Politics & Policy

Picture Permanent

Lock-in the incentive, lock-in the growth.

President Bush wants to make last year’s tax-cuts permanent. His argument is simple and succinct: A permanent reduction in tax rates reduces uncertainty and fosters a higher level of economic activity. Letting people keep more of what they earn, he argues, is the right thing to do.

He’s correct.

Even though Bush hasn’t mentioned it, the timing of the recovery and the market resurgence coincided with the tax-rate cuts on income and dividends that he signed in 2003. As the data clearly show, people respond to incentives.

Under the old tax rate, a taxpayer in the top bracket who earned $100 netted $60.40 of after-tax income. Under the new rate of 35 percent, $100 worth of pre-tax ordinary income now produces $65 worth of after-tax income. So the lower tax rate increases the take-home pay, or keep rate, by 7.6 percent.

Meanwhile, taxing dividend income at a 15 percent rate increases after-tax take home pay (on $100) to $85 from $60.40 (under the old tax law). That’s an increase of 40.73 percent in after-tax income.

Comparing the keep rate of ordinary income and that of dividend income, it is clear that dividends have a huge advantage over ordinary income — 33.12 percentage points to be precise. Thus, while the tax law increases the incentives to produce all sorts of income, it favors dividend over ordinary income.

The right incentives produce the desired results.

If one looks at the disparity in after-tax returns produced by the two alternatives, it is easy to understand the increase in the number of companies paying dividends, the increase in the dividend payout, and the superior performance of value stocks since the passage of the Bush tax-rate cuts.

The story continues: Lower tax rates also encourage people to save and invest. If an investor earns a 6 percent return that is taxed as ordinary income, the investor earns a 3.03 percent after-tax rate of return under the old tax rate. Thus, for ordinary income, the $60.40 grows to $62.69 after one year. In contrast, under the new tax rate, dividend income generates a 3.9 percent after-tax return. If invested, the $65 grows to $67.53 after a year.

The 15 percent dividend tax rate not only increases initial after-tax income, it also increases the after-tax rate of return. In simple economic parlance, the lower tax rate significantly reduces the double taxation of interest income.

That’s why, in addition to making the new tax rates permanent, President Bush must also pursue his new savings plan, which will eliminate the double taxation of income completely and reduce the effective capital-gains tax rate to zero (for investments made under these new savings accounts).

Tax-rate changes impact an economy’s incentive structure. Under Bush, permanent tax cuts on income and dividends, as well as savings, will give Americans more of an incentive to save and invest. This in turn will give the economy and financial markets a boost that should last for quite some time.

— Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.

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