Commentary - The kind of tax cut does matter

By Raymond J. Keating

Small Business Survival Committee

All tax cuts are not created equal. That is something the White House and the incoming 108th Congress need to keep in mind as talks once again heat up as to what can be done on the policy front to give the economy a boost.

Almost any kind of tax relief would be welcome - especially during a time when government spending is accelerating at a disturbingly fast pace. Let's face it, when the federal government sucks more than $2 trillion out of the economy in a year, any tax cut should be appreciated.

However, some forms of tax reduction will have very little impact on spurring economic growth, while others can contribute substantially to enhanced growth in both the short run and over the long haul. The key is how tax relief impacts incentives that are critical to economic growth, namely, incentives for working, investing and entrepreneurship.

Economic growth occurs through a boost in resources used for production purposes and/or greater productivity, efficiencies, innovations, and inventions. It is entrepreneurs and investors who introduce new products, services, inventions, and innovations.

These key economic facts need to be kept foremost in mind when considering how best to provide truly pro-growth tax relief. So, what policies make the most sense from a growth perspective? How about another round of tax rebates? Unfortunately, tax rebates are temporary and do nothing to alter key economic incentives. They amount to little more than shifting around of resources from one group to another.

It's also long been popular to drive social policy through the tax code. There can be merits to such undertakings, for example, regarding health care and education. However, such measures do little to really promote economic growth, and can have the effect of increasing the complexity of the tax code.

What about ending double taxation of dividends? Currently, corporations pay out dividends from after-tax dollars, and then individuals are taxed on those dividends as well. So, ending double taxation of dividends certainly would strike a blow for eliminating a layer of multiple taxation, and it also would boost incentives for investment a bit.

However, it should be noted that redressing unfair taxation of dividends is not going to provide a major boost to small businesses that provide most of the growth in the economy. After all, small and/or entrepreneurial enterprises that drive the economy forward usually are not in a position to be offering dividends. Instead, they are plowing earnings back into innovations and expansion.

Why not expanded tax breaks for retirement savings? This is a good idea, as incentives for savings would be enhanced and the pool of available capital for businesses would be expanded.

In the end, though, tax relief in three key areas promise to make the most significant contributions to the economy - death taxes, capital gains taxes and income taxes.

Elimination of the death tax would enhance incentives for investment, and keep many businesses alive that otherwise would go under, taking with them countless jobs. Under the 2001 tax cut, the death tax is not scheduled to phase out until 2010, and then it comes back to where it was before the 2001 tax cut in 2011. Immediately killing the death tax, and making its demise permanent, would be a big plus for the economy.

Meanwhile, capital gains taxes arguably are the most destructive levies imposed by government. After all, these taxes are specifically targeted at the returns from investing and entrepreneurship. Starting up and investing in businesses are high-risk undertakings. Capital gains taxes diminish potential returns, and thereby inhibit such risk taking, and restrain economic growth and job creation.

The best capital gains tax policy is no capital gains tax at all. Next best would be to reduce rates paid by both individuals and corporations to about 10 percent, and fully index all gains for inflation.

Finally, income taxes in general hurt incentives for working, saving and risk taking. The 2001 Bush tax cut included cuts in personal income tax rates. That's good news, including for the roughly 90 percent of U.S. businesses that pay the personal income tax rather than the corporate income levy. However, the cuts are not fully phased in until 2006, and again are wiped out in 2011.

The Bush income tax cuts need to be fully implemented now, and made permanent. Further cuts would be beneficial. For example, bringing the top personal income and corporate income tax rates both down to 25 percent would provide a major boost to pro-growth incentives.

Again, almost any kind of tax relief is welcome. But why not focus such efforts on the tax cuts that will provide the economy the biggest bang for the buck.