A Hollow Victory

I believe that the White House won a hollow victory in the Senate last week on its tax bill. The bill will do almost nothing for growth and could even be counterproductive, owing to harmful tax increases included in the package.

In defense of the Senate, it was in an untenable position once it imposed a $350 billion cap on the bill’s net revenue loss over 10 years. This meant that President Bush’s original $726 billion proposal had to be cut by more than half. Yet the White House never told the Senate how to square the circle. Senate Finance Committee Chairman Charles Grassley (R-IA) was left to his own devices as to how to squeeze more than 2 pounds of feathers into a 1-pound bag.

Senator Grassley was under intense White House pressure to give President Bush a legislative victory by abolishing taxes on dividends. But because there was not enough money to do it the way he asked-which would have cost $400 billion for that provision alone-Senator Grassley abolished such taxes for just 3 years. Beginning in 2007, under the measure adopted by the Senate, dividends will go back to being taxed as they are now.

Congress has adopted such stupid sunsets before. The best example is the estate tax, which expires in 2010 and returns again in 2011. They are the necessary price for getting any tax cut enacted within the so-called Byrd Rule and over the objections of recalcitrant Republican Senators John McCain (Arizona), Lincoln Chafee (Rhode Island), George Voinovich (Ohio) and Olympia Snowe (Maine).

The Byrd Rule mandates that no legislative change enacted under reconciliation may be in effect for more than 10 years. But reconciliation is necessary to keep Democrats from filibustering the tax bill as they are filibustering judicial appointments.

Senators Voinovich and Snowe are responsible for the $350 billion cap. For some reason, they decided that this was the biggest tax cut we can afford-even though it represents a trivial sum over 10 years in an economy that will generate well more than $100 trillion over this period. Senator Chafee is simply a Democrat in all but party registration. Senator McCain, however, is a conservative from a conservative state. He said there should not be any tax cut as long as the nation was at war. Yet he continues to oppose even a $350 billion tax cut despite the end of war.

With President Bush insisting on ending dividend taxation, Senator Grassley gave the president what he asked for but only for 3 years. Just to get that he had to add a $20 billion bailout for the states to buy the vote of Senator Ben Nelson, Democrat of Nebraska, and raise taxes by $72 billion.

Unfortunately, Senator Grassley picked some bad revenue raisers to offset the cost of eliminating taxes on dividends. The worst is a provision that will make Americans working abroad pay both U.S. taxes and taxes in the country in which they work. At present, the first $80,000 of foreign earned income is exempted from U.S. taxes.

Some view current law as an unjustified tax loophole. But no other major country on earth taxes its citizens on wages they earn by working in a foreign country. There is no reason why they should, since taxes pay for services one receives from government. If one receives no such services from the U.S. government, since a foreign government is providing them, why should Americans working abroad have to pay twice?

Of course, Senator Grassley would allow Americans a credit against their U.S. taxes for foreign taxes paid, saying that this will eliminate any additional tax liability for most. But clearly many Americans will be paying substantially more, which is why this provision raises $35 billion. Remember that those earning less than $80,000 will mainly be affected, so we are not talking about millionaires. And the exclusion applies only to wages, not investment income.

The only effect of raising taxes in this way will be to force U.S. companies to hire foreigners to run their foreign subsidiaries. Studies have shown that this will reduce U.S. exports and increase the trade deficit, because foreign managers will more likely buy from foreign suppliers.

In all likelihood, all of the Senate’s revenue raisers will be dropped in conference. Neither the House nor the Bush Administration support them. But if that revenue is lost, then so is 2 years of dividend relief, meaning that the elimination of dividend taxes will last for just a single year. Obviously, this is too short a time to have any value economically and is really not worth doing. What the conferees will do instead is the question of the day.