The Heritage Foundation

WebMemo #403 on Taxes

January 22, 2004

January 22, 2004 | WebMemo on Taxes

Make the Temporary Tax Cuts Permanent Tax Reductions

President George W. Bush sent a clear signal in his State of the Union Address to his political friends and foes that also comforts advocates of pro-growth tax policy change: he is eager to run for re-election on his economic record. Despite unrelenting attacks on the centerpiece of the Bush economic plan (the tax cuts of 2001 and 2003), the President remains confident that his package of economic policies is boosting economic activity and assuring long-term growth.

Confident, but also cautious: As the President urged, Congress must act immediately to make the temporary tax cuts enacted in 2001 permanent. Otherwise, the economic improvement that is seemingly springing up all around the country will disappear. Not only will taxpayers pay billions more in taxes if Congress fails to make the tax cuts permanent, but the economy will suffer a blow that could well erase the strong gains it recently has made.

Within the next two years, key provisions of the 2001 Economic Growth and Recovery Tax Act will expire, and nearly all elements of this act disappear in 2011. What does that mean for taxpayers? As the President noted, the steady expiration of this landmark tax act will:

  • reduce the child tax credit by $300 dollars,
  • revive many of the worst "marriage penalties" in the old tax code,
  • repeal the expanded 10 percent tax rate which cuts taxes on all taxpayers (rich and poor),
  • reverse the support for capital purchases by small and medium sized businesses,
  • and resuscitate federal death taxes scheduled to die a long deserved death in 2010.

The worst news for the economy would come in 2011 when all of the tax rate reductions disappear and taxpayers are faced with the biggest tax increase in the nation's history.

Why should members of Congress care? One reason, of course, would be votes. Political people know that tax increases commonly worry taxpayers, who then express their concerns in the next election. While the President did not mention this consideration in his State of the Union address, it doubtless weighs heavily on the minds of most members of Congress.

A more important reason, however, is the harm that Congress would cause the economy if it failed to make the 2001 tax cuts permanent. For most Americans, the vitality of the economy trumps nearly every other aspect of life outside the family. A growing body evidence strongly suggests that the 2001 tax cuts and additional tax cut legislation since have significantly boosted short-term economic growth. For example:

  • Business investment, a key engine of economic activity, expanded in late 2003 at the fastest rate since 1980;
  • The pace of economic activity in the third quarter of 2003 jumped by over 8 percent, which is the best quarterly increase in the gross domestic product in 20 years;
  • Stock market wealth has increased by over $3 trillion dollars this past year, thus bringing overall market values near their levels during the last economic expansion; and
  • Worker productivity in the last half of 2003 grew nearly three times faster than the long-term trend, which means that wages will rise and inflation is kept firmly in check.

This good news and more like it, however, could fade away if Congress refuses to change these temporary tax cuts into permanent ones. Why? Taxpayers know that taxes raise the price of everything. If capital is taxed (as it is when taxes are imposed on savings accounts, stock dividends, and the value of land and other tangible assets), then it costs more for businesses and homeowners to borrow money from the bank. The higher cost of borrowed money means that fewer houses are built and businesses are more reluctant to expand their operations. In short, you get less economic growth when capital costs more.

The same economics applies to the taxation of labor and other forms of economic activity: raising taxes increases the cost of the activity taxed, which generally lowers its use. The pace of economic activity suffers, which ultimately means slower job and income growth.

Thus, when Congress lets a tax cut expire, it endangers economic growth. Even when it threatens to let a tax cut expire in the distant future, say 2011, investors make plans to put their money into projects that will pay out over a shorter amount of time and pull out of long-term investments, like research that will yield results only in ten years or a new factory that has to be paid off over a twenty year period. In other words, investors often view inaction by Congress to make a tax cut permanent as a signal of higher taxes - and thus prices - in the future. The economic damage is done even as Congress sits on its hands.

The President was right to call for immediately making the temporary tax cuts permanent. If Congress dithers rather than acting, they will directly shape an economic future filled with more joblessness and poverty than there otherwise would be.

William W. Beach is Director of the Center for Data Analysis at The Heritage Foundation.

About the Author

William W. Beach Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis