Council of Economic Advisers
Pro-Growth Tax Policy
June 2, 2008
Pro-growth tax policy aims to reduce economic distortions. In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) reduced individual income tax rates, created a new 10% bracket rate, provided marriage penalty relief, and began a phase-out of the estate tax. In 2003, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced the tax rates on dividends and long-term capital gains. It also accelerated the phase-in of the tax rate reductions scheduled to occur under EGTRRA.1
These tax cuts have reduced distortions to labor supply, saving, and investment decisions by lowering the tax burden on labor and capital income. They have also resulted in a more efficient tax structure by reducing the double taxation of corporate income. However, the economic benefits of the tax cuts are limited because they are scheduled to expire at the end of 2010. Making the tax cuts permanent could greatly improve long-run economic performance.
Taxes represent a transfer of resources from the private sector to the government. In the process of making the transfer, output that would have created value for producers, consumers, and workers is lost because taxes give individuals an incentive to avoid activities that are taxed. The lost value of output from tax distortions is referred to as deadweight loss it is a cost borne by the private sector that does not result in any additional government revenue. A recent study by Parry (2002) suggests that the personal income tax creates 30-50 cents of deadweight loss for every additional dollar of revenue raised.2 Thus, any government services funded by that revenue would have to have a social value of at least $1.30 in order to justify the cost (direct taxpayer cost plus deadweight loss).
Individuals decide whether to work and how much to work by weighing the take-home pay that they would earn against the value of the leisure time they forgo. Income taxes distort the labor supply decision by reducing individuals' take-home pay from working.
The average tax rate the share of income paid in taxes affects an individual's decision to enter the labor force. High average tax rates can discourage labor force participation. The marginal tax rate the share of additional income paid in taxes affects an individual's decision to work more hours, take a higher paying job, or invest in education. Because of the joint treatment of married individuals, a family's marginal tax rate can also affect the second earner's decision to enter the labor force. Workers vary in their sensitivity to average and marginal tax rates. Single mothers and married women are especially sensitive to income taxes, so the deadweight loss is particularly high for these groups. Meyer and Rosenbaum (2001) show that a $1,000 reduction in taxes increases single mothers' employment rate by 2.7 percentage points. Eissa, Kleven, and Kreiner (2004) show that the 2001 tax cuts increased the labor supply of single mothers.
Income taxes also distort the decision to save and invest. When individuals choose to save, they forgo current consumption in favor of future consumption. Individuals' savings get channeled through financial markets to firms, which can use the funds to invest in capital and become more productive in the future. Taxes on capital income reduce the return to saving and investment. Under the current tax code, some firms (Subchapter C corporations) are subject to a firm-level tax on their income (after deducting expenses, including interest payments). Individual savers may also be subject to tax when they receive this income in the form of interest on bonds or dividends and capital gains on stock. Thus, income from dividends and capital gains is often subject to double taxation it is taxed at both the firm and the individual levels.
The tax cuts of 2001 and 2003 reduced the tax burden on capital income in several ways. First, the 2001 tax cuts lowered individual income tax rates. Many small businesses including Subchapter S corporations, sole proprietorships, and partnerships are subject to individual income tax. These types of firms are known as flow through businesses their income flows through to the owners who pay personal income tax on it. As a result of the lower individual income tax rates, these businesses face a lighter tax burden on their investment returns. Interest income also receives the benefit of lower ordinary income tax rates. Second, the 2003 tax cuts reduced the top tax rate on qualified dividends and long-term capital gains. Third, the 2001 tax cuts also began a phase-out of the estate tax, which reduces the tax burden on savings left to one's heirs.
The structure of taxation refers to the way in which the tax burden is distributed across individuals and activities. A tax structure is more efficient if it can raise the same amount of revenue with less deadweight loss. Thus, making the tax structure more efficient can improve economic outcomes even if the overall level of taxation remains the same.
The 2003 tax cuts have substantially improved the business tax structure. As discussed above, many small businesses do not pay a firm-level tax their income is attributed to the owners and taxed under the individual income tax system. However, businesses organized as Subchapter C corporations (referred to here as "corporations") pay a firm-level tax of up to 35% on their income after deducting wages, interest payments, raw materials, and depreciation. When corporations undertake investments, they can finance them with equity (issuing new shares of stock or using retained earnings) or debt (issuing bonds). If a firm chooses equity financing, it can either pay the investment returns to shareholders in the form of dividends, or retain the earnings to reinvest in the firm. The tax treatment of these organization, financing, and payout options results in a number of distortions.
The tax cuts of 2003 reduced all three of these distortions by lowering individual-level tax rates on qualified dividends and long-term capital gains to 15%. This substantially reduced the bias against paying out dividends (although capital gains still have some tax advantage because of deferral). It also reduced the tax bias in favor of debt financing. Finally, it reduced the tax disadvantage from choosing the corporate form of organization.
The tax cuts have clearly had an impact on dividend payments. Chart 1 shows the amount of dividend income received by households over time. From the beginning of 1983 to the end of the second quarter of 2003, real dividend income increased at an annual rate of 5.8%. After the second quarter of 2003, that rate increased to 12.8%.3 Chetty and Saez (2005) find that the fraction of companies paying dividends increased substantially following the 2003 tax cuts, after 20 years of decline. Moreover, firms that were already paying dividends increased their regular dividend payments after 2003. Overall, there was a 20% increase in regular dividend payments.4 A study by Poterba (2004) suggests that the reduction in distortions has the potential to raise the long-run level of dividends by 31%.
The 2001 and 2003 tax cuts are currently scheduled to expire at the end of 2010. This scheduled expiration limits their beneficial impact on the economy, particularly with regard to decisions that pay off over long periods of time (for example, education or long-term investments). Making the tax cuts permanent can substantially improve economic performance. However, the long-run effects of extending the tax cuts depend on how the tax cuts are financed.
This point is illustrated in a 2006 study by the Treasury Department, which examines the long-run macroeconomic impact of making the tax cuts permanent. This study assumes that the tax cuts are financed by additional government borrowing through 2016. After 2016, two scenarios are considered. In the first scenario, government spending is reduced after 2016 to maintain a constant debt-to-GNP ratio. In the second scenario, income tax rates are raised across-the-board after 2016 to maintain a constant debt-to-GNP ratio. Treasury finds that in the first scenario, the capital stock increases by 2.3%, and long-run GNP increases by 0.7%. In terms of today's $14 trillion economy, this would amount to almost $100 billion per year in additional output, or $329 per capita. In the second scenario, long-run GNP falls by 0.9%.
Not all of the tax cuts have the same impact on output. Treasury also estimates that extending only the dividend and capital gains rate cuts would raise long-run GNP by 0.4% (assuming they are offset by spending reductions). If the top four ordinary income tax rates were made permanent as well, long-run output would increase by 1.1%. Adding the remaining tax cuts (including the child tax credit, marriage penalty relief, and the 10% bracket rate) would lower the impact on long-run output to 0.7%. These remaining provisions lower long-run output because they increase take-home pay without a reduction in marginal tax rates. The increase in take-home pay allows individuals to reduce their labor supply.
The tax cuts of 2001 and 2003 reduced the tax burden on labor and capital income, thereby reducing economic distortions to individuals' work, saving, and investment decisions. The tax cuts of 2003 also improved the efficiency of business taxation and reduced distortions to corporate financing and payout decisions. Making the tax cuts permanent combined with control of government spending can substantially boost economic performance.
1 These two tax bills also included an increase in the child tax credit, increased contribution limits to IRAs and 401(k) plans, and other provisions. The provisions discussed in the text accounted for the bulk of the tax relief. In 2005, the Tax Increase Prevention and Reconciliation Act extended the dividend and capital gains tax rate reductions through 2010.
2 This study takes into account the various exemptions and deductions (for example, the mortgage interest deduction) that narrow the tax base. If all income were taxed at the same rate, the deadweight loss would be lower.
3 The spike in the graph represents a special one-time dividend paid by Microsoft Corporation.
4 As further evidence, they note that dividend payments did not increase for the subset of firms whose largest shareholder was exempt from taxes (as would be the case for a pension fund). This suggests that the increase in dividend payments was indeed a response to the reduction in the tax distortion.
5 This study includes all of the tax cuts except for the estate tax.