If I had to guess, I’d say President Bush’s tax-cut proposals have a pretty good chance of becoming law. But two widespread assumptions about how to evaluate tax cuts are working against them.
The first is that the purpose of a tax cut is to put money in people’s pockets. They will then spend the money on consumption, boosting the economy out of recession (or at least improving the economy). If that’s the goal, Bush’s tax cuts look poorly designed. His plan has two main components: reductions in income-tax rates that are currently scheduled for 2004 and 2006 would instead be apply to this year’s income; and dividends would no longer be taxed at the individual level.
So, critics say, people won’t get the extra money until next year, when they pay their taxes (which isn’t quite true, since withholding would go down, but leave that aside). Then they’ll keep getting money in subsequent years, when the economy might be doing just fine without the tax cuts. Moreover, the people getting the money won’t be the ones most inclined to spend it. All of these points have been emphasized by the opposition.
The plan looks different if you assume that its purpose is to raise long-term growth rates by improving incentives to work, save, invest, and allocate resources efficiently. If that’s the case, the plan doesn’t start providing “stimulus” only when taxpayers get the money next year. The stimulus arrives as soon as people know they’ll be keeping more of what they earn. The fact that the tax cuts are permanent becomes more comprehensible, too. The Democratic posture — complaining that Bush’s tax cuts aren’t quick enough while seeking to delay reductions in tax rates until 2004 and 2006 — begins to look perverse. And the “size” of Bush’s tax cut, measured in terms of how much it would cause federal revenue to fall, is almost irrelevant. (Which is good, since nobody really knows what the answer is.)
The second assumption is that the people who will benefit when a particular tax rate is reduced are the people who have paid that tax rate in the past. Conservatives often make this point. They note that the people who benefit from a reduction in the top income-tax rates will not only be those who pay those rates now, but those who will be in the affected income categories tomorrow (as well as others indirectly benefited through higher economic growth).
This point seems especially worth stressing when it comes to Bush’s proposal to end the taxation of dividends at the individual level. The critics note that most Americans who own stocks do so through 401(k) plans and the like, which are already free from dividend taxes. They will thus, supposedly, not benefit from Bush’s plan. The smaller number of people who do pay taxes on dividends tend to be rich.
Many people who hold 401(k)s will, in fact, benefit if the stocks held there appreciate in value thanks to the dividend tax cut. Just as important is that the number of people who hold dividend-paying stocks directly will increase, as will the share of their income made up by dividends. The dividend tax cut works by inducing companies to pay out more dividends, remember? Dividend-paying stocks will become more attractive to anyone who can invest, which is not a tiny number. I’d bet that if Bush’s plan passes, in a few years the income profile of dividend collectors will change markedly. Once that happens, it will be politically impossible to bring the dividend tax back.