Is It Class Warfare?

That's what the political fight will be about. But the economic reality is much more promising

Ever since Abraham Lincoln instituted the first income tax to help pay for the Civil War, the U.S. tax system has been built around two principles of fairness: The rich have always faced higher tax rates than the poor, and no form of income has been immune from taxation. Wages, dividends, interest, capital gains--all have felt the relentless bite of the tax collector.

Until now. On Jan. 7, President George W. Bush proposed fully exempting dividends from the federal personal income tax, a bold step that even the great tax-cutter himself, Ronald Reagan, never tried. This elimination of the tax on dividends--a far more ambitious move than expected--accounted for over half of Bush's proposed $674 billion economic-stimulus package. Also included in the plan: accelerating income tax cuts scheduled for later in the decade, investment incentives for small businesses, and a modest amount of money for job retraining.

Bush justified his proposals by saying that they would put more people back to work in the short run by pumping tens of billions of fiscal stimulus into the economy in 2003 and 2004. At the same time, he argued that the elimination of the dividend tax would encourage investment and lay the groundwork for growth and prosperity in the long run. Democrats countered with the undeniable fact that the biggest beneficiaries of the tax cuts would be the well-to-do. Estimates from the Urban-Brookings Tax Policy Center suggest that 60% of the benefits in 2003 will go to taxpayers with an adjusted gross income of more than $100,000. That rises to nearly 70% in 2010.

Such an appeal to fairness has often proved powerful in the past. But the political and economic landscape has changed, and in the New Economy, the old rhetoric of class warfare--rich vs. poor, investor vs. worker--may be increasingly obsolete. Dividends, interest, and other capital income are more evenly distributed than they once were. Moreover, America can prosper only if investors are willing to take a chance on innovative new businesses and technologies--and one way to encourage them to do that is to cut the taxes they pay.

Indeed, the 1990s showed that a fast-growth, high-productivity economy can benefit poor and average Americans even as it generates increasing income inequality. During the boom years and the bust that followed, the share of income going to the top 5% of households crept up from 21% in 1993 to 22.4% in 2001. But over the same stretch, the poverty rate slid from 15% to less than 12%, despite the 2001 recession. Just as important, real wages rose significantly for the average American.

Certainly, reducing income inequality is in itself a laudable economic goal. But it's not the only one. If the benefits of widespread and growing prosperity outweigh the negatives of growing inequality, then the Bush plan must be judged in that context. If eliminating the tax on dividends and implementing the other parts of the Bush proposal can stimulate growth and create jobs, that will help hold down poverty and boost wages. In the end, the price of improving performance at the bottom end of the economy may well be outsize gains at the top, but that may be a price worth paying.

The danger, of course, is that the Bush plan doesn't work to boost investment and growth. In the worst-case scenario, the extra money available to high-income taxpayers could be invested abroad or spent on imports--neither of which does anything for the U.S. economy. The result, then, would be higher budget deficits with little or nothing to show for them.

Moreover, whatever the economic merits, it's not clear that the Bush Administration has the votes in Congress to pass such a far-reaching and expensive plan. There will be plenty of changes to the scale and details of the President's proposals--not to mention attempts to rejigger it more toward short-term stimulus. Already, the Democrats have made it clear that they would like to provide more direct funds to state and local governments for such things as spending on Medicaid, homeland security, and infrastructure projects.

No matter what legislation finally passes, simply by proposing to eliminate taxes on dividends, Bush has transformed the economic debate in a way that goes far beyond the magnitude of the proposals themselves. Economists of all political stripes have long agreed that reducing taxes on capital income--of which dividends are one kind--is a good thing to do. In fact, from the economic perspective, such a reduction in capital taxes makes far more sense than simply cutting the marginal tax rate on high-income households, as Reagan did. Lower taxes on capital makes it more profitable to invest while higher rates of investment boost long-term growth and productivity. "I don't know of anything else we can do that has a similar prospect for improving incomes," says Robert Hall, a Stanford economist who also heads the business cycle dating committee at the National Bureau of Economic Research.

Despite the consensus within the economics profession, the difficulty in reducing taxes on capital income, such as dividends and interest, always has been political. Capital income has historically been concentrated among the wealthiest taxpayers, who had big holdings of stocks and bonds. So reducing the taxes on capital income would mainly have helped the richest people--effectively making such a move a political nonstarter. "Intelligent supply-side economics often proposes regressive changes in the tax structure that if enacted would be good for growth," says Alan Blinder, a Princeton University economist and former vice-chairman of the Federal Reserve. "This is probably one of those."

But almost without notice, the concentration of capital income has been steadily decreasing. More and more, the top tax brackets are not mainly populated by wealthy investors who collect dividends and interest payments. Instead, the biggest incomes go to high-end managers and professionals, who get most of their money from salaries and other compensation, such as stock options and bonuses, along with active business owners who draw funds from their own enterprises. As recently as 1981, the top 0.5% of taxpayers got 35% of their taxable income (excluding capital gains) from dividends, interest payments, and rental income. But by the late 1990s, the same top 0.5% of taxpayers got only 16% of their income from such sources, according to a study by Emmanual Saez of University of California at Berkeley and French-based economist Thomas Piketty. That means a reduction in capital taxes no longer disproportionately benefits the top as much as it once did.

Moreover, the nature of the economy has changed over the past two decades, making reducing taxes on capital more appealing. The rise of a global economy, with increased mobility of capital between countries, means that it may backfire if an individual country--even one as large as the U.S.--tries to tax its investors too heavily. "The U.S. is pretty unique in taxing dividends the way we do," says James R. Hines Jr., a tax economist at the University of Michigan. "Almost no other high-income countries have double taxation of dividends."

Perhaps most important, the U.S. has increasingly become an economy dependent on high rates of capital spending and innovation to compete globally. Even though Silicon Valley's image has been tarnished by the tech downturn and dot-com implosion, the best way to encourage risk-taking is still to reward successful companies, entrepreneurs, investors, and workers with big gains. That means that in a high-innovation economy, lowering taxes on capital should always be a top priority, because it encourages investment and rewards success.

What about the impact of the Bush plan on workers, particularly those at the lower end of the income scale? The lesson from the 1990s is clear: Low unemployment, combined with rapid productivity growth, is the best tonic for poverty and low wages. As overall unemployment dropped below 5.5% or so in the mid-1990s, real hourly earnings for production and nonsupervisory workers, which had been falling since the early 1980s, finally turned up. At the same time, the tight labor markets forced businesses to hire and train workers who had previously had a tough time getting jobs. That's why, in part, the unemployment rate for black workers finally dropped below 10% in the late 1990s.

All of this explains why the Bush package is good news for workers, irrespective of what happens to those at the top. In the short term, Goldman Sachs estimates the tax cuts--including bigger tax credits for families with children--would put at least $50 billion to $75 billion into the economy in 2003. Perhaps as much as $150 billion would arrive in 2004. Fiscal stimulus of that level should take at least half a percentage point off the unemployment rate, and perhaps more.

What about in the long run? Historically there's been plenty of disagreement among economists about the best way to bring down unemployment, especially at the low end. One view has been that over the long run, the sustainable unemployment rate is basically determined by demographic factors, such as education and experience. While the Bush plan does include a proposal focused on improving employability--the Personal Re-employment Accounts, which give unemployed Americans a credit to be used for training and other expenses--the amount of money involved is less than $4 billion and wouldn't have much of an effect.

But a recent paper by economists Laurence Ball of Johns Hopkins University and N. Gregory Mankiw of Harvard suggests that higher productivity growth was the key to lower unemployment in the 1990s. If that's true, a policy that encourages investment and productivity should bring growth in jobs and wages that will benefit the poor as well.

What are the downsides? While the numbers in Bush's plan sound impressive--$674 billion over 10 years--they are relatively small compared with the size of the U.S. economy. They represent considerably less than 1% of GDP over the next decade, based on reasonable estimates for growth. And the estimates from Bush's Council of Economic Advisers acknowledge that eliminating the tax on dividends will only boost the nation's stock of plant and equipment by less than 1%. By comparison, during the investment boom of the second half of the 1990s, the nonresidential capital stock grew at almost 4% per year. "The world is made a little better by tax reform, but it is not transformed" says economist Hall of Stanford.

The other big problem could be the rise in the budget deficit as taxes are cut. The Bush Administration is assuming that faster growth can provide enough extra tax revenue to keep the deficit from exploding out of control. But many economists are skeptical. "What I'm most worried about is the attitude that we can keep giving away revenue as if there were no long-run budget constraint," says Blinder. "When you look out to the long run, we're desperately in need of revenue."

That suggests it would be a good idea to combine the reduction of tax rates with a broad attack on corporate tax shelters and loopholes. If dividends are not going to be taxed at the individual level, it should be more difficult for corporations to evade taxes on their profits by tricks such as moving their official headquarters overseas. The Bush plan goes part of the way in that direction, but more needs to be done to convince citizens that corporations are paying their fair share.

President Bush has offered his opening bid in a lengthy legislative process. But at a time when the U.S. is trying to recapture some of that New Economy magic, it's a good place to start.

Read a Letter to the Editor about this story.

By Michael J. Mandel in New York, with Rich Miller in Washington

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