Most supporters of George W. Bush's new "jobs and growth" package are being dishonest, just like most of the plan's critics—but what else is new? One of the reasons intelligent reform of America's tax code has always been difficult is that intelligent discussion of this subject seems to be downright impossible, at least in Washington. When it comes to tax reform, more than any other area of policy, partisan loyalties do not just color the debate, they are the debate.
The White House is offering its plan as a response to the economic slowdown: The situation is urgent, it says. This is dishonest because the president and his advisers know that the proposal, if enacted, would do little to stimulate the economy in the short term. Bush also says his plan is fair to working Americans. This is dishonest too, because the boldest and most important idea in it—cutting to zero the tax on dividends—eases taxes on capital, not taxes on earnings. This approach helps the rich more than the poor, and investors more than workers. If the president's stated aims really were what mattered most, his plan ought to be rejected out of hand.
The Democrats' attacks on the proposal are just as empty and self-serving. Tax cuts for the rich, they declaim. Well, yes. But the rich pay most of the taxes, so cutting taxes tends to give the rich most of the benefit. Does that make cutting taxes wrong in principle?
Democrats also complain that the additional stimulus in the new plan is too small, given the state of the economy after two years of the president's depredations, remembering also that Bush did not actually win the election of 2000. On the other hand, they add, the deficit was out of control even before this new proposal. Maybe so, but if that problem is as big and urgent as Democrats say, the administration should be planning to raise taxes or cut spending. The president's critics recommend neither.
What the White House is proposing is not, contrary to what it says, a plan to stimulate the economy in the short term—but that is all right because the economy no longer needs it. Plenty of stimulus is already on its way from easier monetary policy and last year's fiscal measures. By the time an extra fiscal expansion (proposed now, agreed to in the spring, and enacted some time after that) had arrived, it would stand a good chance of being too much, too late.
What if the recovery falters? That could happen, but the Federal Reserve has scope to cut interest rates again, and the Fed is in a better position than fiscal policy makers to respond quickly to bad news.
The economy's sluggish growth demands no short-term fiscal fix, but it did create a political opportunity—and perhaps a political requirement—for a new policy initiative. Democrats and Republicans are as one on that. So the right question to ask of the president's plan is whether it uses this opportunity wisely. Specifically, will it support faster economic growth in the long term? The answer is yes, with qualifications.
Ending the tax on dividends is a good thing so far as economic efficiency goes. There is a pretty solid consensus among economists specializing in tax policy that saving is overtaxed in the United States (as in most other countries). In typical income tax systems, people save out of taxed income and are then taxed again on the income their savings generate. This so-called double taxation encourages people to consume now rather than later, because it lowers the after-tax return on savings. Tax reformers all over the world urge governments to avoid this by excluding savings from the income tax base, either by granting an immediate deduction for saving or by exempting the income subsequently paid to the saver.
In America the disincentive to save is even bigger than in almost all other industrial countries, partly because of generous assorted deductions for interest outlays. Through these provisions, the tax code in effect subsidizes borrowing, notably for buying a house.
Also, dividends are actually triple-taxed, because companies have to pay corporate income tax before they pay their dividends to shareholders. Ordinary investors buy corporate stock out of taxed income, then pay tax on their dividends, which are themselves paid out of taxed profits. But the point is not that double, triple, or n-tuple taxation of any particular stream of income is unfair as such. People ought to be treated fairly by the tax system; streams of income have no such ethical entitlement. The point is this: The net effect of all those layers of tax is that future consumption—saving—is taxed more heavily than present consumption, an anomaly that makes society as a whole worse off.
Tax shelters such as 401(k) plans and other such schemes mitigate some of the burden, but because they are not comprehensive, they add distortions of their own. The net effect is almost certainly that people save less and borrow more than they would under a neutral tax code. Investment suffers, and companies hoard cash and return income to shareholders in the form of stock repurchases rather than dividends.
This effect on the way companies are financed bears emphasis. The preference for debt over equity, and for retained earnings and capital gains over dividends, is intimately connected with the stock market bubble and corporate malpractice of the late 1990s. Dividends discipline managers and empower shareholders, not least by reminding corporate boards that they have obligations to the people who own the company. Dividends promote a long-term view of a firm's prospects over an obsession with the share price and short-term speculation. Because dividends thereby tilt the balance of power between managers and owners, business organizations—which represent managers—have long been cool on proposals to lift the discrimination. That is a recommendation in itself.
As it stands, then, the proposal to eliminate the tax on dividends is a good one. Unfortunately, the administration's overall approach to taxes and spending gets much lower marks. Two big things are wrong with it.
First, critics are right to say that the overall effect of the fiscal changes—taking last year's measures together with the new proposal—is to force the budget deficit much too high in later years. Remember that the out-year numbers, bad as they may seem, are being artificially improved in official forecasts by implausible assumptions about trends in public spending and by the scheduled reversal of some of the tax cuts. Remember too that the relative shrinkage of the working-age population will serve in the future to drive public spending higher (for instance on Social Security and Medicare), and to weaken prospects for growth in revenues.
Given all this, the long-term outlook for the deficit is grim. A responsible administration would be thinking hard right now about how to address the issue once the recovery is in place. The Bush administration shows no inclination to do so.
Deficit-control aside, there is no sign of a thought-through, productivity-enhancing fiscal strategy. If tax reform is to balance the demands of economic efficiency and fairness to taxpayers, it needs to combine a variety of changes in an integrated way. Strategic goals need to be developed to guide this process. Eliminating the tax on dividends eases the burden of taxes on savings, which is a good thing—but at the expense of worsening the deficit and shifting the tax burden from rich to poor.
It would be possible to design a strategy that lifted the burden of taxes on savings in a more thorough way while bringing the deficit under control and leaving the distribution of the tax burden relatively unchanged. But it would require a much more comprehensive proposal. Ad hoc measures taken one by one cannot reconcile these conflicting aims.
An approach with a lot to recommend it would be to move toward exempting all savings from taxes while abolishing all or most other exemptions. These measures would partially offset each other from a revenue and distributional point of view, while boosting the economy's long-term growth. To get the deficit off its current path, though, additional revenue is likely to be needed. One tax that is crying out to be raised on efficiency grounds is the gasoline tax. The revenue could be used not only to contain the deficit but also to lower other taxes or pay for reform of Medicare or Social Security. Is any of this even being considered?
The president's proposal has won praise for its boldness. True, it was a bigger package than people had expected, with a good idea at its center. Measured against a well-planned, comprehensive tax reform of the sort that the United States really needs, it was timid.