May 24, 2003

The good, the bad and the ugly

By James W. Coons

The cowboy president emerged victorious from his tax policy showdown with Congress. As in the typical spaghetti western, the result combined the good, the bad and the ugly.

The best provision in the bill is the acceleration to the beginning of this year of previously enacted reductions in marginal personal tax rates. The reductions were created by the 2001 tax bill and phased-in through 2006. The move will help the economy in two ways.

Lower marginal rates reduce what economists call deadweight loss. If you work less because your income is taxed, you lose some income and the Treasury loses some tax revenue. Your loss is no one’s gain.

The marginal rate cuts enacted in 2001 were a good idea, because they reduced this loss to society. But phasing-in the cuts through 2006 offset some of the benefits. Savvy taxpayers respond to future tax rate cuts by postponing activities that generate tax liability. The result is slower economic growth than otherwise until the cuts are fully in place.

The phase-in of the steep marginal rate cuts in 1981 no doubt deepened the 1981-82 recession and delayed recovery.

Making the already-legislated rate cuts effective now will unleash their powerful benefits quickly without the offsetting negative effects of the phase-in. The increase in the size of the 10% bracket and further amelioration of the so-called marriage penalty will have the same effect.

Also in the good category are the reductions in tax rates for capital gains and stock dividends. Much of corporate income is taxed at least two times. First at the corporate level as profits. And then at the individual level as dividends or capital gains.

The new bill partially rights this wrong by lowering personal tax rates on dividends and capital gains. The double taxation of the portion of corporate income responsible for capital gains is completely eliminated in 2008. The result will be a lower reliance of corporations on long-term debt and a greater propensity for individuals to save and invest.

All of these good aspects were magnified by the quick action of Congress.

Unfortunately, the bill also included some bad features. Most notably, the proposals that led up to the bill and the bill itself were evaluated using projections of lost revenue over 10 years. A provision that lets taxpayers keep an estimated $20 billion of their own money annually, for example, is scored as “costing” the Treasury $200 billion.

That sounds like a lot of money until you realize that the total value of all goods and services produced in the U.S. economy during that time will easily exceed $130 trillion. Yes, trillion. And add to that the fact that the estimates of lost revenue do not fully account for the positive effects of lower tax rates on the size of the tax base.

The acceleration of the increase in the child credit also falls into the bad category. Children are great, and tax credits are nice. But lasting lift to the economy comes from tax reform that changes behaviors rather than passing out money. Child creation ultimately leads to a larger economy, but is an activity hardly in need of a subsidy.

On the ugly side, remaining phase-outs and new and existing sunsets create mind-bending complexity and stifling uncertainty in the tax code.

The personal exemption is still phased out and itemized deductions limited at higher incomes, directly undercutting the beneficial effects of reducing marginal rates.

All of the provisions in the 2001 tax bill sunset, or automatically expire, at the end of 2010. And to cram $725 billion in new tax cuts (over 10 years) into a $350 tax cut bag, many of the new features were scheduled to expire sooner.

Temporary deductions for business investment in equipment expire in 2004 and 2005. The added child credit expires after 2004, as do marriage penalty relief, the expansion of the 10% bracket, and higher alternative minimum tax exemption amounts. Tax rates on dividends and capital gains reemerge in 2009. All of the marginal rates spring back to pre-2001 levels and the estate tax is resurrected on January 1, 2011.

The guys with the white hats won another one. But the ride into the sunset is foreboding this time.

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