The President's Tax Agenda: Pro-Growth Measures Jeopardized by Excessive Spending and Misguided Focus on Deficit

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:

• Lower marginal income tax rates: The top tax rate has been reduced from 39.6 percent to 35 percent, and other income tax rates have been reduced by similar amounts. While not dramatic, these rate reductions have increased incentives for productive activity.
   
• Reduced double-taxation of dividends and capital gains: The top tax rate on dividends used to be 39.6 percent, and the top tax rate on capital gains used to be 20 percent. Both rates are now 15 percent, significantly reducing the double-taxation imposed on business investment, particularly for dividends.
   
• Death tax repeal: Though not effective until 2010, and then only for one year, the phase-out of the death tax is a much-needed reform to eliminate a particularly pernicious form of double-taxation. It is difficult to estimate the extent to which this reform has encouraged families to allocate their resources more productively because there is uncertainty about whether the tax will be permanently repealed.

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:

1. Higher taxes encourage additional spending. There is no fixed relationship between taxes and spending. But history suggests that politicians generally will spend every penny the government collects-and then as much more as they think they can borrow without making voters nervous about deficits and the debt. Tax increases, then, almost surely have the effect of loosening the reins on government spending. In some cases, such as the 1990 tax increase, federal spending rose significantly. In other cases, such as the 1993 tax increase, spending grew by a smaller amount. But the long-term relationship of more taxes leading to more spending is unavoidable.
    
2. Higher tax rates hurt competitiveness and growth. All tax increases cause economic harm because they encourage bigger government. But some types of tax increases do more economic damage than others. Specifically, higher marginal tax rates on work, saving, and investment reduce incentives to engage in productive behavior. If the Bush tax cuts are allowed to expire, this is precisely what will happen. The increased tax on dividends, for instance, would hit the economy hard. The maximum rate of double-taxation would jump by more than 100 percent, climbing from 15 percent to 35 percent (and potentially 39.6 percent in 2011 if income tax rates are allowed to increase). This will hurt investment and financial markets. The capital gains tax rate would not jump as dramatically, though even small increases in the rate have a significant impact because investors always can avoid the additional layer of tax by not selling assets. This would hinder the allocation of capital to more productive uses. And the re-imposition of the death tax, in theory, would have the worst economic impact because it would impose a marginal tax rate of 60 percent on any additional wealth that certain taxpayers accumulate. This would dramatically reduce incentives for these taxpayers to engage in productive behavior and dramatically increases incentives to engage in costly and inefficient tax-planning strategies. The only silver lining-albeit a very perverse one-is that many of the targeted taxpayers have doubted all along that the tax would actually be repealed. This means that a significant economic hiccup as 2011 approaches is less likely-though it also means that the economy has missed out on the faster growth that would have occurred had those taxpayers believed that the death tax was going to die.
    
3. The tax rates/tax revenue downward spiral. If the Bush tax cuts are not extended and the economy is hit by a sizeable increase in marginal tax rates, economic performance will falter. This translates into fewer jobs, lower incomes, and diminished profits, and that means less money for the government to tax. In some cases, such as with the capital gains tax, the reduction in the "tax base" can be so great that the government collects less revenue at a higher tax rate. In most cases, though, the shrinkage in the tax base merely means that the revenue increase will be smaller-perhaps dramatically smaller-than estimated.  Sadly, government revenue-estimating models are very simplistic and fail to measure any impact of tax policy changes on economic performance. As a result, politicians will fall into a rut of raising tax rates, boosting spending, and then raising tax rates again when revenues are lower than anticipated. This type of downward spiral already has caused great damage in Europe. It would be a terrible mistake to let America travel down the same path to economic stagnation and high unemployment.

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.

Deficits Are a Symptom, Spending Is the Disease

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 Failure to Address Tax Reform

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:

• Estonia was the first to adopt a flat tax, back in 1994, and it is now known as the "Baltic Tiger" because of its fast growth. The government is even in the process of lowering the flat tax rate from 26 percent to 20 percent to reap even bigger benefits.
   
• Russia's 13-percent flat tax has been in effect just since 2001, but already personal income tax revenues have skyrocketed by 106 percent-and that is after adjusting for inflation!
   
• Slovakia's 19-percent flat tax is even younger, taking effect in 2004, and yet the results have been stupendous. On a per-capita basis, there is now more foreign investment in Slovakia than anyplace else in the world.

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.