The Federal Reserve Board's recent decision to put downward pressure on interest rates has temporarily quieted those who claimed George W. Bush was exaggerating the possibility of an economic downturn solely to boost his tax cut plan. Many critics, however, continue to believe that tinkering with monetary policy is all that is needed to boost the economy. This is misguided. The Federal Reserve's actions may or may not be warranted, but its job is to preserve a stable price level, not to fine tune the economy. Lowering marginal tax rates for individual taxpayers represents good tax policy, good economic policy, and good leadership--particularly if there are fears that the economy is performing below its potential.
Specifically, the plan proposed by President-elect Bush would reduce personal income tax rates. A new 10 percent tax bracket would be created that would apply to a substantial portion of the income that is currently taxed at 15 percent. The 28 percent and 31 percent tax brackets would be reduced to 25 percent, and the 36 percent and 39.6 percent tax brackets would be lowered to 33 percent. This is good policy for several reasons:
- The current tax rate on work, savings,
and investment penalizes productive behavior and impedes economic
growth. Because of steep personal income tax rates, highly
productive entrepreneurs and investors can take home only about 60
cents of every dollar they earn, not including state and local
taxes or other federal taxes. This reduces the incentive to be
productive. Lower tax rates will reduce this "tax wedge" and
encourage additional work, savings, investment, risk-taking, and
- The budget surplus is growing.
According to the latest Congressional Budget Office (CBO)
projections, the aggregate budget surplus for the 10-year period of
2001 to 2010 will be at least $4.6 trillion, and the CBO is
expected to revise this projection upward. The Clinton White House
reportedly projects surplus tax revenues between 2002 and 2011 of
$5 trillion. President-elect Bush's proposed tax relief package is
expected to save taxpayers $1.3 trillion to $1.6 trillion over the
next 10 years--not including revenue feedback from the additional
economic growth that will follow.
- Reducing the tax burden will help
control federal spending. Without the specter of deficits,
lawmakers lose the will to say no to special interests and
pork-barrel projects. In the three years since the surplus
materialized in 1998, inflation-adjusted federal spending has grown
twice as fast as it did during the three prior years when the
government was running a deficit.
- Lower tax rates are an important step
toward fundamental tax reform. When tax rates are high,
deductions, credits, and exemptions provide large tax savings to
some taxpayers; but roughly 70 percent of all taxpayers receive no
benefits since they claim the standard deduction. A simple and fair
tax code would treat everyone equally, without creating winners and
losers, by taxing all income only once and at one low rate.
Reducing marginal tax rates will move the nation toward a low tax
rate system and reduce the value of special-interest tax breaks
(which are more valuable when rates are high), the economic
distortions they cause, and the political pressure to add new
preferences to the code.
- Tax increases did not cause the
surplus, and tax cuts will not cause a deficit. Opponents of
tax cuts often claim that the 1993 tax increase is responsible for
today's budget surpluses. This is contradicted by Clinton
Administration budget documents: In early 1995, nearly 18 months
after enactment of the 1993 tax increase, the Office of
Management and Budget projected budget deficits of more than $200
billion for the next 10 years. Clearly, events after that
date--including the 1997 capital gains tax cut and a temporary
reduction in the growth of federal spending--caused the economy to
expand and the budget deficit to vanish.
- Tax rate reductions and entitlement
reforms are not mutually exclusive actions. Critics argue that
a big tax cut would make it harder to reform Medicare or modernize
Social Security by allowing younger workers to shift some of their
payroll taxes into personal retirement accounts. Given the
magnitude of the projected budget surpluses, there is no conflict
between these goals. Moreover, entitlement reform would be
desirable even without a budget surplus because it would
significantly reduce the long-run unfunded liability of both
programs. Large projected surpluses simply make it easier for
legislators to implement the necessary
Opponents once argued that tax cuts were unwarranted because the federal government was running a budget deficit. Now they argue that tax cuts are unwarranted because there is a surplus. Their real agenda is to block any reduction in tax rates and increase the dollars they have available to spend.
Some critics claim that the economy may need help right away, not six months down the road. Believing that aggregate demand drives the economy and enamored with short-term economic tinkering, such advocates of Keynesian economics prefer an "easy money" Federal Reserve policy to reducing tax rates and reforming the code. But the economic damage caused by high marginal tax rates cannot be "fixed" by making changes in monetary policy.
The extent to which people are concerned about the timing of a tax cut suggests that lawmakers should act now, making a tax reduction retroactive to January 1, 2001. The President-elect should not be swayed by those who fundamentally disagree with his vision for the nation. Rather than reduce his proposed tax relief package--which includes eliminating the death tax, reducing the marriage penalty, and expanding educational savings accounts--President Bush should expand it to include a reduction in the capital gains tax. Under no circumstances should he compromise on personal income tax rate reductions. An across-the-board reduction in marginal tax rates should be the cornerstone of the tax relief package.
Daniel J. Mitchell, Ph.D. is McKenna Senior Fellow in Political Economy at The Heritage Foundation.