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Tuesday, January 07, 2003



Where Are The Incentives?

Supply siders have said for years that it is not simply the magnitude of tax cuts that stimulate the economy, it is the incentive effect (or lack thereof). For example, cuts in marginal tax rates reward additional work; cuts in standard exemptions reward additional breathing. Supply siders typically prefer to reward the former, since the incentive to engage in the latter is scarcely a function of tax rates.

An example of this belief is presented in today's WSJ, excerpted as follows:

...This isn't to say that all tax cuts raise revenue, as in the liberal caricature of supply-side economics. But it does mean that some tax cuts change incentives enough so that taxpayer behavior also changes and so less revenue is "lost" to the Treasury. This is especially true of the response to cuts in marginal tax rates, as ample evidence has shown over the years.

In a June 1995 study for the National Bureau of Economic Research, Harvard economist Martin Feldstein followed the behavior of the same taxpayers before and after the marginal rate cuts passed in the 1986 tax reform. The taxpayers "who had the biggest taxable rate cuts had the biggest behavioral response," he says.

Estimating conservatively, Mr. Feldstein found that at least 30% to 40% of the revenue loss predicted for those tax cuts was regained as a result of changes in behavior -- that is, by taxpayers working and investing more and in more productive ways. A separate NBER study has shown that marginal rate cuts have an especially large incentive impact on second earners in a household, mainly spouses.

...An added benefit of such a move would be to show Members that when it comes to promoting growth (and thus revenue) all tax cuts aren't equal. In Joint Tax's static world, a marginal rate cut that changes incentives is no better than a one-time tax rebate that taxpayers pocket but don't build into their future work calculations. In such a world, Members will naturally support whatever tax cut happens to do best in the polls or have the most special-interest support, not the one that does the most economic good.


Fine, I'm convinced. But when I look at the proposed Bush tax package, what do I see?

According to official White House figures, the administration proposes spending $364 billion over 10 years to end dividend taxation; $64 billion to accelerate cuts in income tax rates; $58 billion to speed up the removal of the "marriage penalty;" $91 billion to hasten an increase in the child tax credit; $48 billion to accelerate the move of lower income taxpayers to the 10 percent bracket; $29 billion for adjustments in the alternative minimum tax; and $16 billion in incentives for small business purchases.

OK, the idea of eliminating the double taxation of dividends has been around forever as an improvement on the economic efficiency of the tax code. However, the idea is also out there that, at the margin, both investors and corporations have attempted to make their peace with the tax code through such mechanisms as share repurchases as a substitute for dividends. Thus, a big portion of this part of the tax cut may simply represent "found money" for the current holders of dividend paying stocks, and would have no significant supply side incentive effects.

$68 bilion to accelerate scheduled cuts in the marginal rates: good. Deferred tax rate cuts can actually encourage people to postpone income producing activity, which is not the best way to give the economy a quick boost.

$58 billion to reduce the marriage penalty: could be good for incentives, depending on the details.

$91 billion to hasten an increase in the child tax credit: I would be shocked if supply siders could make a case for this.

$48 billion to accelerate the move of lower income taxpayers to the 10 percent bracket - I have to give this a maybe - it depends on whether the 10% is the relevant top bracket for the folks in question.

$29 billion for adjustments in the alternative minimum tax, and $16 billion in incentives for small business purchases: Again, a maybe.

So, from a supply-side perspective for folks scoring at home, we have $68 billion of "good" tax cuts, most of the $364 billion associated with dividends as "not good", $91 billion for the child-care credit as "not good", and a bunch of "maybes".

Now, Karl Rove is the reigning genius in Washington. But I doubt that supply-siders will be beating the drums for this tax package. Where Rove and Bush find the Senate votes for this is a mystery to me.

UPDATE: Alan Reynolds, supply-sider, makes the case for the dividend tax cut. Perhaps it is my selective reading, but he seems to emphasize the political appeal to seniors, rather than incentive effects.

UPDATE: OK, the Gamma-man sees dividends differently. And he goes to great dinner parties.


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