This fall’s battles in Washington over taxes and spending are not going to disappear when Congress adjourns for the year. These struggles will resume in January, and the decisions made over the coming months will have enormous economic and political consequences.
While the Republican majority deserves great criticism for the excesses it has indulged in on the spending side of the ledger, the GOP led by President Bush (and aided by pro-growth Democrats) has enacted some very good changes on tax policy. But many liberal Democrats, with hopes of retaking control of one or both houses of Congress in 2006, are seeking to prevent the Bush tax cuts from being made permanent.
The Republican majority needs to ignore these calls for increasing federal revenues.
In the past couple of weeks, the House and Senate have each passed competing plans that partially extend some of the Bush tax cuts. They are now trying to settle their differences in conference. The House bill—but not the Senate bill—extends the most important provision, the 15% tax rate on capital gains and dividends. But even the House bill extends these lower rates for only two years (from the current expiration date of 2008). Thus, even in the best case scenario for 2005’s tax bill, much more work remains to be done on making the Bush tax cuts permanent.
Although you would not be able to tell it from the liberal press, the American economy is doing quite well. While there is no single reason behind the strong economy, the Bush tax cuts are a big part of the story. Real Gross Domestic Product has grown by 3% or more for 10 straight quarters. Since May 2003, America has added almost 4.5 million jobs. The stock market continues to move up.
The Bush tax cuts have helped the economy by lowering tax disincentives to productive activity. The cuts in taxes on income, dividends, and capital gains have reduced the marginal effective tax rate on capital by 17.4%. This in turn has helped increase investment. As economist Lawrence Kudlow writes (see page 13): “American businesses, the backbone of our economy, have responded to tax incentives that sharply reduced the cost of capital.”
A growing tide of economic studies has demonstrated that changes in taxes—especially taxes on productive activity—have an impact on economic growth. As the Federal Reserve Bank of Dallas found, “Increases in government spending or taxes lead to persistent decreases in the rate of job growth.”
One myth about the Bush tax cuts is that they are responsible for the federal deficit. Not true. The red ink flows from the explosion in federal spending during the Bush years. Spending in 2005 was 33% higher than it was four years ago. Spending increases have come across the board (not just in defense and homeland security). But Washington is not lacking for revenue: The latest projections from the Congressional Budget Office indicate that 2006 federal revenues will be 57% higher than federal revenues were a decade ago. Clearly, the deficits provide no justification for halting the Bush tax cuts.
This is not to say the tax cuts have created more revenue than would otherwise be the case. They haven’t (so big-spending Republicans can drop the fantasy that all they need to do to balance the budget is cut lots more taxes). But by generating high economic growth, the Bush tax cuts have led to some revenue recapture by the federal government. While tax cuts rarely “pay for themselves,” tax cuts that are pro-growth cost the Treasury far fewer dollars than would be indicated by formulaic (static) analysis.
Although the President’s opponents deny the connection between his tax cuts and economic growth, surely some secretly recognize that raising taxes (i.e., terminating the current lower tax rates) in an election year would be political folly for Republicans. Continuing the Bush tax cuts—especially the pro-growth components—would continue the recent economic benefits. If the tax cuts are made permanent—creating a greater measure of certainty in financial markets—the boost will probably be even greater.
Republicans should also remember that their core voters count on them to deliver on taxes. They should recall that, in 1998, big spending increases enacted right before the election outraged GOP voters, contributing to a shocking loss of GOP House seats. There’s no need to repeat that in 2006.
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