Tax Cuts and the Economy

One web user recently wrote to ask about President Bush's proposed tax cuts and their effects on the economy.  The following is Mackinac Center for Public Policy President Lawrence Reed's reply.

How will President Bush's tax cuts help the economy, if they help at all? Aren't they targeted only to the rich? Won't rich people stop giving to charities if the estate tax--with its charitable deductions--is repealed?

Let me answer each of these questions in a slightly different order.

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First, the estate tax. The implication that to encourage philanthropy we need an estate tax to, in effect, tax the same income a second or even a third time, is quite suspect given recent experience of substantial increases in charitable giving even as tax rates fell. Charitable giving is far higher today, in real terms, than it was when the top rate was above 90 percent (from which President Kennedy cut it to 70 percent). It continued to rise when President Reagan cut the top rate to 50 percent and then exploded when Reagan cut it again to 28 percent. If the theory that tax deductions were necessary to boost charitable giving was correct, then as tax rates fall, we would expect charitable giving also to fall because a 28 percent write-off isn't as valuable as, say, a 50 or 70 or 90 percent write-off.

The lesson there is that charitable giving is much more a function of the health of the economy (as well as the general health of the charitable impulse) than it is a function of tax rates. I believe the evidence of the healthy effect of marginal tax rate cuts is overwhelming and that as much as anything, they explain the last 19 years of an almost uninterrupted economic expansion. Hence, tax cuts are a more prudent policy than early debt retirement because the debt burden can conceivably fall faster (as a percentage of national income) if the economy grows faster, and tax cuts are more growth-inducing that early debt retirement.

However, President Bush's tax cuts are being largely misadvertised as an economic stimulus. In their original form, they are so back-loaded as to be nearly useless in the near-term, which once again means that fiscal policy is behaving true to form--namely, a day late and a dollar short. They will have some stimulative effect in time, though not as much as some are saying and certainly not soon enough to make a difference at the moment.

Incidentally, the primary economic stimulus that comes from a tax cut is not on the spending or consumption side. The primary stimulus comes from the incentive effects with regard to work, thrift, and investment. When you get a tax cut, you can do a number of things with it. The economy gets far less of a boost from what you spend of it than it gets from what you save of it (and thereby make available in the form of capital for loans for things like homes and business expansion), or from what you directly invest of it. In other words, we all, in the long term, could easily benefit more from a hundred dollars that one man invests than from a thousand dollars that another man may spend. If that's not the case, then we can discard several hundred years of economic knowledge about how an economy grows and how a people become wealthier.

Now, are Bush's tax cuts targeted more to the wealthy? On a percentage-of-income basis or on a portion-of-the-tax-burden basis, they are not. They are actually weighted, in those terms, more in favor of the lower-income brackets. The 15-percent bracket is to be lowered by a greater degree than is the 39-percent bracket.

If one looks only at the actual dollar amounts, however, then yes, it looks like "the rich" make out better. But if we consider that the rich are far fewer in total number than are the nonrich and that they are paying a disproportionate share of the tax burden to begin with, then the Bush tax cuts do not appear to be overly weighted to them.

"Tax breaks for the rich" is essentially the same class-warfare argument that was raised in the 1920s (actually, any and every time anybody wants to cut tax rates for people earning more than a modest sum). Andrew Mellon, the Treasury secretary then, wanted to cut the bottom rate from 4 percent to one-half of one percent--an eightfold reduction. He wanted to cut the top rate from 73 percent to 24 percent--approximately a threefold reduction. Yet his plan was assailed as "a gift to the rich" as if the government has some inherent or divine right to 73 percent of the income someone else has earned and which the government shared none of the personal risk to produce.

Here's one way, perhaps the only way, to appease the soak-the-rich crowd: Have a tax cut stated in dollar terms. Example: Cut everybody's taxes by exactly $1,000. If you make $30,000 (and pay at least $1,000 in taxes), you get a $1,000 tax cut. If you make $3,000,000, you get a $1,000 tax cut. Maybe then the class-warfare folks would start talking in percentage terms and would favor this approach because a $1,000 cut from a $30,000 income is a far higher percentage tax cut for the lower-income bracket than is a $1,000 cut from a $3,000,000 income.

Lawrence W. Reed
Mackinac Center for Public Policy

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