every dollar of additional debt, this tax reform produces $2.14 in additional income.

 

Marriage Penalty Reform

This provision would provide some economic growth.

 

The President's budget would enact the marriage penalty reform immediately in 2003 rather than wait for phasing in tax relief between 2005 and 2010.  The standard deduction for joint filers would be increased to twice that of single filers and the starting point of the 28 percent bracket would be set at twice that of the single bracket. This would end two of the different penalties that hurt joint filers.

 

This provision will provide some economic growth because a number of duel-earner families would not pay as much in taxes simply because they are married. Therefore, this provision would raise the incentives of a family's secondary earner to work and earn more. Other families will receive a marriage bonus if they have only a single-earner. 

 

CDA economists estimate that on average from 2004 to 2008 marriage penalty reform will create 42,000 new jobs, $4.4 billion in real GDP and increase disposable income by $13.7 billion. For every dollar of additional debt, this tax reform produces $1.66 in additional income.

 

The Child Tax Credit

This provision does not create much economic growth.

 

The President's budget proposed to speed up the increase of the child tax credit from $600 to $1000 per eligible child. Originally, this increase would be gradual and phased-in from 2005-2010. The new proposal, which results in tax savings of $90 billion in the next ten years, immediately increases the credit by $400 per eligible child. While this increase helps families, it does create much economic growth. Families have no incentive to invest more and the income phase-out of the child tax credit actually creates a disincentive to earn more. Furthermore, this is only speeding up a tax break that is scheduled to happen anyway.

 

CDA economists estimate that from 2004 to 2008 the child tax credit will create 44,000 new jobs, $5.3 billion in real GDP, and increase disposable income by $16.5 billion. For every dollar of additional debt, this tax reform produces $1.62 in additional income.

 

The Final Tax Cut Package Should Include the Most Pro Growth Provisions

Tax policy changes can enhance the rate of economic growth when they improve the incentives for work, saving, and investing. Businesses grow when they have lower costs allowing projects to become profitable that otherwise would not be undertaken. With the amount for tax relief already set by the budget agreement, Congress should focus on tax proposals that create the most economic growth for the smallest static price and accept a tax cut that fulfills the budget agreement of $550 billion.

 

Reducing the tax on dividends and accelerating the marginal rate provisions of 2001 are the two best elements of the tax cut. They cause the most job growth and return the best value for their cost. Congress should also expand the depreciation bonus and expensing for business. The provisions cause strong growth in the early years by reducing business costs. Marriage penalty reform and the child tax credit do not cause enough economic growth to be included in a package that can only be a maximum of $550 billion.

Rea S. Hederman, Jr. is Senior Policy Analyst in the Center for Data Analysis at The Heritage Foundation.



[1] As scored by the Joint Tax Committee in "Estimated Budget Effects of the Revenue Provisions Contained in the President's Fiscal Year 2004 Budget Proposal," JCX-15-03, March 4, 2003.
[2] For further information, read Dan Mitchell's Webmemo #263 "Understanding Pro-Growth Tax Policy" April 18, 2003. http://www.heritage.org/research/taxes/wm263.cfm.
[3] See Norbert J. Michel, "Everyone Profits From Hurdling Dividends," WebMemo #248, April 3, 2003, at http://www.heritage.org/Research/Taxes/wm248.cfm.
[4] The Job Creation and Worker Assistance Act of 2002 created this business depreciation originally scheduled for only three years, expiring at the end of 2004. Qualified property covers many capital expenses a business would purchase from computer software to physical property.
[5] Cohen, Darryl, Hassett, Kevin and Hansen, Dorthe-Pernille, "The Effects of Temporary Partial Expensing on Investment Incentives in the United States", National Tax Journal, Vol. LV, No. 3, September 2002

About the Author

Rea S. Hederman, Jr. Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis