Tax Cut Compromise Could Be Worse Than No Tax Cut

The Bush administration is rapidly losing control of the tax legislative process. Its unwillingness to acknowledge that its plan needed to be totally rethought once a $350 billion revenue loss cap was imposed in the Senate has created an anarchic situation in Congress. There is now a danger that Congress may pass a bill that is worse than doing nothing. New tax ideas are streaming forward hourly to fill the gap left by de facto abandonment of President Bush’s proposal to eliminate double taxation of dividends. But because the administration continues to cling to its original plan, there is no one in a position of authority to say which of these ideas are good and which are terrible. One of the worst ideas is to phase in the dividend tax cut. On paper, this reduces the revenue cost and still allows the White House to claim victory for its proposal. But the result could be that businesses will have an incentive to shift dividends into the future. This might lead them to minimize profits in the short-run by incurring costs now while realizing income later. The effect would be to reduce growth of the gross domestic product going into the 2004 election. We saw such a phenomenon in 1992 as a result of Bill Clinton’s tax increase. People like his wife, Hillary, then a high-priced lawyer for the Rose Law Firm in Little Rock, Ark., knew he was going to raise taxes and so shifted some of her income from 1993 into 1992 so that it would be taxed at lower rates. While the number of people who had the freedom and foresight to do this was small, it was enough to significantly impact the national economy. Personal income rose sharply in the fourth quarter of 1992 and then plunged in the first quarter of 1993. Personal income remained weak for the rest of the year and did not rebound until 1994. Something similar might result from phasing in a dividend exclusion. While total dividend income is only about 5 percent of personal income, it is much more volatile than wages and salaries. In any given year, changes in dividend income can account for a significant amount of the variation in personal income growth. Since personal income represents 85 percent of GDP, even small changes in personal income can raise or lower the GDP growth rate by enough to matter in terms of perception of how well the economy is doing. Even knocking tenths of a percent off the GDP growth rate in an election year can have important political consequences. Another danger is that the dividend plan will be replaced by more politically popular, but economically insignificant, tax measures. Unfortunately, many of the tax provisions enacted by Republicans in recent years, such as the child credit, have absolutely no effect on growth whatsoever because they do not affect incentives to work, save or invest. When the economy is doing well, we can afford such giveaways, but when the economy is lagging, as now, it is important that we enact tax cuts that will have the maximum economic impact. Realistically, this means that tax cuts need to be concentrated on corporate investment. Corporations always have investment plans well into the future that they can speed up if it pays them to do so. A temporary investment tax credit or speed-up of depreciation allowances would act like automobile rebates to increase investment quickly, by bringing some future investment into the present. Speeding up the reduction in the top income tax rate will also help, because many small businessmen — who mostly pay taxes at individual, not corporate, tax rates — have been putting off investment and the realization of income until the phased-in reduction in rates enacted in 2001 is complete. Something like this happened in the early 1980s, when Ronald Reagan’s 1981 tax cut was not fully phased in until 1984. Economist Arthur Laffer has long argued that this phase-in reduced economic growth in 1982 and 1983. This is another example of how phase-ins can have negative economic consequences. It is essential that the White House become more engaged in the tax legislative process. It must ensure that the tax bill Congress almost certainly will enact has as much incentives for growth in it as is politically possible. But this almost certainly means abandonment, temporarily, of the dividend plan. There is simply no way of doing anything worthwhile in this area within a $350 billion revenue constraint. Fighting for it to the bitter end may foreclose options that will be better for the economy now, and perhaps even lead to enactment of tax provisions that may actually be harmful.