The Best Tax Policy

Posted: Nov 03, 2006 11:37 AM

Half a loaf, they say, is better than none. And that’s true, as long as you’re allowed to keep that half.

Americans today are enjoying half a loaf -- the pro-growth tax cuts of 2003. Those cuts lowered tax rates on capital gains and reduced the double-taxation of dividend income. That sparked economic growth by giving people and businesses extra incentives to save and invest.

The results are evident. Unemployment has plunged from an average of 5.8 percent in 2003 (when the tax cuts were passed) to 4.6 percent today. At the same time, tax revenues have soared.

Federal tax collections jumped by 11.8 percent last year alone. This means the federal government collected an extra $254 billion. That should surprise no one, as the right sort of tax cuts can offset at least part of their “cost” by increasing taxable activity.

Because tax revenues increased by more than spending did, the share of the budget financed by borrowing fell from $319 billion in 2005 to $248 billion in 2006. So the Bush administration is correct when it says its policies have cut the deficit.

But this is where the missing half of the loaf comes in. Because even as tax rates were coming down, federal spending kept going up. This is the real fiscal problem facing America, not the deficit (which merely measures the share of government financed by borrowing rather than taxes).

Federal spending jumped by 7.4 percent last year, climbing to $2.65 trillion. This $182 billion increase was about twice the pace of inflation. Federal spending now makes up about 20.3 percent of GDP. What’s worse is that entitlement programs (driven mostly by the massive new Medicare prescription drug benefit) grew by almost $100 billion. That’s why the federal debt continues to grow, even though revenues are at an all-time high.

Eventually we’ll need to pay for all of today’s spending and the even more extravagant spending promised by our many entitlement programs. There are only three ways to do so. We could raise tax rates, which would slow the economy just as our children and grandchildren are entering the workforce. We could borrow more, which would impose higher interest costs on future generations. Or we could control the growth of spending.

Which option is best? Well, the Office of Tax Analysis, a branch of the Treasury Department, recently completed a study that showed the best approach is to cut taxes on the supply side, thus reducing penalties that discourage businesses and individuals from saving and investing. But it’s also critical to trim government spending. That helps balance the budget in the short run, and it reduces government interference in the economy in the long run.

Treasury’s study, which took into account the obvious fact that the right tax cuts can boost an economy, found that Gross National Product, or GNP, grows the most if tax relief is limited to permanent marginal rate cuts and is offset by lower spending.

It also found that GNP declines in the long run if the government raises income taxes in the future to make up for today’s shortfalls. So we should certainly take that option off the table. After all, Congress cut taxes three years ago to improve economic performance. We don’t want to wreck that growth by raising taxes down the line.

The economists also determined that GNP increases in the long run if tax relief is made permanent and financed with future spending restraint. That’s a better approach, but it still assumes that tomorrow’s lawmakers will spend less than today’s are spending. History shows this isn’t likely.

In other words, the report provides plenty of good news. It predicts we will be able to make the tax cuts permanent, grow the economy and shrink the deficit -- if we’re willing to hold the line on spending.

Americans deserve the benefits of permanent lower tax rates and the smaller, less-intrusive government that should go with them. But the only way to get there is to cut spending. If we can’t do that, we may find ourselves with no loaf at all.