Growth Beats Simplicity

Larry Kudlow
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Posted: Nov 07, 2005 12:05 AM
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.