Decoupling Taxes on Capital

By / 11.15.2010

The president will meet with leaders from both parties on Thursday to discuss Congress’s unfinished business for the lame-duck session, and the only thing that is clear going into that meeting is that item number one on the agenda (for right or wrong) will be the Bush tax cuts.  Speculation is running high this week that the White House is considering a compromise approach that would extend all of the Bush tax cuts temporarily, most likely for two years.  This comes in place of the previous round of speculation that the president’s strategy was focused on “decoupling” the tax breaks, meaning he would push for Congress to vote separately to permanently extend lower tax rates for all households making less than $250,000 per year, while allowing another vote on a temporary extension of the cuts for the two percent of taxpayers earning more than that.

As both sides prepare to dig in their heels for the coming tax fight, the possibility of policy alternatives has given way to a pure tug-of-war exercise, in which compromise is limited to questions of how long to extend the cuts or whether to draw the line at $1 million rather than $250,000.  The rare occurrence of a fresh approach is too quickly ignored, such as Senator Mark Warner’s op-ed last week calling for the high-income tax cuts to be redirected as targeted tax incentives for business to boost investment and jobs.

Warner’s proposal would likely be a far more effective way to put lost tax revenues into the most productive hands for lifting our economy, but it’s probably not on the table.

Both parties appear hell-bent on confining this battle to the provisions of the original Bush tax cuts, with the winner to be determined by which provisions do or do not get extended.  It’s an unfortunate corner we have painted ourselves into, but there are still important policy issues within this narrow debate that deserve greater attention and vigilance.

In a new memo released today, PPI Senior Fellow Michael Mandel acknowledges that the current tax debate has totally missed the most important big-picture questions about the need to modernize our outdated tax code for what he calls the “supply-chain world” of the 21st-century global economy.  However, Mandel points out specific elements of the Bush tax cuts that could actually help move us closer to the type of tax code we need for today’s economy: namely, the lower rates on dividend income and capital gains rates.

Mandel explains that keeping rates low on income from capital is critical for encouraging investment in critical innovative industries over the long-term, and that raising these rates right now would be a particularly bad idea, because our economy is still languishing in what he calls a “business investment drought.”  Compared to the data on consumer demand, government spending, and even the collapse in housing, Mandel concludes that the real hole in the economy is nonresidential investment, which has plummeted even more sharply than housing.  So while the tax debate has so far focused on the economic impact marginal tax rates would have on consumer spending, Mandel makes the case that we should be looking at the impact that upcoming tax votes will have on investment:

It doesn’t make sense to raise the tax rate on corporate dividends and capital gains in the middle of a U.S. investment drought. That’s true, whether you believe in Keynesian economics, supply-side economics or anything in between.

Taxing capital at too high a rate impairs the environment for innovation, especially in this world of permeable borders and mobile money. In particular, raising the tax rates on dividends is likely to hurt innovative industries such as telecommunications and pharmaceuticals, which tend to pay out dividends at a higher level than other industries.

I have raised similar issues about this potential problem of dividend rates before (mainly here, but also here), but Mandel’s analysis of investment brings the question into much sharper relief.  Unfortunately, the positions of the White House and Congress have been much less clear in this issue.   This year’s tax debate has been an exercise in gamesmanship more than a battle of ideas, so both the president and Democratic leaders have remained a little ambiguous about their proposals for these rates, largely because they don’t fit well with the line-drawing fight over whether the wealthiest Americans should have any of their tax cuts extended.

President Obama has said he supports keeping rates on dividends capped at 20 percent, in line with what the rate will be for capital gains income (both are currently taxed at 15 percent, but the dividend rate is scheduled to more than double in 2011 to 39 percent for taxpayers receiving the bulk of these payments).  Secretary Geithner has said the same.  Both men stopped short of saying outright that the 20 percent rate would apply to all taxpayers, even those making above $250,000, even though the president’s budget for 2011 spells it out explicitly.  The 20 percent rate has also been endorsed by Senate Finance Committee Chairman Max Baucus, who called it “good policy” to keep the rates in line with capital gains rates:

Changing dividends to 20 percent as opposed to ordinary income rates and keeping it the same as capital gains, I think, is good policy. I’m going for policy. Twenty percent on dividends and capital gains is the right policy.

Senator Baucus and President Obama both deserve enormous credit for “decoupling” good policy from the political gamesmanship over the Bush tax cuts, and Baucus should continue to advocate for the lower dividend rate to be included in whatever compromise proposals get thrown around in the coming days and weeks.  As Mandel writes in today’s memo, “the best we can hope for may be small steps in the right direction” from this Congress toward a smarter tax code that encourages sustainable growth and innovation.  Hopefully Obama and Baucus can avoid taking a step backward on this one.