Bush's Tax Cuts: Reaganomics Redux?

By Robert J. Barro

In the 1980s, President Reagan led the effort to improve economic performance through tax reform. Marginal income tax rates were sharply reduced, many tax loopholes were eliminated, and the tax code was simplified. The rewards were twofold. First, the improved incentives to work and invest helped foster the U.S. economy's strong performance after 1982. Second, the tax cuts shifted revenues away from Washington, curbing the growth of government. Federal budget deficits grew in the late 1980s, but there's no evidence they raised interest rates or lowered investment.

The Reagan revolution was eroded by the ill-advised income tax rate increases of the early 1990s by Presidents Bush Sr. and Clinton. The creeping rise of the alternative minimum tax and the piling on of tax credits and adjustments to income complicated the code further. Nevertheless, the income tax environment remained better than that before 1980 and thus contributed to the strong economic performance of the 1990s.

The spirit of Reaganomics has returned in the current Bush Administration's proposals for a new round of tax cutting. Although the momentum for the tax changes may come politically from the desire to spur a weak economy, the proposals are designed to reduce tax distortions, cut marginal income tax rates, and thus achieve higher economic growth in the long run.

Perhaps the most important element in the Bush plan is the elimination of the personal tax on dividends. The general idea is that taxes on profits are already paid at the corporate level, so levies on dividends at the personal level constitute double taxation of these profits. Corporations react to the double taxation in several ways. First, instead of paying dividends, they retain earnings and use accumulated earnings to make stock repurchases. These practices, in essence, convert dividends into capital gains, which are taxed at low effective rates. A downside to this tax-spurred corporate financial strategy is less transparency and weakened stockholder control over management--important concerns these days.

A second corporate response is to finance investment by borrowing rather than issuing new equity. This procedure lowers taxes because the interest payments are tax deductible at the corporate level. But it can inflate the debt-equity ratio, creating financial instability especially in downturns. The elimination of the personal dividend tax would promote a more efficient corporate financial structure, which in turn would encourage higher corporate investment.

Another important part of the tax proposal is the moving up to this year of the marginal income tax rate cuts promised in the 2001 law. For example, the reduction in the top marginal rate from 39.6% to 35% would become fully effective as of January, 2003. Although the cuts in the 2001 law were attractive, the gradual phase-in through 2006 was a bad idea. The prospect of lower future tax rates gives individuals and businesses incentive to defer income and production. For this reason, the rate reductions can actually retard the economy in the short run. In the 1981 law, a similar phase-in of income tax rate cuts likely contributed to the 1982 recession. We learned from the early 1980s that any legislated tax rate changes should occur all at once. The new tax plan recognizes this principle.

The tax proposal also properly accelerates some other features of the 2001 law--including the reduction of the marriage penalty, enhanced child tax credit, and a broadened scope for the 10% tax-rate bracket. Left for the future are other desirable reforms, including cutting corporate tax rates, accelerating and making permanent reductions in the estate tax, changing the AMT, and eliminating phase-out rules for benefits such as itemized deductions. But, rather than complain about these omissions, I mostly have to applaud the return to a sensible economic approach for tax policy.

Democrats, no doubt, will stress that most of the direct benefits from the proposed tax changes accrue to richer families. In the current income tax system, this characterization of the cuts is inevitable because so little of individual income taxes are paid by poor families. For example, in 2000, taxpayers in the lower half of adjusted gross incomes paid only 4% of individual income taxes, compared with 56% paid by those in the top 5%. In 1970, taxpayers in the lower half paid 17% of individual income taxes, vs. 31% paid by those in the highest 5% of adjusted gross incomes. Thus, more and more, the individual income tax has been paid primarily by the well off, creating a dangerous political cleavage that promotes class warfare. Democrats, to the extent that they represent poorer families, can argue that the income tax is something paid primarily by other people. Of course, even those who pay little or no income taxes benefit indirectly when tax-rate cuts encourage economic growth. Growth is still the best way to raise employment and wages.

The tax-cutting proposal reflects the view that the best short-run economic policy is a good long-run policy. This is very refreshing coming from Washington.

Robert J. Barro is a professor of economics at Harvard University and a senior fellow of the Hoover Institution (rjbweek@harvard.edu).

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