The Heritage Foundation

WebMemo #981 on Taxes

February 1, 2006

February 1, 2006 | WebMemo on Taxes

State of the Union 2006: A Mixed Message on Tax Policy

President George W. Bush last night asked Congress to make the expiring tax cuts permanent. This is the good news. Tax cuts enacted in Bush's first term, especially the marginal tax rate reductions on work, saving, and investment that were part of the 2003 tax cuts, have played a key role in boosting growth and improving competitiveness. Failure to extend these pro-growth provisions will mean higher tax rates on personal income and an increase in the double-taxation of dividends and capital gains.


The bad news is that the President was silent on the issue of fundamental tax reform. This does not preclude Administration action, of course, but it certainly suggests that the White House is not planning a major effort to fix the internal revenue code. This is unfortunate. In a competitive global economy, America no longer can afford a tax system that combines the worst features of special-interest deal-making with class-warfare redistribution.


But the perfect should not be the enemy of the good. While it would be nice to replace the IRS with a simple and fair flat tax, many incremental changes would move the tax system in the right direction. Indeed, many of the tax cuts adopted in 2001 and 2003 can be considered small steps on a long journey to tax reform.


One key feature of tax reform, for instance, is low tax rates so that the penalty for engaging in additional productive activity is as small as possible. The 2001 legislation lowered marginal tax rates (although the lion's share of those lower rates were postponed until 2004 and 2006-a mistake that lawmakers rectified in 2003 when the lower rates were made effective immediately).


Another key feature of tax reform is that there is no double-taxation of income that is saved and invested. This approach would eliminate the bias against capital in the current system and therefore boost investment, productivity, and wages. The 2001 legislation took an important step in this direction by beginning the gradual phase-out of the death tax. The 2003 tax bill went even further, reducing the double-taxation of dividends and capital gains to 15 percent. This does not eliminate the tax bias against capital income, to be sure, but it was a big step in the right direction.


Unfortunately, all of these pro-growth tax cuts will soon expire. The tax rate on dividends and capital gains, for instance, will increase substantially beginning in 2009 if the 2003 law is not made permanent. Similarly, income tax rates will increase in 2011 if the 2001 law is not made permanent. Even the death tax will be back in full force in 2011 if the 2001 law is not made permanent.


These tax rate increases would have an adverse impact on economic performance. It is particularly shocking that Congress has failed to make permanent the lower 15 percent tax rates on dividends and capital gains. These policies have been remarkably effective, boosting financial markets, increasing investment, and improving corporate governance.


Indeed, there is an important economic lesson to be learned. Tax cuts do not help the economy by giving people more money to spend. Any money "injected" into the economy with tax cuts is offset by the money "withdrawn" from the economy as the government either reduces its surplus or increases its deficit. Instead, certain types of tax cuts can help the economy by changing the "price" of productive activity. For example, lower income tax rates mean that the relative price of working has declined. Lower tax rates on dividends and capital gains mean that the relative price of investing has declined.


But other types of tax cuts have little or no impact on economic decision-making. Child credits and tax rebates, for instance, do not have any measurable impact on growth because they do not alter incentives to work, save, and invest. Indeed, this is why the 2003 tax legislation worked so much better than the 2001 tax legislation. The first bill was dominated by child credits and rebates, whereas the 2003 legislation lowered marginal tax rates on dividends and capital gains while also accelerating the lower income tax rates promised in the 2001 law. This is why the economy's performance has been so much stronger since the 2003 law.


It also is worth noting that pro-growth tax cuts have much less impact on tax revenues than rebates, credits, deductions, and other preferences. When tax rates are lowered and people have more reason to engage in productive activity, the results is more taxable income. Depending on the increase in taxable income and the change in the tax rate, the actual reduction in tax revenue will be lower than forecast by "static scoring." And in a few instances-such as lowering the capital gains tax rate-it is even possible that a tax rate reduction can increase tax revenue. But if the government offers a tax credit, the "static" estimate of the revenue loss will be very close to the actual revenue loss.


The real goal of tax policy should be faster growth. This is why permanent tax cuts are important, especially the tax rate reductions that increase incentives to work, save, and invest. The President presumably wants all his tax cuts made permanent, but some tax cuts generate more bang-for-the-buck than others. Capital gains and dividends should be the first priority, quickly followed by an initiative to make permanent lower income tax rates and death tax repeal.


Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow 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