How Would President Bush's Tax Plan Affect the Economy?
March 5, 2001
PARTIAL TRANSCRIPT
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Lawrence Lindsey, Assistant to the President for Economic Policy |
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Proceedings:
MR. LINDSEY: Thank you. It is great to be back.
Now, the real question is: Who got that great office? The right way to do it here at AEI was an auction, a proper market.
Thank you. It is a pleasure to be here to discuss the tax proposal. I understand that you had a very good discussion this morning. I wish I had the opportunity to hear your comments.
Let me begin by pointing out something that is unusual in Washington, and that is that the President sent up to the Hill exactly the same proposal that he laid out first in Des Moines, Iowa, December 1st, 1999. That is unusual in that intervening polls, focus groups, primaries, and the general election didn't change it.
The reason is that the President spent a lot of time looking over the options before he proposed it in the first place. A number of us here were part of that effort. We spent about 6 months going back and forth with then-Governor Bush looking at the various alternatives that he could propose, and our mission was quite straightforward. We were to identify the biggest problems in the Tax Code as they affect the economy and society and see what we could do about them given the revenue constraint, and that is why we settled on basically five changes and I would like to review them today.
The first problem we found was a very high effective marginal rate at the bottom end of the income tax. It turns out a single parent with two children making about $25,000 gets to keep half of any material progress he or she makes from that point on. That individual loses 21 cents in earned income credit. They have to pay a 15-percent Federal income tax. They also have to pay a FICA tax and a State income tax. So, having someone who is desperately trying to break into the middle class be told, "Sure, go ahead and try, but we are going to let you only keep half of any raise you get," has got to be a very demoralizing case. It has got to be bad for society and also bad for the economy.
We conservatives have always argued that high tax rates are disincentives. They are disincentives not only for well-to-do people, but for everyone, and the way the economy is going to advance, particularly given a fully employed situation, is for people to upgrade their skills and for people like that $25,000-a-year parent to get a 35- or $45,000-a-year job through upgrading skills.
So we thought this was a very important change to make. It turns out that there are a number of ways to do it. We settled on one that we thought provided the best benefit as far as getting that top rate down. It turned out to be expensive from a revenue point of view. It costs a little over $400 billion, but we thought it was an important change to make. That involves the combination of the child credit increase and the 10-percent bracket.
But in the process of doing so, 6 million American families--that is 20 percent of all families with children--are taken off the income tax.
The second change that we thought was important to make has to do with the marriage penalty. Again, this is an issue where there are many, many ways of tackling the marriage penalty issue. What we settled on was the approach taken in the early '80s in the Economic Recovery Tax Act which allowed a two-earner couple to lower their income, adjusted gross income, by 10 percent of the earnings of the lower-earning spouse.
This is, again, somewhat controversial, but we found that it was best correlated with how much marriage tax individuals actually pay. It has the added advantage of lowering the effective marginal tax rate for the most elastic labor suppliers in the country which are the lower-earning spouses in a two-spouse family. So, again, we thought it was a well-targeted approach to solving an economic problem caused by the Tax Code.
The third reform we made had to do with taxation of the unincorporated business sector. In 1990, the top rate on an unincorporated business was 28 percent. Today, it is about 44 percent, coming out of the profits of the entrepreneur, be it a partner, proprietor, Subchapter S corporation.
One can argue endlessly about the advantages and disadvantages of incorporation or not incorporating, but this was a very large shift in the taxation of the sector, still a very important sector for job creation, and because it comes right out of the cash flow of that business, I think it has probably adversely affected the growth of that sector, which as it turns out has grown significantly slower than GDP since the tax increase went up.
Now it is particularly important that that rate be reduced, I think, because the sector is facing a bit of a credit crunch, and there are many ways of getting around that problem. The most direct is to allow the entrepreneur to keep more of his or her income in the company, and so the President proposed setting a maximum Federal income tax rate of 33 percent. That will take down the tax rate on that individual by a little bit less than 7 points. The extra HI tax is still on, and that is what got the 44-percent rate to begin with.
The fourth change that we proposed had to do with the taxation of capital, and here, we examined a number of proposals, but I think the literature suggests that from a cost-benefit analysis point of view, the worst capital tax we have in place right now is the death tax. It is arbitrary. It is clearly an impediment to capital formation. It turns out, it is also unfair in a way we don't often think about in Washington.
What I discovered on the campaign trail was that this was always the biggest applause line before any group, getting rid of the death tax, and the reason was that people in general look at it this way. If you pay taxes when you earn the income, you pay taxes on the interest when you save it, for Government to come around when you die and take 55 percent of it away, a third bite at the apple, was simply one level of taxation too many.
To that, let me add a third reason, aside from the economic reason and the fairness reason, and that has to do with its effect on the rest of the Tax Code.
There is a lot of sentiment to simply raise the exemption amount, something we did in 1981. The problem with that is that the death tax, as we all recognize, is a tax that many, many individuals spend a lot of time, effort, and money at avoiding, and Congress has long recognized this. So we have had a race between the legal community and the tax collectors to try and create and plug various loopholes.
I will just tick off a few of the problems. We have as a result of the death tax, the gift tax. We also have the kiddie tax, the generation-skipping tax rules, and a good portion of the rules relating to insurance company taxation. If you dig more and more into the Tax Code, you will find that the reason for a lot of the complexity has to do with the death tax.
This is probably a Gordian knot that has to be cut. It is bad for an economy that had to import $400 billion in capital last year. It is unfair, and it is needlessly complicating the entire Tax Code.
The fifth change had to do with the tax treatment of charitable giving. At the present time, only about 30 percent of all taxpayers get a deduction when they make a charitable gift. The President, as you know, is a great believer in having Government partner with the non-profit sector to solve social problems.
Today, that 30 percent includes most of the donors, the American Enterprise Institute and other worthy institutions. Harvard University probably would be among them. Most of my vita probably reflects institutions for which most of the donors get a tax break
On the other hand, local churches and civic organizations, which may actually be providing the social good, be it after-school care, support for people who may be trying to break in addiction or may be out of prison, those people contribute to charities generally do not get a deduction. So we felt that we ought to level the playing field here and extend charitable deductibility to everybody.
So you will see there is a mix of economic and social objectives here, but in each case, I think what we did was to identify a major impediment to making one of those economic or social goals come true.
It is not to say that there aren't many, many, many other changes that can't be made in the Tax Code. There are plenty. Indeed, I would count myself among the supporters of fundamental tax reform, but it is unclear that you could get fundamental tax reform done quickly, and it is certainly clear that the single mom keeping half of any raise she gets shouldn't have to wait for Washington to get around to building the political consensus for fundamental tax reform.
Hence, the President believes that pushing these five changes through now and leaving other changes for later probably is a good idea.
Why am I optimistic that we will get other changes later? What I would stress is the very, very cautious nature of the two major economic assumptions in the CBO and OMB forecasts. The first has to do with the growth rate of the economy. The second has to do with the tax share of GDP.
The major driver of budgetary math is the real growth rate in the economy, and the reason is that there is a very good relationship in the Government's favor for economic growth and tax revenues. Basically, 1 percent more real growth generates about 1.4 percent more real tax revenue.
The assumption in the budget was that we would have 3 percent real growth for the rest of the decade. That is below historical averages. That is below the blue-chip consensus, and that is below what I think of as the Alan Greenspan speed limit which is more like 3.5 percent or perhaps higher.
If we were to grow at 3.5 percent instead of 3 percent, we are talking about 1.25- to $1.5 trillion extra in tax revenue over this period.
The second observation I would make has to do with the assumption about the tax share of GDP. Now, remember, if you have an elasticity of 1.4 and you assume real growth, which everyone does, the tax share of GDP should rise, other things equal, and yet, CBO and OMB both have the tax share of GDP declining over this period.
If you even assume it is going to stay even, which I think would probably be too cautious an assumption, you would again get another 1.25- to $1.5 trillion from that assumption. So you have in place conservative economic assumptions, cautious economic assumptions, which if more realistic assumptions come true means that you have the money there for roughly two more tax bills this decade on the order of the one that we are proposing.
That is even without touching the issue of dynamic scoring, which might very plausibly--both, I believe, Heritage and also Marty Feldstein at NBER suggest would reduce the net cost, revenue cost of the bill by about a third.
So there, we have what I believe is the prospect for further reductions, and, certainly, again, there are other changes that need to be made, but, again, the President as he did in his budget established priorities, felt that these were the most important changes he could make given the resources that were available, and they are changes that we hope Congress enacts quickly because they certainly merit it.
On that note, I would be very happy to take questions.
