During the last few years, the idea that low rates of taxation encourage prosperity has come back into favor. The first tangible evidence that this idea might be ascending came with the reduction in capital gains rates in 1978, followed by the Reagan tax cuts of 1981, which liberalized investment incentives and cut the top individual tax rate from 70 percent to 50 percent. The latest breakthrough toward lower tax rates has come with the impending tax reform law - widely considered to be dead until the Senate was given the opportunity to slash the top rate from 50 percent to 28 percent.
However, there is a major difference between this new tax act and previous tax legislation: rather than simply reducing taxes, the new act will attempt to pay for lower rates by repealing various tax exemptions and preferences. This raises a question: Can tax reform actually boost productive incentives and economic growth?Even among low-tax advocates, there are skeptics who question that tax reform can accomplish any such result. As they point out, it isn't true that work incentives are held down simply by the high statutory tax rates imposed on each additional dollar of income - what economists call "marginal" tax rates. What actually impedes work incentives are effective tax rates - which are statutory tax rates adjusted for tax deductions and other tax considerations. For example, if your income increases by $100 under the current law, if $30 of this income is sheltered by deductions and if $70 is taxed at a rate of 30 percent, then you will pay $21 in additional tax. In this case, the effective tax rate on the $100 increase in earnings is 21 percent. Now assume that the statutory tax on this income is reduced to 21 percent, but all deductions are wiped out: the effective tax rate remains at 21 percent and nothing has changed.
For this reason, although tax reform seems to achieve large reductions in marginal tax rates, work incentives won't improve because effective tax rates won't fall by very much. In short, skeptics argue, the problem with tax reform is that it doesn't reduce the tax burden. It just redistributes it.
This argument is true as far as it goes. But it overlooks three important advantages to sharply reducing statutory tax rates. First, as anyone who has lost money on a tax shelter investment can verify, maneuvering through tax loopholes is both risky and time consuming. Take into account the considerable cost of dodging taxes, and it becomes clear that effective tax rates are higher under the present system than they appear to be. On the other hand, cutting tax rates and plugging loopholes reduces this cost, since both the incentives and opportunities to use tax shelters decline. Consequently, cutting statutory tax rates makes effective rates lower than they appear to be.
The second advantage, as economists have been fond of pointing out, is that investment will become more rational. In a market economy, people tend to invest their capital productively. Competitive pressures compel them to either produce the things for which consumers are willing to pay, or lose money. However, the present jungle of tax loopholes distort production by making uneconomic ventures look profitable. By repealing various exemptions and tax shelters to achieve sharply lower rates, investment will again flow into the production of things people really need. Instead of throwing up half-empty office buildings, businesses may find it more profitable to produce cheaper blue jeans or new medical drugs.
Third, and perhaps most important, the progressivity of the tax system is being reduced by more than meets the eye. If tax reform cuts the top rate from 50 percent to 30 percent, then someone in the top bracket will see his after- tax income on his last dollar earned jump from 50 cents to 70 cents - a 50 percent increase. On the other hand, if a middle income taxpayer sees his top tax rate cut from 25 percent to 15 percent, his after-tax income on his last
dollar earned will rise from 75 cents to 85 cents - an increase of only 13 percent. Unfortunately, state and local taxes also take a substantial bite out of income, so the after-tax effects are not quite this dramatic. However, big reductions in federal tax rates will go a considerable distance toward restoring incentives among higher-income earners.
If so, then people from all income classes will benefit. The most creative and productive among us will have greater financial incentives to raise living standards for everyone - through new and better products, cheaper production processes, lower prices.