Congress has voted to provide $1.35 trillion of tax relief. But the battle continues as lawmakers jockey to fit favored tax cuts into the final bill due for passage this week. Moderate lawmakers want to dilute the tax rate cuts at the heart of President Bush’s tax proposal. These efforts should be resisted because rate cuts can reduce the economic waste created by federal income taxes.
That waste is created by high tax rates distorting market wage, price and profit signals, with the result that work, savings, investment and entrepreneurial efforts are reduced. Marginal tax-rate cuts reduce these distortions so that every dollar used to lower rates will generate gains to the economy worth more than a dollar. If, for example, a skilled doctor takes more patients in response to reduced tax rates, the economy benefits beyond simply the extra cash in the doctor’s wallet from the tax cut.
How much does the economy stand to gain from a $1.35 trillion tax cut directed primarily at reducing marginal tax rates? Harvard’s Martin Feldstein found that the president’s proposal would create economic gains of about 38 percent of the value of the tax cut itself. That means that families and businesses would be $500 billion better off from the tax cut, in addition to enjoying the $1.35 trillion more of their earnings they got to keep.
Such large savings are not out of line with other estimates. For example, the Congressional Budget Office recently noted that economic losses caused by taxes range from about 20 percent to 60 percent of the cost of every additional tax dollar. Therefore, every dollar of the budget surplus given back in tax cuts benefits the private sector by between $1.20 and $1.60.
The Bush proposal focuses on reducing the highest income tax rates paid by top earners. This is important because the efficiency losses caused by taxes are much higher in the highest rate brackets. High-income taxpayers respond strongly to high tax rates by increasing unproductive activities such as tax avoidance, and reducing their productive labor and entrepreneurial efforts. And many in the top tax brackets are entrepreneurs: Over one-quarter of those with incomes over $200,000 are sole proprietors. Research has found that sole proprietors substantially increased their investment and hiring activities following the tax rate reductions enacted in 1986.
Lower tax rates both increase the cash flow available for small business investment and increase after-tax returns to make marginal investments more worthwhile. With high marginal rates many projects are not funded because the government places a tax wedge between what the market says is a good investment and what entrepreneurs get to keep. In the pre-income tax world, entrepreneurs such as the Wright Brothers could invest all of their net earnings in risky new endeavors. But the Wrights may not have had the extra few thousand dollars of cash flow from their Ohio bicycle shop, or the marginal profit incentive, to fund their flying experiments at Kitty Hawk if they had lived in today’s high-tax climate.
Today, more countries are realizing that lower marginal tax rates are crucial to generating their own 21st century versions of the Wright Brothers. The average top personal income tax rate in the G-7 major economies has fallen 18 percentage points since 1980. Most recently, Germany and Canada have cut income tax rates, and Mexico’s president Vicente Fox has proposed reducing that country’s top personal income tax rate from 40 percent to 32 percent. Treasury Secretary Paul O’Neill recently noted that we must examine everything we do in the tax code that adds excessive cost without creating value, and then reform it. We should start with our wastefully high marginal personal income tax rates.