Mason Herron is a freelance political writer living in New York City and a contributor to FrumForum.
Although the final plan released by the Bowles-Simpson deficit commission failed to receive the votes necessary for official recommendation to Congress, it has proved effective at advancing a serious dialogue about deficit reduction. Its proposals will form the basis of any meaningful debates we have in the next year on deficit issues. In particular, the plan has placed tax reform on the table as a potential legislative goal over the next two years.
Should Congress decide to take up tax reform, Republicans should take hold of the issue and advocate a tax system that leans toward consumption, rather than income. The result would be a tax system that encourages more savings and investment. While such a drastic and sudden reform is politically unlikely, there are modifications that conservatives could make to the current tax system that would shift the source of taxes.
The kind of tax reform that the Bowles-Simpson plan endorses contains three primary adjustments to the tax code: lowering marginal rates; eliminating the plethora of tax expenditures that cloud our tax system; and treating capital gains and dividends as income, rather than treating them as a separate means for investment. It’s this last provision that could prove to be the most economically harmful. Although the plan aims to lower the capital gains rate for the bottom rate to around 12%, it would significantly raise the middle and upper rate to 22% and 28%, respectively.
While the 3% rate reduction for the lower bracket would stimulate investment among individuals and businesses with a lower income, it would significantly impede the incentive to invest by those in the middle and upper brackets—two groups who dedicate a significant part of their income toward capital gains.
Worse, however, is that the health care reform bill contains a 3.8% tax on interest, dividends, and capital gains on couples making more than $250,000 per year or individuals making $200,000, which would effectively raise the upper rate to 31.8%.
With the elimination of a significant number of tax expenditures also comes the elimination of numerous tax shelters for savings, such as tax-exempt IRA accounts or nontaxable interest on state and municipal bonds. These expenditures create incentives to invest, rather than spend, and in effect provide households with a much firmer financial ground to stand on.
Increases in the capital gains rate also impede new business startups. Between 1969 and 1972, the capital gains rate rose from 27% to 45%, resulting in an overall decrease of venture capital funding of 69% over that same period. Between 1986 and 1988, the capital gains rate rose from 20% to 33%, leading to a venture capital decrease of 52%. In contrast, decreases in the capital gains rate have led to significant increases in venture capital. It’s hard to ignore these numbers, and anyone with a desire to raise the capital gains rate should keep them in mind.
Taken together, the tax reform proposed by the Bowles-Simpson plan is essentially a shift away from a tax system that encourages investment, savings, and limited debt, toward a system that encourages consumption and spending.
Such a system would be based on a severe misunderstanding of the causes behind the financial crisis, which was preceded by increases in consumer spending and debt. To help prevent future crisis, our tax system should work toward injecting banks and other savings institutions with funding while providing incentives to invest rather than consume. Doing so would promote innovation, growth, and higher future living standards.
Of course, conservatives could face strong opposition from Democrats who would argue that such a tax system is a handout to the rich that hurts the poor, partly because higher-income households have a greater propensity to save than lower-income households do. However, the benefits that a pro-investment tax system provides would affect everyone in the form of higher real incomes and wages.
Considering that tax reform will be merely part of the larger effort of deficit reduction, placing the right tax system in place could prove to be a valuable windfall. A tax system designed to promote investment is exactly the kind of stimulus the U.S. economy needs right now.
Bowles-Simpson is a healthy start. Its desire to simplify our tax system and expand the tax base points us in the right direction. But in following its lead we should not take our eyes off the key drivers of investment and economic growth that our economy so desperately needs right now.