The misdirected tax debate and the small business stock exclusion

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President Obama signs the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, providing tax cuts and unemployment insurance extensions on Dec. 17, 2010.

Article Highlights

  • Supporters of marginal #tax rate reduction have ignored its real advantages and instead advanced invalid arguments

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  • In the current debate, the focus on small business has played a pernicious role #taxes

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  • In its current form, section 1202 is a prime example of distortionary and complex #tax policy

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For a complete listing of all On the Margin articles, please visit: www.aei.org/onthemargin/.

Intense debate continues over the appropriatelevel of marginal income tax rates, particularly aspolicymakers consider whether to extend part or allof the 2001 and 2003 tax cuts, which are currentlyscheduled to expire at the end of 2012. Unfortunately,much of this debate has been misdirected.Many supporters of marginal tax rate reductionhave ignored its real advantages and instead advancedinvalid arguments. Their strategy underminesthe effort to lower marginal tax rates, and itpromotes the spread of other, less desirable, formsof tax reduction.

The real economic case for marginal rate reductionis that it alleviates the work, saving, andinvestment disincentives associated with incometaxation. Rate reduction allows a greater range ofmutually beneficial transactions involving work,saving, and investment to occur throughout theeconomy. Of course, the feasible and desirablescope of marginal tax rate reduction depends onbudgetary and distributional concerns, which areimportant issues in light of the ongoing increase inMedicare, Medicaid, and Social Security spendingand the rise in inequality during the last fewdecades. 

A key advantage of marginal rate reduction isthat it does not single out particular sectors of theeconomy for favorable tax treatment over othersectors. Yet, supporters of rate reduction often advocateit on the ground that it helps particularsectors. The use of those arguments undermines thecase for rate reduction. It also creates a politicalopening for policies that are more directly targetedto help the particular sectors, even though thosepolicies are likely to be economically inferior tomarginal rate reduction. Targeting particular sectorsfor tax relief tilts the economic playing field andmisallocates economic resources, unless the targetedsector is initially taxed more heavily thanothers, in which case the targeting actually helpslevel the playing field. Targeted policies also tend tocreate complexity. 

Viard: The misdirected tax debate and the small business stock exclusion

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Alan D.
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