Tax cuts increase economic growth

Posted: Feb 26, 2002 12:00 AM
This is the time of year when many Americans reluctantly turn their attention to filling out tax returns. They quickly encounter complicated forms, confusing instructions, contradictory definitions and widely varying tax treatment of different forms of income. No wonder that filing one's taxes ranks among the most stressful human activities, according to psychologists. It is too easy to blame the Internal Revenue Service for this state of affairs. In truth, the IRS suffers as much from it as taxpayers do. The problem is that the tax law itself is a total mess. Congress is always trying to accomplish conflicting goals with the Tax Code, and those goals change frequently. The result is a federal tax system that is desperately in need of fundamental reform. An excellent road map to tax reform has recently been produced by the Organization for Economic Cooperation and Development in Paris. Because the OECD has an international focus, unencumbered by domestic politics, it offers as close to an objective perspective on U.S. tax policy as one is likely to find anywhere. The OECD report starts with a simple point: Tax cuts increase economic growth. Commenting on those enacted last year, it says, "The average tax burden does influence the growth rate of the economy, and so these cuts should boost the medium-term growth rate of the economy by a small yet worthwhile amount." It shouldn't even be necessary to mention this point. It's equivalent to declaring that the sky is blue. Nevertheless, in Washington today it is controversial. Sens. Ted Kennedy, D-Mass., and Tom Daschle, D-S.D., have both blamed last year's tax cut for slowing growth, and the latter is almost single-handedly stalling a stimulus bill because he so adamantly opposes tax cuts. The OECD goes on to explain that it is not just the amount of money that the state takes from our pockets that affects growth, but how it does so. In comparison to other major countries, the United States has relatively low taxes. On average, other OECD countries have total tax burdens about one-third higher than ours. However, the U.S. tax system is unusually complex and has disincentive effects out of proportion to the revenue raised. A key source of complexity is the Alternative Minimum Tax, which appears to be unique among industrialized countries. It is supposed to ensure that all rich people pay some taxes. Yet the OECD notes that the number of such people has actually risen. Moreover, the burden of the tax now falls most heavily on those with middle incomes. Thus, the AMT adds greatly to tax complexity without even achieving its stated purpose. Another source of complexity is Congress' inability to resist adding more and more special provisions to the tax law. At least 50 so-called tax expenditures have been added to the Tax Code since 1986, lowering federal revenue by about 1.5 percent of the gross domestic product. Basically, Congress has incrementally repealed almost all of the Tax Reform Act of 1986. The great achievement of the 1986 legislation was to get the top income tax rate down to just 28 percent. At this level, most tax loopholes are not worth bothering with. As a result, rich people were encouraged to spend their time starting businesses and making profitable investments, rather than wasting their time on tax shelters designed to generate losses instead of profits. Now, with a top rate of 39.6 percent, rich people spend considerably more time on the latter activities and less on the former. The OECD notes that this misdirection of economic activity by the wealthy -- and increasingly among the middle class -- reduces federal revenue at the same time it stifles growth. Consequently, tax-rate reductions can partially pay for themselves by reducing the use of tax shelters. Says the OECD, "The fall in tax yields from rate cuts would be significantly offset by changed behavior and perhaps most markedly at high income levels." The principal barrier to cutting tax rates on the wealthy is that they are thought to be needed to equalize incomes. But the OECD notes that progressive tax rates have a very small impact on income distribution. Most redistribution in the United States takes place on the spending side of the budget, rather than the tax side. Lastly, the OECD is highly critical of the way the United States taxes business and capital income. Only three major countries tax new equity investments more heavily than we do. The result is excessive reliance on debt finance, which leads to problems such as those with Enron. The OECD report makes many useful suggestions for reforming the U.S. tax system. They echo those often put forward by American economists. However, because they come from a neutral international organization, perhaps they will command more respect. Reference: Richard Herd and Chiara Bronchi, "Increasing Efficiency and Reducing Complexity in the Tax System in the United States," Economics Department Working Paper No. 313 (Dec. 17, 2001). Available at