The Right Way To Cut Taxes

It is easy to be cynical when vote-hungry politicians talk tax cuts at election time. But the dramatic 10%-to-15% tax cuts being discussed by GOP candidate Bob Dole deserve serious--and careful--consideration. We believe that a cut in marginal income tax rates can spur higher economic growth. We believe, as well, that this growth can generate some of the revenues lost to the Treasury. We worry, however, that politicians will confuse cutting taxes with fiscal responsibility. We're concerned about the new silence in Washington surrounding runaway entitlement spending and the loose talk of tax cuts fully paying for themselves. In a quarter when business profits are healthy, inflation remains subdued, and economic growth purrs along, the last thing this nation needs is a replay of the 1980s' financial fantasy of a free lunch.

To succeed in spurring long-term growth, tax cuts, by and large, must be paid for. But how and at what cost? "Dynamic scoring" is supposed to answer these questions by predicting the effect of tax policy on economic behavior and government revenue. Many supply siders a decade ago used dynamic scoring to estimate that each dollar in tax cuts would create enough economic growth to return a dollar in tax revenues. It didn't work out that way, and taxpayers are still paying the interest on the resulting $3.1 trillion debt. Without those interest payments, the federal budget would be in surplus. Now, many economists are saying that a buck in tax cuts gets you back 35 cents to 40 cents in tax revenues. Maybe.

Economic research is murky on dynamic scoring. We'd prefer to take a conservative stance and assume that the Treasury could count on only a 30% return at best. That means that 70% of a tax cut must be paid for, dollar for dollar, in spending cuts and higher revenues through closing tax loopholes. A 15% across-the-board tax cut, one idea being discussed in the Dole camp, would transfer $600 billion over six years from the government to the people. That's great, but only if the politicians have the courage to find $420 billion in spending cuts and added revenues from closing loopholes. If not, that's $420 billion in new deficits, higher interest rates, and lower, not higher, economic growth.

Returning to the simple two-tier income tax system of the sweeping tax reform of 1986 could help. We think getting back to the 15%-to-28% tax rates would shake most of the tax-break ornaments out of the tax tree. A simple system that cuts tax breaks for gasohol, private-purpose bonds (stadiums), and other business and personal activities could generate up to $50 billion a year. A two-tier tax system would save billions just by simplifying IRS paperwork. Best of all, a two-tier tax system would help stop the recent drift of special-interest tax policy that encourages consumption and distorts more rational economic decision-making. The Contract With America's $500 child tax credit, for example, would cost $147 billion over seven years and does virtually nothing to promote economic growth or jobs. Indeed, by promoting consumption, the tax credit also encourages imports and hurts the trade deficit and the dollar.

The goal of a major tax cut must be to foster investment and growth. The U.S. economy is in good shape, and companies are more competitive after years of painful effort. The economy can benefit from lower marginal tax rates, but it can also be hurt by the wrong tax policy. If politicians pander to voters and refuse to pay for tax cuts, they can cause the budget deficit to balloon again, send rates higher, and kill off growth. If they push for tax cuts that boost consumption and not investment, they risk exacerbating the trade deficit, hurting the dollar, pushing rates higher, and killing off growth.

So go ahead and cut taxes. Simplify the code. End loopholes. Lower spending. Focus on investment. But don't blow the gains of a decade.