In 2001 and 2003, under the administration of George W. Bush, Congress passed significant tax reductions. These will expire on December 31, if Congress does nothing. Instead, Congress should seize the opportunity to show economic leadership, by extending the cuts and cutting federal spending.
The current debate in Washington centers around the extension of some or all of these cuts, to avoid foisting an implicit tax hike on a weak economy. Generally speaking, President Obama and the more liberal Democrats in Congress want to extend the cuts only for middle-class workers. Centrist Democrats and Republicans want to extend the tax cuts for everyone.
The convoluted IRS code makes it difficult to summarize the exact impact of the expiring tax cuts on a particular household. The impact would vary based on whether someone is married, has children, and so forth. In terms of affecting economic growth, however, the verdict is clear: the most important incentives are those involving tax rates on the most productive citizens.
For example, if Congress fails to act, in January the top federal personal income tax rate will increase from 35 percent to 39.6 percent. The federal tax on dividends will more than double, jumping from 15 percent all the way to 39.6 percent. Many analysts consider these increases to be modest, and with little effect on economic activity, but consider how they change the marginal incentives facing shareholders.
Right now, suppose a corporation in California earns $10,000 in pre-tax profits. Right off the top, the state of California will take 8.84 percent through its corporate income tax. After allowing for a deduction of the state tax, suppose the federal government takes an additional 35 percent in corporate income tax (the precise rate varying in a complicated way based on the tax bracket).
This leaves $5,925 available for distribution as a dividend to the shareholder, currently taxed at 15 percent at the federal level and up to 10.55 percent in California for a wealthy individual. When all is said and done, the original $10,000 in pre-tax corporate profits raises the California shareholder’s after-tax income by about $4,500.
Consider the same calculation, this time replacing the 15 percent federal tax on dividends with the more punitive 39.6 percent rate. That whittles down the original $10,000 in corporate earnings to only $3,200 that actually ends up in the shareholder’s pocket, a 29 percent reduction in the after-tax yield to the shareholder compared to the status quo.
To people who have never run their own businesses, this change in incentives seems trivial, especially when it falls on “the super rich.” But corporations don’t earn their profits automatically. It takes vision and risk to invest money hoping for a return. If Congress lets the tax cuts expire, the relative reward from successful innovation will be greatly diminished for some of the nation’s most productive individuals. If the goal is to boost job creation, this is not a wise policy.
It is ironic to listen to the pundits excoriate Bush’s “tax giveaways to the rich” as having no beneficial economic impact, when very often these same pundits praise Barack Obama’s stimulus package for “avoiding another Depression.” Of course, we will never know what would have happened in an alternate universe where Bush didn’t cut taxes, and where Obama didn’t approve a stimulus package.
We do know that our current economic recovery is far more sluggish than our previous one. That is not in dispute. It is true that President Obama inherited a financial crisis, but Bush had to deal with the collapsing dot-com bubble and the terrorist attacks on 9/11.
In macroeconomics, we can’t run controlled laboratory experiments, so it’s impossible to isolate the impacts of particular policy changes. Economic theory, however, teaches that raising tax rates, especially on the top earners, lowers the incentives for growth. And economic history teaches that massive tax hikes and deficit spending go hand in hand with stagnation.
Congress should learn the lesson and show leadership. To revive the economy, they should renew the tax cuts while slashing government spending to rein in the massive deficits.
Robert P. Murphy earned a PhD in economics from New York University and is a senior fellow in Business and Economic Studies at the California-based Pacific Research Institute. He is the co-author with Jason Clemens of Taxifornia, available on PRI’s website. Contact him at