Commentary

Tax Credits Won’t Lift Economic Growth

There’s a policy debate among conservatives in Washington about the best way to cut taxes and reform the tax code. The supply-siders want to replicate the success of Reaganomics with lower marginal tax rates. But there’s also a camp who call themselves “reform conservatives” who want income tax credits or payroll tax cuts explicitly for the purpose of reducing tax liabilities for middle-class parents.

The supply-siders argue that if you want to encourage more work, saving, investment and entrepreneurship, then it is a good idea to reduce marginal tax rates on productive behavior. The reduction in marginal rates alters the trade off between labor and leisure—favoring the former—at any given level of income, as well as the trade-off between saving and consumption. This is why even a revenue-neutral reform that focuses on lowering marginal tax rates can be very conducive to growth.

Those in the other camp, led by Sen. Mike Lee of Utah, and championed by former Treasury official Robert Stein and James Capretta of the Ethics and Public Policy Center, don’t necessarily disagree with the supply-siders. They note that it was important to lower marginal tax rates in 1980 when the top personal tax rate was a confiscatory 70%. But now that the top rate is “only” about 40%, they argue, lower tax rates won’t deliver nearly as much bang for the buck.

Unlike supply-side rate cuts, tax credits have little if any effect on incentives to work, save and invest.”

That’s almost certainly correct. But does that mean child tax credits and payroll tax relief are better options? Let’s look at some reasons for skepticism.

From a political perspective, reform conservatives say it’s time for new ideas. That’s a nice concept, but Republicans already have enacted many of their proposed policies. The child tax credit was adopted in the 1990s and expanded during the Bush years. The earned income credit also funnels a lot of money (in the form of tax relief or cash payments) to families with children, and that provision also has been significantly expanded over the years.

These policies have worked, at least in the sense that households with children now face lower tax liabilities. There is little evidence, though, to suggest positive economic or social outcomes. Were families strengthened? Did the economy grow faster? Did middle-income households feel more secure? In the absence of supporting data, it is not wise to double down on more of the same.

The tax-credit reformers also argue that their proposals are much less susceptible to class-warfare demagoguery that is the supply-side approach, since tax relief flows to lower- and middle-income voters. Child tax credits generally have restrictions based on income, so millionaires don’t benefit even if they have 10 children. Since payroll taxes only apply to income up to $117,000, the potential gain for the top 1% is very limited there, too.

But here’s the downside: Conservatives can bend over backward to appease the class-warfare crowd, but they can never outflank them. So if they propose a family-oriented tax cut only for households making less than $100,000, the left can propose even bigger tax cuts (or more government spending in the form of refundable credits) limited to those making under $50,000.

Once conservatives have accepted the left’s premise that tax policy should be based on static distribution tables, they won’t have a ready answer for the left’s gambit. And since tax credits have little if any effect on incentives to work, save and invest, conservatives also won’t be able to make an argument about the less fortunate benefiting from faster growth.

Now let’s look at the economics. The most commonly cited reason for family-based tax relief is to raise take-home pay. That’s a noble goal, but it overlooks the fact that there are two ways to raise after-tax incomes.

Child-based tax cuts are an effective way of giving targeted relief to families with children, particularly when compared to a reduction in tax rates, which would have only a modest impact on take-home pay for a family in the 10% or 15% tax bracket.

The more effective policy—at least in the long run—is to boost economic growth so that families have more income in the first place. Even very modest changes in annual growth, if sustained over time, can yield big increases in household income.

This is what happened in the 1960s and ’80s. Based on static income-distribution tables, the so-called rich were the big winners from the Kennedy and Reagan rate reductions. But better policy led to better economic performance, and this meant rising real income for households up and down the income ladder.

The 2014 Social Security Trustees’ Report projects that long-run growth will average only 2.3% over the next 75 years. If good tax policy simply raised annual growth to 2.5%, it would mean about $4,500 of additional income for the average household within 25 years. This is why the right kind of tax policy is so important.

Tax-credit conservatives generally admit that child-oriented tax cuts have few, if any, pro-growth benefits. Yet there is considerable agreement that supply-side reductions in tax rates can boost economic performance, even if there is no consensus on how much growth would rise.

There may be a productive way to resolve this debate. While the camps disagree on lower individual income tax rates vs. child-oriented tax relief, both agree that the tax code’s bias against capital formation is very misguided. The logical compromise might be to focus on reforms that boost saving and investment, such as lowering the corporate tax rate, reducing the double taxation of dividends and capital gains, and allowing immediate expensing of business investment.

These reforms would have strong supply-side effects. And since more saving and investment will lead to increased productivity, workers will enjoy higher wages, including households with children.

Daniel J. Mitchell is a senior fellow at the Cato Institute.