Commentary

Tax Cuts on Savings are the Rx for Strong Growth

President Bush’s tax policy team started off in the right direction last year with tax rate reductions. It made further progress with the capital investment tax cut enacted as part of the March stimulus bill. The president has indicated that the next tax proposal will be a pro-savings cut on dividends or capital gains. Tax cuts on personal savings have great potential to stimulate growth, whether pursued now or when the new Congress assembles next year.

Reducing taxation on savings has become the new frontier of tax policy. After the 1986 tax law, which hiked capital gains taxes and pared back individual retirement accounts (IRAs), Congress reversed course in the 1990s by cutting the capital gains rate and making piecemeal improvements to savings vehicles. Now, the Bush administration should accelerate the process, and lead the charge to further cut taxes on savings.

There is no economic reason not to cut taxes on savings. The resistance comes from those who carp that such cuts only benefit the rich. They are wrong. Cutting taxes on the returns to savings, or capital income, would benefit every American-whether or not they own a single stock certificate. That’s because lower capital taxes would boost the amount of capital equipment that every wage earner works with. More technology per worker means higher wages.

That tax cut benefit would be true even if the United States were isolated from the world economy. Instead, there are more than $2 trillion of net investment flows moving across international borders every year searching for high returns. We need good tax policy to attract that capital and build our economy. Besides, the burden of capital taxes in an open global economy falls harder on immobile workers than on the mobile capital owners that high-tax supporters try to target.

Other countries have recognized those realities and made reforms. The United States needs to get with the program. While our individual capital gains rate is 20 percent, the capital gains rate is zero in Austria, Belgium, the Czech Republic, Germany, Greece, Hong Kong, Mexico, the Netherlands, New Zealand, Poland, and Switzerland (in some countries holding periods apply). The high-tech boom of the 1990s spurred many countries to remove tax barriers to entrepreneurs and the financing of start-up companies. Fast-growing start-ups rely on private equity from “angel” investors, venture capitalists, and others who fund portfolios of higher risk companies. Their payoff comes from capital gains on the few winners that hit it big. Cutting the gains tax directly encourages more funding of the risk-taking firms that are the primary engines of economic growth.

High taxes on dividends also cause problems. Earnings paid out as dividends face both a 35 percent corporate tax rate plus an individual tax rate of up to 39 percent. That “double taxation” pushes up financing costs, causes an excessive reliance on debt, and provides an excuse for companies to limit dividend payouts. Indeed, the United States has the fourth highest corporate plus individual tax rate on distributed profits of the 30 countries comprising the Organization for Economic Cooperation and Development. At least two-thirds of OECD countries partially or fully relieve dividend double taxation. For example, after recent reforms Germany allows individuals a 50-percent exclusion on dividend income, and so should we.

Policymakers in this country must get over their knee-jerk resistance to corporate tax cuts, as well. After the tax law of 1986 cut the U.S. corporate rate from 46 percent to 34 percent, Congress fell asleep at the switch. But most other major nations cut rates substantially during the 1990s, while we raised our rate to 35 percent. The United States is now left with the fourth highest corporate tax rate in the OECD.

Corporate tax cuts could be a hard sell right now. So Bush should focus on cutting individual taxes on dividends and capital gains. He could also propose creating a new “Super Roth IRA” that would cut taxes on all types of savings. A Super Roth IRA would have high contribution limits and eliminate withdrawal restrictions. Withdrawal restrictions on current IRAs greatly reduce liquidity and discourage their use. Any family would be able to open a Super IRA and pour their funds into stocks, bonds, or simple bank deposits. That way, families could build large pools of savings to use for any contingency, and avoid the risk of dependence on company pension plans and Social Security.

The Bush team needs to communicate the many benefits of tax cuts on savings and investment to the public. It helps that capital ownership in this country is already very democratic, with about half of households currently owning stocks. But even countries with much less widespread share-ownership have awakened to new realities, and cut taxes on dividends, capital gains and corporate profits. America should be the world leader on tax reform, and tax cuts on savings can begin to make that happen.

Edward H. Crane is president and Chris Edwards is director of fiscal policy at the Cato Institute.