Tax Cuts: Making Sausage

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  • 08/19/2022

It is often said that the legislation process is like watching sausage being made: disgusting. What is left off this analogy, however, is that sausage can be very tasty. We have just seen a good example of tasty sausage being made in the tax area. Although the process by which it was made was convoluted and painful, at the end of the day Congress will have enacted one of the best tax bills in history.

To summarize: President Bush proposed full elimination of the double tax on corporate profits. This proposal was considered audacious and over-the-top when first proposed in January. His staff had recommended a 50 percent reduction in dividend taxes. But Bush reasoned that he was not going to be attacked any less for proposing half of what he wanted instead of 100 percent, so he insisted on total repeal of taxes on dividends.

The total tax package proposed by Bush, including a speed-up of individual tax rate reductions and other provisions, was estimated to increase the budget deficit by $726 billion over 10 years. But Congress, in its wisdom, decreed that $550 billion was the most it would accept in its budget resolution.

Things got further off track in the Senate where two Republican senators - Olympia Snowe and George Voinovich - decided that they would only support a $350 billion tax cut. Senate Finance Committee Chairman Charles Grassley gave his word that the final legislation would cost no more than $350 billion, effectively capping the final legislation at this amount.

House Ways and Means Committee Chairman Bill Thomas quickly recognized that Bush's original plan was no longer viable given the budget constraints. He also recognized that full abolition of double taxation was not necessarily the most effective way to jump-start the economy, especially if it had to sunset after a few years to meet budget targets. This led him to put forward an alternative plan that cut the top tax rate on dividends from 38.6 percent to 15 percent. With the revenue that was saved, Thomas was also able to cut the capital gains tax from 20 percent to 15 percent and boost depreciation allowances for business investment by 50 percent.

I thought the Thomas plan was a brilliant compromise that provided as much bang for the buck as one could hope for in a tax cut limited to $550 billion. However, the White House was still insistent on its plan and appeared willing to totally abandon its substance just to say that the president "won." In the Senate, it was successful in getting dividend taxes eliminated for just three years. Doing more was impossible within a $350 billion limit.

My view was that three years of dividend relief - with full taxation returning after that - was not enough to change corporate behavior, boost the stock market and raise growth. I thought it was better to do a little less for longer, as Thomas proposed. I also thought that the capital gains and depreciation provisions in his plan were crucial to increasing growth between now and next year's elections. However, some economists I respect, like Brian Wesbury and David Malpass, disagreed, saying that even temporary elimination of dividend taxes would strongly stimulate growth.

In the end, some unknown economists in the bowels of Congress, who determined that the Senate dividend provision cost $70 billion more than they initially thought, settled the debate. This required shaving two years off the three-year dividend exclusion. At this point, everyone agreed that this was not viable, and they turned to the Thomas bill. That now forms the basis for the legislation that passed the House yesterday and will be taken up in the Senate today.

When President Bush signs this bill, we will have a significant cut in taxes on corporate dividends, which will lower the cost of capital and give a huge boost to the stock market. Lower capital gains tax rates will greatly improve the investment climate and be a major stimulus to venture capital and other high-risk investments. Larger depreciation allowances will bring forth new business investment that will create jobs and incomes for thousands of Americans. And a reduction in tax rates for all taxpayers will increase incentives to work, save and invest.

Amazingly, there are those who view this wonderful tax package, which is probably the best tax bill since Ronald Reagan's 1981 tax cut, as some sort of defeat for President Bush. Since he got "only" a $350 billion tax cut instead of the $726 billion he asked for, this means that he lost big time, they say.

Those who believe this simply don't know what they are talking about. It's not the amount of dollars a tax cut puts into the economy that matters for growth, but how that tax cut affects incentives. This tax cut improves the tax system enormously in that regard. That is why it is a big victory for President Bush and all Americans.


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