The Entrepreneurial View #487
Tax Cuts Five Years Later
by Raymond J. Keating
Five years ago, the economy got a boost from politicians. That's pretty rare, so let's take a moment to review what happened and in what economic context.
Recall that the economy started to slow in the third quarter of 2000, and went into recession in 2001. The newly elected President George W. Bush pushed for a tax cut package, which was passed and signed into law roughly this time seven years ago.
Unfortunately, the pro-growth aspects of that tax cut - namely, reductions in personal income tax rates, and the eventual elimination of the estate tax (or death tax) - were to be phased in over several years. Delaying tax cut meant delaying the benefits of tax relief as well.
The economic recovery underperformed, largely due to the fact that business investment, which had begun to decline in early 2001, continued to contract through 2002 and into early 2003.
It was in May 2003 that Congress and the President stepped forward with a tax cut package that truly made an economic difference. The package put the full 2001 personal income tax cuts into immediate effect, while also reducing capital gains and dividend tax rates, and expanding expensing levels for capital investments made by small businesses.
On May 23, 2003, the U.S. House of Representatives passed the measure by a 231-200 margin, and then Vice President Dick Cheney broke a 50-50 tie in the Senate on the same day. President Bush signed the legislation on May 28.
The impact on the economy was clear, immediate and positive. Business investment picked up, and real GDP growth accelerated to levels more appropriate for a period of economic recovery/expansion.
In recent times, these reduced taxes no doubt have served as something of a counterweight to developments that have hit the economy hard, in particular inflationary monetary policy, higher energy costs, and the housing mess. Indeed, given the challenges faced, it's rather amazing that real GDP continued to grow at a respectable rate until the fourth quarter of last year.
But now, the 2001/2003 tax relief measures ironically are creating uncertainty for entrepreneurs, investors and the economy in general. Why? Well, the tax cuts are not permanent. They have an expiration date of 2011. That is, at the end of 2010, they are wiped out. For example, the death tax, which is scheduled to disappear in 2010, returns in 2011 with a top rate of 60 percent. The top personal income tax rate will increase from 35 percent to 39.6 percent, the top dividend tax rate goes from 15 percent to 39.6 percent, and the individual capital gains tax rate will rise from 15 percent to 20 percent. In addition, the small business expensing level will decrease from $125,000 to $25,000.
That's a looming, massive tax increase on the productive capacity of the United State economy. It would reduce the incentives for working, entrepreneurship and investing, which in turn, will restrain economic growth and job creation.
Yet, the current Congress seems oblivious to this economic reality. So, as the economy struggles in a no-growth mode or in recession - with real business investment experiencing negative growth in the first quarter of 2008 - the signal coming from Congress is that they choose to ignore the economic lessons of five years ago, and favor allowing most of this huge tax increase to go into effect.
Data just released by the Treasury Department and the White House make clear that this tax increase would mean a direct hit on the bottom line of small business. The White House noted that small business owners face an average tax hike of $4,066, compared to an average increase of $1,800 for all taxpayers. For good measure, Treasury noted that 74 percent of taxpayers benefiting from the reduction in the top personal income tax rate are entrepreneurs with pass-through businesses (such as sole proprietorship, partnership, and S-Corps), and 70 percent of those reaping rewards from reductions in the top two tax rates own small businesses. So, these tax increases are not about socking the so-called rich, as many argue, but instead, they would hit entrepreneurs hard, with fallout coming in the form of restrained economic and job creation.
Let's hope that after the November elections, a new Congress and a new White House resident will remove the threat of this major tax increase, and even get down to helping the economy through additional tax relief.
If not, the results will be less-than-pretty for the U.S. economy.
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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.
