Moving in the right direction

Posted: Sep 17, 2002 12:00 AM
It is now clear from the way the Bush administration has handled the build-up to war against Iraq that it is following a long-term political strategy. It is perfectly willing to endure months of criticism for lack of decisiveness and even allow members of its Cabinet appear to argue in public, all toward the end of achieving its ultimate goal. I suspect that something similar is underway with regard to tax policy. President Bush started his effort with a plan for cutting marginal tax rates. He was criticized by people, such as myself, for not doing more, faster. The phase-in of the rate reductions enacted last year are indeed too slow for maximum economic impact. However, given political realities, I concede that it may have been impossible to do more under the circumstances. Nevertheless, the rate reductions do move us in the right direction, however slowly. The question is, the right direction toward what? Economic theory is quite clear that high marginal tax rates are bad for economic growth. People make all kinds of important decisions about investments, life styles and careers based on tax considerations. The most obvious is the choice of whether to rent or buy a home. Clearly, the deductibility of interest and the tax exemption for capital gains on a primary residence (up to $500,000 every two years for a couple) is a major motivation to buy, rather than rent. But people make many other important decisions about their lives based on taxes, as well, even if they are not fully aware of them. For example, people must decide whether to buy taxable bonds or tax-free municipal bonds, buy stocks more likely to appreciate in value and be taxed at lower capital gains rates or those with high dividends that are taxed as ordinary income, and to develop careers as wage employees or as self-employed entrepreneurs. Such decisions are all based to a large extent on tax considerations. Ideally, decisions about whether to work for oneself or another, to save or consume, to invest in one form or another should not be related to taxes at all. People make such decisions based on their own judgments about what skills they possess, how much risk they are willing to bear, their age and family status, and other factors. Taxes ought not to be one of them. In theory, we should strive for what economists call tax neutrality. Perfect neutrality cannot be achieved as long as there are taxes. But there are greater and lesser degrees of it. Right now, we have a tax system that is very far from neutrality. Taxes bias investment and work decisions in ways that hurt economic growth. That is, we could raise the same amount of revenue in different ways and increase economic growth in the process. Most economists would say that a low single tax rate on consumption is probably best for growth. A rate of around 20 percent would be enough to fund all of what the federal government pays for from the corporate and individual income taxes. For years, tax reformers have pushed for a flat rate tax system that would achieve this goal. However, getting from here to there without excessively hurting those who made investment and career decisions based on the current system has proven impossible. The prospect of throwing out the current tax system altogether and replacing it with something entirely new frightens even those who would pay less under the new regime. The solution, therefore, is to move incrementally toward a new system. That, I think, is the Bush administration strategy. We have already seen two major moves in this direction. Marginal tax rates were cut last year, and earlier this year businesses were given a 30 percent "bonus" on depreciation for new investments in machinery and equipment. Since, in theory, firms should be allowed an immediate deduction for such investments, the effect is to move in the direction of fundamental tax reform. The next step is to liberalize incentives for saving and investment. Elimination of taxes on these would give us a de facto consumption tax, as Edward McCaffery explains in his new book, "Fair Not Flat." Therefore, reducing taxes on saving, dividends and capital gains, as President Bush wants, can be seen as further steps toward fundamental tax reform. Although the Bush administration sometimes appears to be fumbling around with tax policy, there may be a strategy at work. Just as it has done with Iraq, the administration may be laying a foundation upon which it will build a justification for action at a later date. It is too soon to say when the end games will emerge, either on Iraq or tax reform, but at least it appears that we are moving in the right direction.