Where's the Growth?

The U.S. Senate overwhelmingly passed a measure endorsing the permanent extension of some of President George W. Bush's tax cuts last month. Finance Committee chair Max Baucus, D-Mont., led the charge, proclaiming that the American public deserves tax cuts and hailing "tax relief for hard-working American families" as "the right thing to do." Has a bipartisan consensus for pro-growth tax policy suddenly emerged in the Senate?

Far from it. The Senate endorsed extending precisely those parts of the Bush tax-cut package that hamper economic growth. And it rejected extending the parts designed to promote growth.

If the growth provisions fall by the wayside, a big part of the blame will rest with the way the Bush administration designed and marketed the tax cuts in 2001. The administration largely abandoned the economic-growth vision that President Ronald Reagan used to push through the 1981 tax cuts. Instead, it primarily promoted tax cuts as social relief, a way to give money to middle-class families, moderate-wage workers and other deserving groups. The social-relief focus may have helped get the tax cuts through Congress. But if that strategy sowed the wind, the economy is likely to reap the whirlwind.

Sound growth policy would have had two key features. First, it would have emphasized tax reforms or tax cuts that lowered the marginal tax burden on work and saving, the extra tax triggered by working another hour or saving another dollar. It's those reductions that provide economic incentives. Second, to avoid passing the buck to future generations and setting the stage for future tax hikes, any tax reforms would have been revenue-neutral, and any tax cuts would have been matched with spending cuts.

Some of the administration's tax cuts did lower marginal tax burdens on work and saving. The four highest marginal tax rates were cut, and the estate tax was slated for eventual repeal. But the administration also loaded the package with social-relief provisions. The child credit was doubled to $1,000; the tax rate on the first $12,000 of income was lowered to 10% from 15%; and special tax cuts were given to married couples. A few social-relief provisions may have promoted sensible policy goals. In the end, though, social relief accounted for half of the cost of the package.

These provisions sucked much of the economic benefit out of the package, swelling the deficit without boosting incentives. An extra $500 per child may be an incentive to have another kid, but not to work or save. A lower rate on the first $12,000 of income does nothing to improve incentives for workers above that level. Not surprisingly, an analysis by President Bush's own Treasury Department last summer confirmed that these provisions detract from long-run economic growth.

The fatal misstep, though, came in marketing the tax cut. The growth effects were mostly ignored, except for some talk about small business. The key selling point became the $1,600 tax savings for an average family with two kids, all of which came from the child credit and the 10% rate. As the president told Congress, "$1,600 buys gas for two cars for an entire year; it pays tuition for a year at a community college; it pays the average family grocery bill for three months. That's real money."

That's a far cry from the tack Reagan took 25 years earlier. He called for "a tax program that provides incentives to increase productivity for both workers and industry" and presented a plan made up mostly of marginal rate cuts and investment incentives.

The administration's social-relief rhetoric, along with its distaste for spending cuts, hasn't changed much over the last six years. The Senate took its cue from the administration's language. It endorsed extending the $1,600 provisions--the child credit and the 10% bracket--along with a bundle of other social-relief provisions. (The measure did call for some estate-tax reductions for smaller estates.) Two days later, the Senate rejected, largely along party lines, a measure calling for the extension of the marginal rate cuts.

The votes were nonbinding--actual decisions won't be made until closer to 2010, when the tax cuts are scheduled to expire. But the groundwork has been laid for the worst possible outcome: an extension of the social-relief provisions that leaves the growth provisions behind.

It's not too late to get policy back on track. Republicans should insist that any tax-cut extension include the marginal rate reductions and be accompanied by spending cuts. They should also put fundamental tax reform on the table. Most important, they need to change the way they talk about tax cuts, abandoning the social-relief vision and returning to Reagan's vision of economic growth.

Alan D. Viard is a resident scholar at AEI.

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