| It is now clear from the way the Bush administration has handled
the build-up to war against Iraq that it is following a long-term political
strategy. It is perfectly willing to endure months of criticism for lack of
decisiveness and even allow members of its Cabinet appear to argue in
public, all toward the end of achieving its ultimate goal.
I suspect that something similar is underway with regard to tax
policy. President Bush started his effort with a plan for cutting marginal
tax rates. He was criticized by people, such as myself, for not doing more,
faster. The phase-in of the rate reductions enacted last year are indeed too
slow for maximum economic impact. However, given political realities, I
concede that it may have been impossible to do more under the circumstances.
Nevertheless, the rate reductions do move us in the right
direction, however slowly. The question is, the right direction toward what?
Economic theory is quite clear that high marginal tax rates are
bad for economic growth. People make all kinds of important decisions about
investments, life styles and careers based on tax considerations. The most
obvious is the choice of whether to rent or buy a home. Clearly, the
deductibility of interest and the tax exemption for capital gains on a
primary residence (up to $500,000 every two years for a couple) is a major
motivation to buy, rather than rent.
But people make many other important decisions about their lives
based on taxes, as well, even if they are not fully aware of them. For
example, people must decide whether to buy taxable bonds or tax-free
municipal bonds, buy stocks more likely to appreciate in value and be taxed
at lower capital gains rates or those with high dividends that are taxed as
ordinary income, and to develop careers as wage employees or as
self-employed entrepreneurs. Such decisions are all based to a large extent
on tax considerations.
Ideally, decisions about whether to work for oneself or another,
to save or consume, to invest in one form or another should not be related
to taxes at all. People make such decisions based on their own judgments
about what skills they possess, how much risk they are willing to bear,
their age and family status, and other factors. Taxes ought not to be one of
them.
In theory, we should strive for what economists call tax
neutrality. Perfect neutrality cannot be achieved as long as there are
taxes. But there are greater and lesser degrees of it. Right now, we have a
tax system that is very far from neutrality. Taxes bias investment and work
decisions in ways that hurt economic growth. That is, we could raise the
same amount of revenue in different ways and increase economic growth in the
process.
Most economists would say that a low single tax rate on
consumption is probably best for growth. A rate of around 20 percent would
be enough to fund all of what the federal government pays for from the
corporate and individual income taxes. For years, tax reformers have pushed
for a flat rate tax system that would achieve this goal. However, getting
from here to there without excessively hurting those who made investment and
career decisions based on the current system has proven impossible.
The prospect of throwing out the current tax system altogether
and replacing it with something entirely new frightens even those who would
pay less under the new regime. The solution, therefore, is to move
incrementally toward a new system. That, I think, is the Bush administration
strategy.
We have already seen two major moves in this direction. Marginal
tax rates were cut last year, and earlier this year businesses were given a
30 percent "bonus" on depreciation for new investments in machinery and
equipment. Since, in theory, firms should be allowed an immediate deduction
for such investments, the effect is to move in the direction of fundamental
tax reform.
The next step is to liberalize incentives for saving and
investment. Elimination of taxes on these would give us a de facto
consumption tax, as Edward McCaffery explains in his new book, "Fair Not
Flat." Therefore, reducing taxes on saving, dividends and capital gains, as
President Bush wants, can be seen as further steps toward fundamental tax
reform.
Although the Bush administration sometimes appears to be
fumbling around with tax policy, there may be a strategy at work. Just as it
has done with Iraq, the administration may be laying a foundation upon which
it will build a justification for action at a later date. It is too soon to
say when the end games will emerge, either on Iraq or tax reform, but at
least it appears that we are moving in the right direction.
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