The Labor Department’s recent announcement that there were 500,000 unemployment claims last week alone sends a clear signal that our economy remains in deep trouble. Our nation’s unemployment rate remains stuck near 10 percent, and some estimates suggest that the real unemployment rate — which counts discouraged workers who have given up looking for work — is above 16 percent.
The bleak employment picture raises the stakes for Congress, which has an important decision to make with regard to “Bush tax cuts,” which are scheduled to expire at the end of this year. While much of the discussion about the Bush tax cuts has focused on whether to extend reductions in marginal income tax rates, the scheduled tax increases on capital gains and dividends could have as much, or even more, impact on our nation’s economic recovery.
If Congress does nothing, every American, regardless of their level of income, will see an increase in the taxes they pay on capital gains and dividends. In fact, the tax rates on capital gains will increase the most on those in the lowest two income brackets, as they do not pay capital gains taxes. Individuals earning income from dividends will see their taxes increase from a standard 15 percent to as much as 39.6 percent. These increases could hit seniors and retirees particularly hard, as they typically rely heavily on investment and dividend income.
Some, including the president, argue that these tax increases are necessary to get control of the deficit. While they are right to acknowledge the growing concern about the deficit, raising taxes on investment income is not the solution. The fact is, raising taxes on capital gains and dividend income is likely to reduce the revenues generated by these taxes, ultimately making it harder to reduce the deficit.
While it sounds counterintuitive, higher taxes can indeed lead to lower revenues.
This fact has been borne out through years of macroeconomic research, most recently by the initial head of President Barack Obama’s Council of Economic Advisors, Christina Romer. Dr. Romer and her co-author and husband, David, have published their findings on the economic impact of all the tax changes since World War II in the American Economic Review. They state emphatically “a tax increase of 1 percent of GDP reduces output over the next three years of nearly 3 percent.” Further, they argue persuasively that tax increases have “a large negative impact on investment.” Professors Romer are coming to the same conclusion that many members of Congress and Presidents John F. Kennedy, Lyndon Johnson, Ronald Reagan and George W. Bush all realized — tax rates matter. Raise a tax and get a three time negative affect on growth.
Given the extraordinary level of economic stagnation and the recent massive increases in costs imposed by Congress on private sector job creation by huge new regulatory burdens in health, banking, securities and environment, the president and congressional leaders probably would be better off actually cutting capital gains and dividend taxes to get the economy moving again. Cutting tax rates would not only enable employers to create jobs but also increase revenues for the treasury to reduce the deficit. In fact, a 2008 report from the Department of Treasury’s Office of Tax Analysis showed that federal receipts from capital gains taxes more than doubled in the two years following the 2003 reductions in the capital gains tax rate.
Is the deficit a long-term problem? Absolutely. But our deficit problem is caused by out-of-control federal spending, not because taxes are too low. In inflation-adjusted terms, federal spending has increased by 75 percent in the past two decades — and by 19 percent in just two years.
There is a way for the federal government to cut the deficit without raising taxes. First, cut wasteful federal spending and stop throwing good money after bad and permanently reform the entitlement programs of social security and Medicare. Government spending doesn’t increase economic activity — it just shifts money from one sector of the economy to the other. And borrowing money for government spending is worse, as it simply shifts economic activity from the future, to the past — penalizing our children and grandchildren with huge debts, fewer jobs and slower economic growth.
Second, extend the 2003 dividend and capital gains tax cuts. Even better, make the tax cuts permanent to reduce uncertainty and send a clear signal to investors — let’s spur economic growth and job creation that will ultimately lead to higher federal revenues.
Failing to extend these important tax cuts would hurt income earners at all levels in the middle of one of our country’s most notable recessions. For our economy to have any chance of recovery, it is critical that our leaders in Washington look at the evidence, not at the unsupported rhetoric.
J. French Hill is an entrepreneur and banker in Little Rock, Ark. He was a senior economic policy official in the administration of President George H.W. Bush from 1989-1993 and has twice been a member of the Steamboat Institute Freedom Conference economics panel. This op-ed also will appear in Arkansas Business.