TCS Daily

What Price Tax Cuts?

By W. James Antle - January 27, 2003 12:00 AM

Supporters and opponents of President Bush's new tax cut proposal agree on one thing: It will cost over $600 billion. Stephen Moore of the Cato Institute and the supply-side Club for Growth referred to a $600 billion tax cut in a National Review Online article; left-wing columnist Thomas Oliphant of the Boston Globe describes a $670 billion tax cut that will really cost $930 billion. Both congressional Republicans and the liberal Center for Budget and Policy Priorities cite a $674 billion price tag.

Tax cuts face great enough obstacles without proponents reinforcing a principle argument against them by focusing on the supposed cost. True, the conventional thing to do is measure any tax cut, especially in the context of a stimulus program that also contains new government spending, in terms of a specific dollar amount. But these dollar amounts are based on unrealistic estimates of foregone revenue that ignore possible economic benefits. Reduced marginal tax rates lead to increased incentives to report income and engage in income-generating economic activities, both of which increase the amount of income subject to taxation even as rates are reduced. The scoring used to report the cost of tax cuts has historically exaggerated the amount of revenue that is lost.

By promoting tax cut proposals in terms of a specific dollar amount, tax-cutters give credence to the argument that tax cuts are a cost to government like any public spending program. This in turn reinforces the notion that the primary result of tax cuts is to reduce revenue accruing to the government and therefore increase budget deficits. Yet the static revenue forecasting models that are used to arrive at these estimates do not take into consideration how economic actors behave in the real world - they assume that changes in marginal tax rates, which inherently involves changes in incentives, do not alter taxpayers' economic activity or the overall amount of taxable income. In other words, these models assume the laws of supply and demand do not apply to taxpayers.

These projections do not just cause liberals to oppose tax cuts. Many centrists in both parties, styling themselves as deficit hawks, argue that any sizeable reduction in marginal tax rates is fiscally irresponsible. Why? Because tax cuts are scored as costing the government a large amount of money, just like spending programs.

Case in point is the first tax cut promoted by the Bush administration. Sold to the public as a 10-year tax cut totaling $1.6 trillion, tax-cut critics in both parties quickly seized on it is a drain on federal coffers. Liberal Democrats pointed out that this figure was specifically based on a 10-year projected budget surplus of $5.6 trillion that may not materialize. Not only did they succeed in reducing and delaying the tax cut based on these concerns, they claimed vindication when budget deficits returned. The deficits and the economic slowdown that caused them had nothing to do with the tax cuts, 90 percent of which have not even occurred as of this writing, but Democrats were nevertheless able to argue that Bush's $1.6 trillion "risky tax scheme" depended on a surplus that proved imaginary.

Of course, the $1.6 trillion figure was equally imaginary. As lower marginal rates increased incentives to work, save, invest and take risks, it is likely that the tax cut would have "cost" less than projected. Both projections for the size of the surplus and the cost of the tax cut over the next decade were based on a variety of economic assumptions that could have proved false. In fact, a tax cut that succeeded in boosting economic growth rates would actually lead to conditions more favorable to a larger 10-year budget surplus.

Former White House economic adviser Larry Lindsey pointed out that President Reagan's tax cut cost less than one-third of the static estimate. Even as the top statutory tax rate was reduced from 70 percent (50 percent on so-called "earned" income) to 28 percent, overall tax collections increased by 99.4 percent. Income tax revenues alone climbed 28 percent. By no means did it prove realistic to evaluate the Reagan tax cuts on the basis of projected revenue loss.

Rather than battle big spenders and anti-tax cut deficit hawks on their own terms, tax cuts should be promoted as an across-the-board percentage reduction in marginal tax rates and specific items within the tax cut proposal. For example, the Kemp-Roth proposal that the Reagan tax cuts were modeled on called for a 30 percent across-the-board marginal tax-rate cut. The tax cut President Reagan eventually signed into law was touted as a 25 percent across-the-board marginal tax cut. President Bush should concentrate on his proposal to lower marginal rates from 38.6 percent to 33 percent at the top and from 15 percent to 10 percent at the bottom, while ending double-taxation of dividends. This allows tax-cutters to focus on the attractive aspects of their policies rather than have them defined by inaccurate static estimates.

The amount of dollars a tax cut can be said to cost is not its most important aspect in any event. The purpose of tax cuts is to reduce barriers to trade and capital formation. Anything that does not focus on increased growth and living standards misses the whole point of the exercise.

If supporters of the president's plan want to improve the chances of its passage, they should ditch references to $600 billion price that may prove illusory and instead talk about how it can improve prospects for economic growth. Supporters of lower taxes need to take this debate to their area of strength.

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