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 inally
we have virtual unanimity on a program of fiscal stimulus to minimize
the impact of a business-led recession that was growing in intensity
prior to September 11th. Unfortunately, current proposals for either
tax cuts or spending increases are too small to have a real economic
effect other than offsetting the contractionary effects of the budget
surplus.
Many economists
see only one vector of the fiscal equation: that tax cuts provide
stimulus. As a result, any tax cut is considered stimulative. The
other side of the equation is that tax increases — i.e., budget
surpluses — produce economic contraction. Since we are running
a large budget surplus, all the talk about a fiscal stimulus package
is nonsense unless it produces a meaningful budget deficit through
higher government spending, lower taxes, or a combination of the
two.
As Larry Kudlow
recently
pointed out, we probably need a budget deficit of 1.5% of GDP
just to provide enough stimulus to generate an acceleration in economic
activity. Others suggest up to 5% of GDP should be expended on growing
the economy given the prior contractionary effects of the budget
surplus. As of the second quarter of 2001, the gross domestic product
was $10.2 trillion.
Supply-siders
come down on the side of tax cuts or, to be more specific, tax rate
cuts to stimulate the economy. By lowering marginal tax rates, individuals
will tend to be more productive — i.e., increase their work
output — if the after-tax rewards are higher. One measure of
the effect of this incentive, when assessing the potential impact
of tax rate cuts, is a concept known as the retention rate, which
is the percentage of income that is retained after a tax rate reduction.
For example, President Kennedy cut the maximum marginal personal
income tax rate from 92% to 70%, a reduction of 22 percentage points.
However, the retention rate went from 8% of income to 30% of income,
an increase of 275%! In other words, for every eight dollars you
earned after tax, you now had thirty dollars!
On the flip
side, as tax rates fall, the retention rate shrinks in importance.
For example, a cut in the capital-gains tax rate from 20% to 15%
reduces the tax rate by 5 percentage points but only increases the
retention rate from 80% to 85%, an increase in after-tax return
of only 6.25% — hardly worthy of generating a major investment
in the stock market based on the incremental future value of equities.
Therefore, one key to a meaningful incentive-oriented tax rate reduction
proposal is the magnitude of the retention rate.
Congress,
the president, and their tax advisors are mulling over the whole
constellation of taxes to come up with the right mix to encourage
economic activity. There are numerous alternative proposals that
would have a different economic impact. For example, tax rebates
have little incentive effect to increase output since money is being
transferred from one economic entity to another. The idea that one
economic group has a higher propensity to spend than another is
the basis for this type of change in the tax law, but there is little
evidence to support this assumption.
A bipartisan
brew of various proposals may very well have an offsetting effect,
or merely satisfy a few select constituencies. We cannot afford
an experiment in fiscal policy that fails to lift us out of the
current recession. Now is the time to act boldly and choose an alternative
that will give the U.S. economy a fiscal-policy initiative that
can turn the recession tide. The elimination of the corporate income
tax provides a unique mix of incentives to get the economy growing
again.
Taking
Care of Business
We are in a business recession. Consumers, upbeat until September
11, were making a major contribution to economic growth. The reason
for their sustained spending spree was relatively simple: they were
benefiting from many of the challenges that plagued business.
In hindsight
it is obvious that the technology sector was too successful: it
created too much product and there was too much innovation and competition.
The greatest enemy of technology was technology. Corporate profits
in this sector suffered because of lower prices — a direct
benefit to consumers who were buying PCs and cell phones at ever-lower
prices with newfound avenues of credit.
A meaningful
change in the tax laws should then be targeted toward business.
Suggestions to chop 3-5% off the corporate tax rate or raise depreciation
allowances are too puny to have the needed effect. A bold approach
would be to eliminate the corporate tax rate altogether.
The absence
of a corporate tax rate means reporting profits becomes more attractive.
As many companies pay taxes at the 35% rate, that tax “wedge” discouraged
the reporting of pre-tax income. By reducing that tax wedge to zero,
reported earnings would skyrocket for companies making a profit.
Obviously in a competitive environment, this increase in income
would produce different responses in the marketplace. By essentially
lowering the marginal corporate tax rate from 35% to zero, the retention
rate increases by 54%!
Corporations
don’t pay taxes, individuals do. When taxes are imposed, either
the corporation raises prices and passes the tax on to consumers
or, if it cannot do that, the shareholder bears the burden as the
stock price falls as earnings fall. By eliminating the corporate
income tax, corporations have the option of either passing the tax
savings along to consumers by lowering prices or by keeping prices
the same and experiencing higher earnings and higher stock prices.
Opponents of such a bold move argue that such a tax reduction is
a gift to the corporation and unnecessary. On the contrary, eliminating
corporate taxes provides a potential benefit to the consumer through
lower prices, to the corporation through lower expenses and higher
profits, and to shareholders — the economy — through higher
stock prices. (Don’t forget the cost savings to the government as
the people who monitor tax compliance are eliminated. Perhaps they
could become sky marshals.)
No corporate
income taxes would trigger a pronounced increase in corporate productivity.
Corporations must spend enormous sums on keeping records for tax-reporting
purposes. Many more hire tax lawyers and accountants — at great
cost — to come up with unique ways of avoiding the payment
of taxes. These expenses are a drag on corporate profitability but
most of these expenses would go away if corporate income taxes were
eliminated. By removing these expenses there would be a dramatic
increase in corporate income — for all corporations that have
earnings. Also, efficiency will improve because the cost of waste
goes up. The idea that you shouldn’t worry about a particular expenditure
being justified because it can be written off also becomes subject
to additional scrutiny because such decisions suddenly become much
more expensive.
According
to the Bureau of Economic Analysis, corporate income tax liability
was $271 billion in 2000. For 2001, the tax liability should be
lower. Can we afford eliminating the corporate income tax? From
1983 through 1996, the U.S. budget deficit exceeded $130 billion
per year with a peak deficit of $298 billion in 1992. Those deficits
neither impaired economic growth nor drove interest rates higher.
In fact, interest rates fell during that period.
So, to all
the opponents of a bold fiscal stimulus package, recent history
demonstrates that a return to substantial budget deficits will not
have a negative effect on interest rates and will contribute to
a major economic recovery.
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