by William W. Beach
Heritage Foundation
February 5, 2004

On February 2, President George W. Bush proposed one of the most far-reaching economic growth plans in the past 30 years, calling for all of the major elements of his 2001 and 2003 tax cut laws to be made permanent. Permanence will make even more certain that the current economic recovery continues to be strong. Congress should not squander this chance for a more prosperous future by allowing these tax cuts to expire.

Pro-Growth Components

The tax policy changes of 2001 and 2003 created a new policy environment for economic growth. By significantly lowering tax rates on labor and capital, President Bush increased the likelihood that the U.S. economy would be more productive and that incomes across the population would rise.

Congress now has before it, in the President’s budget submission, a plan to make these tax changes permanent. Specifically, the President calls for:

Making permanent the tax policy changes enacted in 2001 and 2003. These changes include:

• Permanent extension of the individual income tax rate reductions enacted in 2001 and currently scheduled to disappear in 2011;
• Permanent extension of the lower tax rates on income from capital gains and dividends that were enacted last year and are currently set to expire at the beginning of 2009;
• Permanent repeal of the federal estate tax and the generation-skipping transfer tax that are scheduled to be re-imposed in 2011; and
• Permanent extension of the child tax credit, the marriage penalty relief, small-business expensing, and a host of pro-growth and tax equity elements contained in the landmark tax acts of 2001 and 2003.
• Expanding the amount of income that can be placed in long-term, tax-advantaged savings accounts. The President has proposed a Lifetime Savings Account and a Retirement Savings Account, both of which will help build savings and contribute, ultimately, to investment.

These and related tax policy changes will boost the rate and level of economic activity by assuring people who work, save, and invest that they won’t face higher taxes in the near future. Taxpayers know that taxes raise the price of everything. If capital is taxed (as it is when taxes are imposed on savings accounts, stock dividends, and the value of land and other tangible assets), it costs more for businesses and homeowners to borrow money from the bank. The same economics applies to the taxation of labor and other forms of economic activity: Raising taxes increases the cost of the activity taxed, which generally lowers its use.

Thus, when Congress lets a tax cut expire, it endangers economic growth. Even when it threatens to let a tax cut expire in the distant future, say 2011, investors both make plans to put their money into projects that will pay out over a shorter amount of time and pull out of long-term investments, like research that will yield results only in 10 years or a new factory that has to be paid off over a 20-year period. In other words, investors often view Congress’s failure to make a tax cut permanent as a signal of higher taxes—and thus prices—in the future.

Achieving Public Policy Objectives with the Tax Code

In addition to these pro-growth proposals, the President’s 2005 budget contains a number of tax initiatives designed to achieve specific public policy objectives. Specifically, the President proposes:

• Providing taxpayers who purchase their own health insurance with tax credits and income adjustments on their tax returns;
• Allowing taxpayers who currently do not itemize their deductions to take a deduction for contributions to charitable organizations;
• Assisting taxpayers with their expenses for education, telecommuting, energy, and housing; and
• Changing the tax treatment of certain types of pension plans, particularly “cash balance” plans.

While these tax proposals do not contribute as strongly to economic growth (and are not primarily designed to do so) as the President’s plan to make his previous tax policy changes permanent would do, they nevertheless address important aspects of everyday life that are affected by tax policy. Health insurance, for example, is provided to workers largely by their employers instead of being purchased by individuals, as homeowners insurance is. This peculiar arrangement is entirely a product of tax law that allows employers to deduct the cost of health insurance from their taxable income.

One Wrong Direction

Even though the plurality of the President’s proposals moves in the right direction, however, a few do not represent good tax policy. Specifically, the President’s budget would raise taxes on corporations by eliminating their ability to establish leasing arrangements with cities and other local governments to manage such activities as subways, sewer systems, and parks. These leases generally result in losses that corporations can use to reduce their taxes. Cutting the ability of local governments to outsource expensive operations such as these would raise the expenses and decrease the efficiency of local government.

This proposal for raising additional revenues from the corporate profits tax would not lead either to higher economic growth or to a fairer tax code.

William W. Beach is Director of the Center for Data Analysis at The Heritage Foundation.