Tax Cut Priorities

We now see the outlines of what Congress is likely to do about taxes this year, thanks to a surprisingly bold and innovative compromise wrought by Bill Thomas, chairman of the House Ways and Means Committee.

The centerpiece is a souped-up version of something I have been writing about since last summer — namely, making the individual tax on dividends the same as the tax rate on long-term capital gains. Thomas quickly topped that proposal. By January, he was talking privately of wanting to bring the tax on both dividends and gains down to 17 percent to 18 percent. The big surprise in his new plan is that these two tax rates would go lower still, to 15 percent.

The plan came in from some odd criticism in a Wall Street Journal editorial, which faults Thomas for including items from the president’s plan. “Thomas also throws in $25 billion in alternative minimum tax relief,” say the editors, but that was actually “thrown in” by the White House. The Journal likewise criticizes Thomas for including plans to speed-up the child credit and other social policies. Such criticism is properly addressed to the White House, which threw all that miscellany into its original plan. With the Senate clearly unwilling to enact such a big bundle, however, something has to go. What should be done right away, and what should be set aside?

Somebody has to set priorities. Changes most important to the economy must take priority over those that just appease interest groups. So far, the White House has appeared to take an all-or-nothing approach. Failure to provide executive leadership just leaves the priorities to legislators. Unfortunately, legislators have strong incentives to take a parochial and myopic approach — to cater to their noisiest constituents and to favor populist policies that appear to make good soundbites for the next elections.

Shortly before the release of the Thomas plan, my old friend Bruce Bartlett (who supports the plan) initially counseled “abandonment” of any dividend tax relief because he could foresee “no way of doing anything worthwhile” about dividend taxes within the Senate’s $350 billion 10-year budget. That depends on what you think is worthwhile.

The Urban Institute and Brookings Institution estimated that taxing dividends at the same rate as capital gains — surely a worthwhile change — would cost only $78.3 billion from 2003 to 2012. Ways and Means estimates that speeding-up the already enacted cut in the top four tax rates would cost only $74 billion. So the two most important reforms would cost the IRS about $152 billion — only $15 billion a year. The government routinely misplaces more than that.

For absolute top priority, I nominate those two items: Bring marginal tax rates down to 25-35 percent right away, and cut the individual tax on dividends to no more than 18-20 percent (there is an 18 percent capital gains tax on assets held 5 years). Those two crucial items fit quite easily within a $350 billion target — with $198 billion to spare. And they preserve the core virtues of the Bush plan. Everything else is optional, icing on the cake. But with all that spare change lying around, it is hard to quarrel with Thomas’ plan to make deeper cuts into taxes on dividends and capital gains.

Slashing the maximum tax on dividends to 15 percent is not just worthwhile, it is absolutely huge. It dwarfs the 1997 cut in capital gains tax from 28 percent to 20 percent, which nobody then dismissed as trivial.

Revenues lost by reducing the tax on dividends to 5-15 percent supposedly amount to $245.8 billion, but such guesstimates ignore the reality that lower tax rates will encourage more people to keep dividend-paying stocks in taxable accounts (not just in pension funds). Some unnecessary revenue loss, however, is because the Thomas plan has a super-low 5 percent tax for dividends and capital gains when overall income is very low. A flat 15 percent rate would be more frugal and less likely to distort the timing of asset sales and the inter-family distribution of assets.

Thomas also retains the president’s pointless plan to cut from 15 percent to 10 percent the tax on the first $7,000, up from the first $6,000 now. That just gives everyone 50 bucks, which loses $19 billion without any effect on marginal incentives. This scheme is my top choice for bottom priority.

The Thomas plan makes valuable additions to the president’s plan yet still remains below $550 billion. It allows companies to write-off half their cost of new equipment in the first year until 2006. That would be an extremely effective device to bolster the weak business investment sector. Small firms could write-off the first $100,000 investment costs, importantly including software.

There has been talk about the Senate Finance Committee leaning toward goofy gimmicks, such as having the dividend tax vanish in some distant year and then reappear the next. With the Senate appearing so neglectful of the critical details, leadership from the White House is becoming vital. To do first things first, somebody has to say what comes second. If senators must pare down the Thomas proposal, there are safe places to do that, such as reverting to the gradualism of the 2001 law for matters of tertiary importance.

In helping to steer the House-Senate conferees, the White House should gladly welcome and embrace the Thomas plan as a truly outstanding starting point. The Senate should not be allowed to take this tasty dish that Thomas has artfully created and then mess it up by adding the wrong vegetables and diluting it with dishwater.

If too many unnecessary $40 billion turnips are tossed into this stew, some of those amateur chefs in the Senate kitchen are likely to forget to include the beef.