As the battle lines are being drawn over the value of President Bush’s proposed tax reform, it is becoming clear that the basis for disagreement rests on who gets the tax cut rather than what effect the tax cuts will have.
The Republicans have opted to sponsor a tax program that is designed to promote economic growth by offering broad tax incentives to both business and consumers — especially investors — as the means to inject real fiscal stimulus into a slow growing economy. On the other hand, the Democrats have staked out their opposition to the president’s plan as a tax cut for the rich. They would prefer to give middle-class voters a rebate check rather than cutting tax rates, figuring that a tax cut for the rich is just unfair.
As I’ve pointed out here a number of times before, there are various types of tax cuts — ones that have distributional effects and ones that have incentive effects. In some cases, the incentive effects are not clear and one must be careful to analyze the change in the tax code to determine who will bear the ultimate burden of, or benefit from, the ultimate change.
A recent Wall Street Journal editorial pointed out the importance of this difference. Back in the 1980s, the pro-tax crowd pushed through a luxury tax on cars and boats. If you were a luxury car buyer — e.g., you bought a car that cost over $30,000 — you might have noticed an additional tax on your purchase. The game plan was to soak the rich folks who bought all these high-priced toys.
But the tax crowd forgot that the buyers of expensive luxury items could defer, or just not purchase, the highly taxed item. In the case of large yachts, the article in the Journal reported that sales of such yachts dropped by 70% after the tax was imposed. As a result of the tax code change, it was the boat builders — or the little guys — who bore the ultimate burden of the tax increase. Over 25,000 hard-working middle-class Americans lost their jobs because of this ill-designed tax increase.
A few years ago, the well-known supply-side economist Arthur Laffer offered an incentive-based idea for improving our secondary school systems. He aptly coined the program the “Twenty First Century Excellence Rewards.” The idea was straightforward: Offer a $5,000 scholarship to all students who score in the top 10% of the universe of students in their final year in school. Of course, it’s not a bad deal when you receive a check for five Gs, but let’s look deeper at Dr. Laffer’s strategy.
Parents would prefer that their children learn in school. All other things being equal they would prefer that their children go to schools that are successful. Groups of concerned citizens have pushed for charter schools and voucher programs to insure their children get the best education. So how do you get all schools to offer a better education knowing that all students can’t go to the best schools?
Dr. Laffer’s idea was that the scholarships awarded under the program would begin to accrue to schools that had more students getting scholarships. Parents would want their students to go to these schools to the degree that they would put pressure on school administration’s to get their act together and produce more winners. As time passed, the competition to garner more scholarships would provide incentives for improving all schools. The final outcome would far outweigh the annual outlays in scholarship funds.
In each of these examples, we are demonstrating the complexities of changes in the tax code. Dr. Laffer has pointed out on numerous occasions that his support of tax-rate reductions is in no way intended to benefit the rich. In our previous example, the apparent beneficiary of the scholarships was the students when in fact the scholarships were just a means to an end — they encouraged the development of better schools. The tax-rate reductions incorporated under President Bush’s first fiscal stimulus plan in 2001 and the acceleration of those tax-rate cuts are intended to increase output by providing incentives for taxpayers to work.
What would you say to a proposed tax plan that increased the after-tax income of Americans in the highest tax bracket by over 400%? A tax cut for the rich? Ironically, when President Jack Kennedy proposed lowering the maximum marginal tax rate from 92% to 70%, that is exactly what happened — and JFK was a favorite of the Democrats.
You see, good economic policy is not party specific — both Democrats and Republicans have seen the light from time to time in understanding how incentive-targeted tax-rate reductions can help America grow. Over the next few weeks, maybe a few Democrats will see the light (as well as a few more Republicans.)
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc., and an investment consultant for Wealth Management Services of South Carolina.