When a Tax Cut Isn’t a Tax Cut

Published in THE HILL

Consider two different U.S. tax worlds:

Today, the U.S. government gets virtually all of its revenue from an income tax, which many Americans believe is unfair, incomprehensive, and an impediment to economic growth. Virtually every American is calling for some kind of reform.

Tomorrow, the U.S. government gets its revenue from a consumption tax.  Familiar examples are a European Value Added Tax (VAT) or a U.S. retail sales tax.  Implicit are measures to prevent the tax from becoming too regressive and a “money machine.”

Tomorrow, a zero capital gains tax is not considered a “loophole” or the “poster child” of an inequitable tax system but rather a predicate for entrepreneurship and investment.

Tomorrow, Americans will invest their hard earned income into IRAs and 40lks without a second thought about tax penalties or repercussions.  It rewards Mr. Thrift rather than Mr. Spendthrift.   Today, they are considered “special tax breaks” or “tax expenditures.”

Tomorrow, a business can expense or immediately deduct the cost of new equipment from its tax bill and be competitive.  Today, it is considered a corporate break.

Is tomorrow’s dream “voodoo” tax policy?  Definitely not.  The U.S. is one of a few global players that relies almost entirely on an income tax for its revenue.  In our current tax system, exempting saving and investment is a tax loophole or tax expenditure rather than a necessity for economic growth. This must change. The time is ripe to do so.

Over the next several months, twelve handpicked politicians in a unique bipartisan, bicameral “mini congress” will be in the limelight.  Dubbed everything from the “Super Committee” to “The Dirty Dozen” to the “Twelve Apostles,” this group must restore faith among the electorate that it can succeed where multiple commissions and study groups have failed in devising an acceptable blueprint to reduce our crushing debt and restore our fiscal health.

It will be a tightrope walk. We must reassure financial markets with a long-term plan to avoid a looming and dangerous tipping point. Professors Carmen Reinhart and Kenneth Rogoff, in an influential analysis of debt and economic growth, conclude that when external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half. At the same time, the long-term reduction plan cannot tip us into recession in the short term.

Spending cuts should be paramount and a major focus for the committee, particularly with out of control health care costs.  Why not aim to reduce spending, currently at 24 percent of GDP to its historic 18 or 19 percent average? President Obama has called for a spending cut to tax increase ratio of ten to one. After spending cuts the committee should then turn to tax policy, which plays a critical role in fostering more savings and investment and ultimately the economic growth we need. Replacing our income tax with a consumption tax is an ideal, but not a politically practical, solution.  But if everything is “on the table,” according to Super Committee members, why not eliminate biases against savings and investment, pay for it with a tax on consumption, and foster economic growth?

Even targeted proposals like a capital gains tax cut can have a positive economic effect despite what skeptics like Warren Buffett believe. An econometric study by the highly respected economist Dr. Allen Sinai notes that eliminating the capital gains tax increases GDP by a little over 0.23 percentage points per year. Jobs increase by an average of 1,322,000 per annum while the unemployment rate drops 0.7 percent at its lowest point.

Conversely, Sinai found that raising the U.S. top individual capital gains rate from the current 15 percent rate to 20 percent, as suggested in several deficit reduction plans, would cut annual economic growth by an average of .05 percent per year and job growth would decline throughout the economy by an average of 231,000 from 2011-2016. This is real food for thought for the Super Committee.

In sum, not every tax cut is truly a cut. A tax reform that favors savings and investment is a necessity to help the U.S. economy. As 17th century philosopher Thomas Hobbes wisely noted, “It is fairer to tax people on what they extract from the economy, as roughly measured by their consumption, than to tax them on what they produce for the economy, as roughly measured by their income.”