February 7, 2006 | WebMemo on Taxes
President George W. Bush's tax agenda is largely focused on making the 2001 and 2003 tax cuts permanent. This is sound policy. The bulk of those tax cuts are pro-growth initiatives that have lowered marginal tax rates on work, saving, and investment. These include:
These are the "crown jewels" of the President's tax agenda, but all of these tax cuts will disappear at the end of either 2008 (dividends and capital gains) or 2010 (income tax rates and death tax) unless they are made permanent. In other words, the economy would be hit by a major tax increase. This raises three concerns:
The President is right to demand that Congress make these tax rate reductions permanent. These tax cuts have helped the U.S. economy easily outperform the world's other major economies.
There is a mistaken belief in Washington that fiscal policy should focus on lowering the budget deficit rather than reducing the burden of government. This confuses cause and effect. Government spending diverts resources from the productive sector of the economy. That diversion imposes a cost because the higher spending misallocates some portion of the economy's labor and capital.
That cost might be worthwhile if policymakers were funding only the legitimate and proper functions of a central government-such as national defense, a court system, and other genuine "public goods." These types of outlays facilitate the environment in which private-sector wealth creation can take place. But most government outlays fail to meet the "public goods" test. The bulk of government spending today is for transfers and consumption.
This is why it is a mistake to obsess about the deficit. Even if the federal budget magically had a $500 billion surplus, the argument for eliminating large amounts of government spending would remain the same.
The deficit only measures the degree to which programs are financed by borrowing rather than taxes. Even if one makes the heroic-and completely implausible-assumption that higher taxes do not lead to higher spending, such a policy merely represents a jump from one frying pan to another.
Some assert that deficits are an especially bad way to finance government because they boost interest rates. This is a dubious claim. Interest rates are very low in Japan, for instance, even though Japan's debt and deficits are more than 100 percent higher than America's. The U.S. experience also is illustrative: interest rates fell dramatically between 2000 and 2004 as the fiscal balance shifted from a $236 billion surplus to a $412 billion deficit.
This does not mean that higher budget deficits cause lower interest rates. Instead, it simply means that in a world where $2 trillion changes hands every day, "big" increases in the budget deficit are tiny compared to the money flowing through global capital markets. Other factors, such as monetary policy and demand for capital, are far more likely to cause interest rates to shift.
None of this should be interpreted to mean that deficits are irrelevant. As a matter of political economy, deficits enable politicians to disguise the price of government from taxpayers. This facilitates increases in the size and burden of federal spending. It also is worth noting that future deficits-assuming politicians fail to control entitlement spending-will be far larger than deficits today, perhaps exceeding 15 percent of GDP. This is uncharted territory, and the economic consequences are difficult to predict.
But it is important to realize that there also would be dramatic adverse consequences if exploding entitlement expenditures were financed by higher taxes. That is not uncharted territory. Europe's slow-growth welfare states are poignant examples of the economic damage caused by governments that consume half of economic output. It also is worth noting that European nations, on average, have budget deficits similar to U.S. levels, and European government debt actually is higher-confirming that higher taxes finance levels of government spending in the long run.
The bad news is that the President's budget is silent on the issue of fundamental tax reform. This does not preclude Administration action at some future point, but it certainly suggests that the White House is not planning on a major effort to fix the internal revenue code. This is a missed opportunity. In a competitive global economy, America no longer can afford a tax system that combines the worst features of special-interest deal-making and class-warfare redistribution.
The absence of tax reform is particularly puzzling given the growing evidence that the flat tax is a very effective way to boost growth and reduce tax evasion. Nine former Soviet-Bloc nations have adopted variations of the flat tax, and the new systems have been a big success. This should not be a surprise. After all, Hong Kong has been the fastest growing economy in the world since it implemented a low-rate flat tax in 1947.
Some of the developments in Eastern Europe are worth noting:
There also is good news in nations like Latvia, Lithuania, Romania, Georgia, Ukraine, and Serbia. The flat tax should not be seen as an elixir, of course, particularly if nations are still struggling with rule-of-law, property rights, and sound money problems. But it is an ideal tax system for nations seeking faster growth and better tax compliance. That last point is particularly worth highlighting because one of the distasteful features of the Bush tax agenda is an ephemeral "reduce the tax gap" proposal. This presumably means giving the IRS more power to harass entrepreneurs and other taxpayers. This is akin to a dog chasing its tail. Low tax rates and a fair tax system is the recipe for tax compliance.
Supply-Side Tax Cuts Work Best
Tax policy from 2001 to the present offers an important economic lesson. 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 a surplus or increases a 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 the child credits and the rebate, 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 much stronger since the 2003 law. The 2001 law's impact was much more modest.
Moreover, this explains why pro-growth tax cuts have a much smaller 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, this results in 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."
The primary 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 the 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.