November 8, 2005
Growth Beats Simplicity
By Lawrence
Kudlow
President
Bush and Treasury Secretary John Snow have made it clear that
tax reform will be at the top the economic-policy list come January’s
State of the Union. Bush has said so in recent speeches, and Snow
has followed up on cable television and in print interviews. Neither
man, however, has endorsed the report of the president’s
tax-reform commission, headed by former senators Connie Mack and
John Breaux. In polite language, senior administration officials
have expressed considerable unhappiness with the Mack-Breaux project,
which lowers income-tax rates only a little and takes away popular
tax deductions for home mortgages and state and local property
taxes.
In short,
the White House sees a bad trade-off, one that won’t pass
the political smell test.
The truest
test of good tax reform should not be its purity (such as a single-rate
income or sales tax) or its absolute simplicity (though simplicity
does matter). Rather, the biggest test should be the impact of
tax-code changes on after-tax incentives to work and invest, incentives
that will determine the course of future economic growth.
The tax-reform
panel does make a number of pro-growth suggestions, such as full
cash expensing for business investment and higher ceilings for
savings-account participation. The panel also proposes territorial,
rather than worldwide, corporate taxation, and would keep investment
taxes on capital gains and dividends at a low 15 percent and in
some cases drop them lower. These initiatives would all lower
the cost of capital and boost economic growth.
However,
the tax panel insists on abolishing the alternative minimum tax
(AMT), which in the world of static scoring would dig a $1.3 trillion
revenue hole. In effect, real income-tax reduction has fallen
into that hole, where it may be stuck for a very long time.
One option
of the panel’s tax plan would flip the top income-tax rate
to 30 percent from 35 percent. That means individuals will keep
70 cents on the extra dollar earned rather than 65 cents, a tepid
7.7 percent increase in after-tax reward. Compare this to the
Reagan tax reform of 1986, which took the top personal rate down
to 28 percent from 70 percent. Back then, people hard at work
suddenly kept 72 cents of each marginal dollar -- a 44 percent
incentive reward.
Of course,
the Reagan reforms produced a quantum jump in economic growth
while at the same time reducing inflation, in effect setting the
American economy on a new course of prosperity which has spanned
twenty-five years. In the post-WWII period, only the JFK tax cuts,
which lowered the top personal rate from 91 to 70 percent, are
comparable to the Reagan effort.
And that
brings us to today’s dilemma. Precisely because Reagan’s
reforms brought tax rates down so much in the 1980s, U.S. tax
rates remain historically low. Hence, marginal gains from future
tax reform will never be as great. But that doesn’t mean
the Bush administration can’t do better than what the tax
panel is proposing.
In putting
together its ultimate reform proposal, the White House could leave
the AMT in place, but index it to both inflation and wage gains.
In this way the tax will not affect Red State middle-income taxpayers,
and will simply impact the very top earners everywhere, including
the Blue State rich folk. More, this adjustment will make room
for deeper income-tax cuts, say to a top rate of 25 percent with
perhaps one more bracket at 15 percent.
At a 25 percent
top rate, successful earners would keep 75 cents on the extra
dollar, a 15 percent improvement over their current plight. This
rate would allow for simplification and reduced mortgage deductions,
while keeping the state and local deduction in place.
Sources tell
me that House Ways and Means chair Bill Thomas is looking at just
this kind of trade-off. With this in place, key investment tax
rates could be set at 15 percent for capital gains, dividends,
and inheritance taxes. (It’s the after-tax yield on investment
that provides the seed corn for job-creating new businesses.)
The top corporate tax rate, now pegged at 30 percent by the tax
panel, could also be brought down to 25 percent. And corporate
capital-gains taxes could be eliminated, further reducing the
multiple-taxation of capital.
A 10 percentage-point
drop in tax rates for individuals and businesses would be a political
eye opener and one worth fighting for. In effect, the purity test
would fail, but the economic growth test would succeed. Three-quarters
of a loaf of tax reform is better than no loaf at all if economic
growth over the next twenty years increases as much as 5 to 7
percent. That’s real money, along with bucketfuls of new
jobs and prosperity.
Lawrence
Kudlow is a former Reagan economic advisor, a syndicated columnist,
and the co-host of CNBC's Kudlow
& Company. Visit
his blog, Kudlow's Money
Politics.
