Selling tax-cuts

Posted: Feb 14, 2001 12:00 AM
Back in the 1970s, I used to work for Jack Kemp, then a Republican congressman from upstate New York. He asked me to draft a tax cut for him that became the Kemp-Roth Bill and eventually formed the basis for Ronald Reagan's 1981 tax bill. As part of my work on this legislation, first introduced in 1977, I had to come up with ideas for selling the plan. We were faced with the same problem that George W. Bush now faces, in trying to put a human face on the tax cut and build support for it among average Americans. Toward this end, Bush repeatedly talks about how much money his tax cut will put back into people's pockets. I tried this tactic as well when I worked for Kemp, but he quickly vetoed my efforts. In fact, he would never even allow me to say the words "tax cut." He always insisted that we were not offering a "tax cut," but a "permanent tax rate reduction." The difference may sound like a matter of semantics, but in fact it conveys a profound difference in terms of economics. The point Kemp was trying to convey is that income taxes do more than take money out of peoples' pockets. They alter the rate of return on productive economic activity such as work, saving and investment. And the most critically important tax rate is the marginal tax rate -- the rate that applies to the next dollar or last dollar that one earns. At the time Kemp first began talking about marginal tax rates, almost all economic analysis of taxes dealt only with average, or effective, tax rates. That would simply be taxes as a share of income. Thus if one had an income of $40,000 and paid $5,000 in taxes, then the average tax rate is $40,000 divided by $5,000, or 12.5 percent. If we had a tax system in which there were a single tax rate and no exemptions, exclusions, deductions or credits, then the average tax rate and the marginal rate would be the same. But that is not the system we have. Generally, we pay no taxes at all on the first dollars that we earn, because of the personal exemption and standard deduction. Then we pay 15 percent on the first dollar above the exempt amount. For a married couple that does not itemize, they would have to earn $13,400 before they paid so much as a penny in federal income taxes. In fact, they might even be eligible for a "refund," even though they had no income tax liability, due to the Earned Income Tax Credit. Leaving that aside, suppose they earned $13,401. They would pay 15 cents in taxes. Divided by $13,401, obviously their average tax rate is close to zero. But nevertheless, they are in the 15 percent tax bracket. Thus for this couple -- when deciding whether to take a second job, work overtime or make an investment -- the relevant economic consideration is whether it is worth keeping only 85 cents for each dollar gained by their additional effort or sacrifice. If their taxable income were to rise to $45,200 -- not very much for a two-earner couple -- then the relevant tax consideration changes because they are now in the 28 percent bracket. In other words, they will keep only 72 cents from each additional dollar earned. At the top of the income tax schedule is a 39.6 percent bracket. For people with incomes high enough to be affected by this marginal tax rate, they get to keep only 60 cents for working or saving more, making risky investments such as starting new businesses or anything else that would cause their taxable income to rise. Clearly, there are investments people will make for a 10 percent return that they won't make for a 6 percent return. Thus someone in the 15 percent or 28 percent bracket would make that investment, but someone in the top bracket will not. This is the fundamental economic problem created by high marginal tax rates. They discourage work, saving and investment that would have been done if tax rates were lower. And because the highest tax rates apply to those who least need to work, save or invest to maintain their lifestyles -- i.e., the rich -- they are especially sensitive to even small changes in tax rates and the after-tax rate of return. Kemp always used to enjoy quoting from President Calvin Coolidge's speech to the National Republican Club on Feb. 12, 1924, to illustrate how steeply graduated income tax rates affect incentives. Said Coolidge, "If we had a tax whereby on the first working day the government took 5 percent of your wages, on the second day 10 percent, on the third day 20 percent, on the fourth day 30 percent, on the fifth day 50 percent, and on the sixth day 60 percent, how many of you would continue to work on the last two days of the week?" Coolidge went on to say that it is the same with capital. If people cannot get a high enough return after-tax, which economists call the "hurdle" rate, they simply will consume their capital with extravagant living, instead of using it to invest in new businesses and technologies that yield not only profits to them but create jobs and income for working people. The point of this discussion is that only permanent changes in marginal tax rates affect the rate of return on work, saving and investment. Temporary tax changes have no impact, and those that affect only average tax rates also have no impact. That is why the idea for a tax rebate, currently popular among liberals and a few economically ignorant conservatives, is so wrong-headed. Because it is not permanent and does not impact on marginal tax rates, a so-called tax rebate is just the equivalent of another form of government spending, which will do nothing to increase economic growth, create jobs or improve competitiveness. Bush has it right. He would cut marginal tax rates for all taxpayers, which unquestionably will increase the rate of return on productive economic activity. Unfortunately, this sound economic policy is being undermined by Bush's sales strategy, which has emphasized dollars in peoples' pockets. By emphasizing this aspect of his tax plan, he has made it harder for the economically unsophisticated to see the difference between his plan and the vastly inferior rebate approach. Bush should meet with Kemp and others who helped sell the Kemp-Roth/Reagan tax cut in 1980-81. Their efforts, based on the economic importance of marginal tax rates, worked in a political climate far more inhospitable to tax cutting than now. Bush would be wise to use the same sales strategy, starting with abolition of the words "tax cut" from his vocabulary, replaced with "permanent tax rate reduction," as Kemp ordered me to do 25 years ago.