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Senate Sense
This contorted tax cut is still good policy.


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Watching the U.S. Senate wrangle a $726 billion tax cut into a $350 billion slot has been an interesting spectacle. In Congress, the budget rules are always stacked against tax cuts, and contortions are the only way to make them work. The first Bush tax cut in 2001 was scaled back and phased-in so that it could fit within the limits, and now the new Bush proposal is going through the same twists and turns.

Pay-as-you-go (PAYGO) budget rules, static scoring, reconciliation, and senators worried about deficits, are just a few of the things that can knock a tax cut off balance. Senator Don Nickles didn’t let these things stand in his way, however, and last week the Senate voted to pass his amendment to end the double taxation of dividends — the centerpiece of the Bush tax-cut plan.

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His amendment allows dividend earners to exclude 50 percent of dividends in 2003 and then boosts the exclusion to 100 percent between 2004 and 2006. The static budget rules forced the Senate to phase-out this tax cut, and in 2007 the double taxation of dividends returns. While some call this “fraud,” nothing could be further from the truth.

The budget rules force these contortions, not some kind of sneaky political sleight-of-hand. The entirety of budget rules are designed to make it difficult to pass tax cuts, but easy to increase spending. Nonetheless, if the Senate version prevails in conference, the U.S. economy will benefit tremendously.

The game is obviously not over. The House passed its own version of an investor tax cut which would cut both the capital gains and dividend tax rate to 15 percent. This bill would sunset in 2012. As a result, there are still two versions of the tax cut in play. But because a very popular President Bush is helping to hold up the Senate plan, it is beginning to look like a winner.

This does not mean all is well. Many are arguing against the Senate plan for some very good reasons. One of the most important is that a temporary tax cut will not change the behavior of corporations and will not benefit the stock market or the economy. Let’s think about that in another context.

If in the middle of a baseball game, the umpires decide that during the next three innings of play, each homerun would count as three runs. Coaches and players would immediately change their strategy and swing for the fences. They would do this even though they knew the rule only lasted for a short time.

By ending the double taxation of dividends — even if only for two or three years — American corporations will change their behavior radically because shareholders will demand it. The Senate version does not have the complications of the president’s original plan and would allow cash-hoarding companies, like Microsoft, to pay dividends from past earnings. In fact, it would encourage the payment of dividends because retained earnings could not be used to step up the basis (cost) of investor holdings.

With dividends flowing more freely, stock prices will rise and support for retaining the new tax policy will build. My bet is that most people will treat the new law as permanent from the beginning, because supporting a return to the double taxation of dividends would be political suicide for members of Congress.

That being said, the House plan is not a bad second choice and would also lead to higher stock prices, a stronger economy, and more jobs. But the Senate’s plan, even in its current contorted form, would do more in the long run for the economy and tax policy.

There are two reasons for this. First, the Reagan tax cuts of the early 1980s had a major flaw. By cutting capital-gains tax rates well below those on personal income, the Reagan tax cuts encouraged more corporate debt, the hording of cash, and stock options. This, in turn, created an environment ripe for corporate shenanigans. By removing the double tax on dividends, these tax-induced pressures will be relieved, debt financing will be discouraged, and the cost of capital will fall.

Second, the debate over ending the double taxation of dividends has started a national discussion on the fairness of the U.S. tax code. The more this discussion flourishes, the closer we will get to wholesale tax reform. Lower tax rates are good for the economy, but a simpler tax code would be a windfall for long-term growth. Dividend tax reform is just a first step toward ending the unfairness of the U.S. tax code in many areas.

The end of the double taxation of dividends is a battle worth fighting and the Bush administration understands this better than some of its conservative critics. While we wish no tax cut proposal had to be contorted to fit into the existing budget rules, the Senate’s version of the Bush tax plan will have the most long-term impact. If it passes, we can all start swinging for the fences.

— Brian Wesbury is chief economist for Griffin, Kubik, Stephens & Thompson, Inc., and is the former chief economist of the Joint Economic Committee of the U.S. Congress.



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