Tax-Cut Scorecard
It's not all Bush asked for, but it will add materially to economic growth.


David Malpass

President Bush met with House and Senate leaders on Monday and urged them to finish the tax cut this week. House Ways & Means and Senate Finance worked out the details and scoring on Tuesday. Final negotiations took place Wednesday with Vice President Cheney. The tax-cut bill should be signed into law by the president around Memorial Day.

So how does it stack up? The final bill is not all that Bush asked for, but it will add materially to economic growth and equity values. Its quick completion will also relieve one of the uncertainties in the economic outlook.

Important growth provisions include the acceleration of the already-scheduled income-tax cuts, a cut in the long-term capital gains tax rate to 15 percent, a cut in the dividend tax rate to 15 percent, and an expansion of the expensing of business-equipment purchases. The cuts in the income and dividend tax rates are retroactive to January 1, while the capital-gains tax cut is retroactive to May 6.

Unlike the president’s original proposal, the final deal reduces dividend taxes to 15 percent rather than zero percent and does not include the “deemed dividend” concept or basis step-up. As a result, it won’t be as beneficial to share values or the U.S. corporate capital structure as the president’s original proposal. However, the final deal, which includes an important cut in the capital-gains rate, will have a material, positive impact on both.

A rough estimate is that the tax cut will add at least $600 billion (or 5%) to U.S. equity market capitalization. This includes the effect of the capital-gains rate cut, the added after-tax value of current dividends, the likelihood of an increase in dividends, and some improvement in the capital structure.

Congress estimates the 10-year deficit cost at $350 billion, not counting any economic benefits from the tax cut. This includes $315 billion from tax cuts and $35 billion from increased outlays.

Two important factors in the ultimate value of the tax cut will be: when and how Congress clarifies whether tax rates will actually go back up at the end of the tax cut provision; and whether this tax cut is used as a step in broader tax or scoring reform.

At presstime, this is what the bill looked like:

Income tax rates will be cut for all brackets, effective January 1, 2003. The top marginal income-tax rate will be lowered to 35 percent from 38.6 percent. Withholding tables will be lowered on July 1. This will cause an increase in discretionary income beginning July in July plus bigger tax refunds (lower payments) in the first part of 2004. The bill also includes temporary relief from the marriage penalty.

The top dividend and long-term capital-gains tax rates will be cut to 15 percent for the 2003-2008 period (from 38.6 percent and 20 percent respectively). Lower-bracket taxpayers will pay a 5 percent rate for the 2003-2007 period and zero percent in 2008. The lower rates apply to dividends paid after 2002 and long-term gains realized after May 6. Dividends will have to be paid from current taxable income. The rate cuts will apply to foreign corporations. And there is no provision for deemed dividends or a stepped-up basis, which were in the president’s original proposal.

The bonus write-off for new-equipment purchases by larger firms will be increased to 50 percent from 30 percent through 2004.

Small-business expensing will be increased to $100,000 from $25,000 through 2005.

The child credit will be increased from $600 to $1,000 in 2003 and 2004. There will be a $400 tax refund check paid in August or September this year to most of the 25 million households who got the $600 credit in 2002. The $400 payment will reduce the $1,000 credit for 2003.

The final bill also includes $20 billion in additional state aid over the 2003-2004 period. But most of the tax increases in the Senate bill were removed, including the increase in taxation of U.S. workers abroad.

To be sure, deep flaws remain in the tax-wriitng process, which is driven by the scoring system rather than by clear steps that can lead to reasonable, growth-oriented tax law. Still, a needed tax-cut bill made it through.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.


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