Politics & Policy

Looking Up, Down The Road

It's not a bad tax cut, if you can wait till 2006.

Assuming we all live to see the year 2006, the Bush tax-cut bill actually turns out to be stronger than expected in terms of new incentives for capital formation and economic growth.

#ad#Thousands of economists are out there pushing pencils to figure out how the estimated $1.3 trillion some-odd static-revenue flows will impact the economy this year and over the next five years. But this is an exercise in futility that completely misses the point.

The point is that incentives matter. It must pay to work, produce, and invest, after-tax. At the margin, the Bush plan provides for higher after-tax rewards for productive economic activity. Tax rates are lowered for personal incomes, savings, marriage, and inheritance wealth.

At the center of this growth-inducing tax cut plan is a reduction in the top marginal tax-rate on personal income. Surprisingly, the House-Senate conference took the top rate back to 35% from the 36% rate passed by the Senate.

Even more, the final bill repeals the phase-out of personal exemptions and itemized deductions for upper-income taxpayers, which effectively reduces the top rate to 33%. That means that taxpayers (and unincorporated small businesses) will keep 67 cents of each extra dollar earned, rather than the 60-cent take-home rate at today’s 40% top bracket.

The new take-home rate is therefore nearly 12% better than the old retention rate. This is the new incentive effect. In particular, since top bracket taxpayers have the highest saving rates, Bush’s supply-side tax cut increases the rate of return on capital investment.

As a result, the trend rate for U.S. economic growth will increase to 3.9% annually during the second half of this decade from 3.5% presently (multiply 3.5 times the 1.117 incentive). Walking through this dynamic economic growth process, the increased supply of capital will foster greater innovation, risk-taking, productivity, profits and job creation.

What’s more, faster economic growth and more profitable productivity returns will generate higher tax revenues at the new lower tax-rate levels. Future budget surpluses will rise, not fall, paving the way for new tax reform and simplification opportunities.

There are other pro-growth elements to the new tax plan. Estate tax-rates are reduced and deduction thresholds increased. Super-saver IRA and 401(k) limits are increased. The 15% bracket is expanded to ease the marriage penalty.

It’s hard to anticipate the likely delaying impact of taking five years to fully phase-in the income tax relief, or the even longer waiting period for estate-tax relief. This is the unfortunate part of the plan, which was necessitated by Congressional budget rules held hostage to a static model that insists that all tax cuts lose money for the government.

One way around this problem would be a capital gains tax-cut later this year that would provide a boost to animal spirits that are still hung over from last year’s stock-market slide. Perhaps cap-gains relief could be tied to a minimum-wage bill. Judging from prior cap-gains votes, there are at least six Senate Democrats who would join with forty-eight Republicans to pass cap-gains.

The Bush tax cut, welcome as it is, remains a much more modest affair than the two Reagan initiatives of the 1980s, which lowered the top personal tax-rate from 70% to 50%, and then to 28%. All in, the Reagan tax-rate reductions bolstered economic incentives by 140%.

However, the Bush program is the first reduction in marginal income-tax rates in 15 years. That’s a long time between haircuts, and it’s a much-needed trim.

Most important, the Bush plan is a crucial first step toward returning to the principle of supply-side tax policy that focuses on marginal tax-rate relief. As the incentive effects gradually kick in over the years ahead, economic growth will increase and inflation will decline. The dollar exchange rate will appreciate. Stock markets will recover.

The president’s steadfast support of lower tax-rates was finally rewarded with 28 House Democrats and 12 Senate Democrats voting aye. Proving all the critics wrong, the president showed that his plan makes good economic and political sense.

As in all sausage-making processes that become large tax bills, this one has its flaws. Too many people are rewarded with refunds for not working. The implementation period is too long. The tax-rate structure is still too high and too progressive.

But given the political realities, this is a good first step. The world has become a bit safer for rich people and for those non-rich who through innovative ideas and hard work will get to keep more of what they earn in order to become rich. Make that a large first step — for free enterprise that will make the economic pie that much bigger.

Larry Kudlow — Larry Kudlow is CNBC’s senior contributor. His new book is JFK and the Reagan Revolution: A Secret History of American Prosperity, written with Brian Domitrovic.

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