The Senate has enacted a tax package as part of reconciliation legislation, and the House is soon voting on its own version of a tax bill. This is generating considerable debate, though some of the discussion is a bit hyperbolic. In neither bill, for instance, is the tax relief very large. Based on Congressional Budget Office and Joint Committee on Taxation projections, tax collections in 2010 would still be nearly $700 billion higher than they are today if either bill became law. Moreover, total revenues over the next five years would fall by less than one-half of 1 percent.

But tax bills should not be judged solely on their size. While it generally is safe to assume that a larger tax cut will boost growth more, the actual impact depends on whether marginal tax rates are reduced. A revenue-neutral flat tax (even using static revenue estimating), for instance, would have a very large positive impact on economic performance because of lower tax rates on work, saving, and investment. A big increase in various deductions and credits, by contrast, would be a large tax cut but would have negligible effects on economic performance since there would be no change in the tax rates imposed on productive behavior.

In other words, the tax packages should be graded based on their content. Using this economic growth yardstick, the House legislation is much better than the Senate legislation. In schoolhouse parlance, the House bill deserves a "B" and the Senate bill deserves a "D."

What's Good in the House Legislation
The most notable feature of the House bill is the provision to extend the current treatment of dividends and capital gains until 2010. In 2003, Congress approved legislation to reduce the double-taxation of both dividends and capital gains to 15 percent. This policy has proven to be remarkably successful. Combined with the lower personal income tax rates that took effect that year, the economy received a substantial supply-side tax cut.

Ever since these lower tax rates took effect, the economy has grown by about 4 percent annually, and about 4.5 million jobs have been created. That's the good news. The bad news is that all of these pro-growth tax cuts expire. The lower income tax rates disappear at the end of 2010, and the lower tax rates on dividends and capital gains disappear at the end of 2008.

Failure to extend these policies or make them permanent would result in a tax increase: specifically, an increase in the effective marginal tax rate on income that is saved and invested. This is self-destructive; all economic theories, even socialism and Marxism, agree that innovation-fueling capital formation is the key to long-run growth and higher living standards.

Ideally, there should be a zero tax rate on both dividends and capital gains. Investment income already is taxed at the corporate level. A second layer of tax if the income is distributed (dividends) is bad, as is a second layer of tax if the income is reinvested (capital gains).

The House bill extends the 15 percent rate on dividends and capital gains only until 2010, but that certainly is better than nothing. The pro-growth impact of this policy already is compromised by fears among investors that the 15 percent rate is temporary. Extending the provisions until 2010 at least creates a bit more certainty.

The House bill's other notable provision deals with the tax treatment of small-business investment. As a general rule, businesses may not fully deduct investment expenditures in the year they occur. Instead, they must deduct those costs in increments over a multi-year period: a policy called depreciation. This is perversely illogical since the only common-sense definition of profit is the difference between total revenues and total costs. But not only is this illogical; it is anti-growth. In effect, tax law treats a portion of business investment as if it were business profit. This increases the effective marginal tax rate on business investment.

Congress has reduced the negative impact of depreciation by giving small businesses "expensing" treatment of the first $100,000 of investment each year. In other words, instead of being forced to depreciate this cost over several years, companies are allowed to deduct such costs in the year they occur. That's the good news. The bad news is that small-business expensing expires at the end of 2007. The House bill extends the expensing provision until 2009.

What's Bad in the House Legislation
The House bill contains a number of special provisions for different constituencies. Some of these, such as the deduction for tuition expenses, are bad policy. Others, such as the "Definition of Qualified Veteran for Purposes of the Veterans' Mortgage Bond," represent senseless complexity and social engineering.

What's Ambiguous in the House Legislation
The House bill contains some provisions that are difficult to quantify. Chief among these is the "Research and Development Tax Credit." In a simple and neutral tax system, this $9 billion-plus provision would not exist. But because the current tax system is so heavily biased against saving and investment, there is a plausible argument that the R&D tax credit is a way to offset some of the negative impact, at least for certain forms of investment.

What's Good in the Senate Legislation
The only significant desirable feature of the Senate bill is a small-business expensing provision that is identical to the language in the House bill.

What's Bad in the Senate Legislation
The Senate bill includes many anti-growth provisions. Other provisions probably would not harm the economy very much, but they nonetheless represent bad tax policy, and a few are best categorized as morally repugnant.

The anti-growth provisions include the "Economic Substance" doctrine, a change targeting the business community that would give the Internal Revenue Service the authority to disallow deductions and impose penalties if bureaucrats decided that decisions were made for tax purposes. To understand the adverse impact, imagine that the same policy was applied to individual taxpayers. Did a family buy a house because it was a good place to raise children, or did they buy it for the tax deduction? Giving the IRS the power to enforce such a vague law would cast a chill on legitimate business activity.

The bad tax policy is found in a number of "Hurricane Tax Policy" provisions, many of which are for special credits and bonds. Like the House bill, the Senate bill has a tuition deduction that will make it easier for colleges to increase costs. The Senate bill also has a number of special tax breaks for charitable giving, further increasing the government's influence over America's nonprofit sector. Last but not least, the Senate bill grants even more power to the IRS.

The morally repugnant tax policy is in the form of anti-expatriation policies against individuals and companies that wish to emigrate. Traditionally, only totalitarian regimes like Soviet Russia and Nazi Germany impose exit taxes. If politicians in Congress are upset that some taxpayers are leaving America for jurisdictions with better tax law, they should lower tax rates and reform the tax code, not violate fundamental freedom of movement.

What's Ambiguous in the Senate Legislation
The Senate bill contains a "Research and Development Tax Credit" that is very similar to the language in the House bill and, like the version in the House bill, can be characterized as the wrong way to do the right thing. Some of the Senate bill's "Hurricane Tax Relief" provisions also fall into this category. The Senate bill has provisions allowing a greater degree of expensing for certain investments in the areas affected by the hurricane, and expensing certainly is the right way to treat new business investment. But to minimize government-imposed discrimination, geographically targeted tax policy should be seen not as an end in itself, but as a precursor to extending good policy across the nation. The Senate bill also has a "hold harmless" provision for the alternative minimum tax. This is the largest tax cut in the bill, but lowering the rate associated with the AMT is the approach that would generate economic benefits.

Conclusion
The House and Senate tax bills represent a tiny blip in the government's finances. The basis for judging the two bills is not the size of the tax cut, but the bills' components. The House legislation is far superior. The good provisions, particularly the extension of the 15 percent rate for dividends and capital gains, exceed the bad provisions. All told, the House bill gets a "B."

The Senate does not fare as well. Its one genuinely desirable provision deals with small-business expensing. Its other provisions are bad, repugnant, or irrelevant. Even though the Senate bill is a net tax cut, it arguably would give America a worse tax code. At best, the Senate bill deserves a "D."

Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.