Corporate Tax Cuts Should Be Part of the Stimulus

The reductions currently in the House bill would do very little for economic growth.

STEPHEN J. ENTIN

This week the House will be voting on a two-year, $825 billion economic stimulus package. This is on top of vast sums already being spent in the financial bailout packages. The program is immense. Will it work?

The idea is to jump-start "aggregate demand," according to traditional Keynesian precepts. Milton Friedman, on the other hand, taught us that government spending and tax handouts do not stimulate demand, because every dollar doled out by government must be first taken in by taxes, borrowing or other spending cuts. The net effect on aggregate demand is zero.

Still, Republicans apparently like that $275 billion, or a third of the package, comes in the form of tax cuts. But to boost output and income, a tax cut must be the right type -- one that cuts taxes "at the margin" on the additional income associated with additional output (supply). And it should be permanent if the gains are to last. (Witness the feckless tax rebates of 1975 and 2008.)

Unfortunately, the tax cuts that are in the current package do not pass the supply-side test. And others that would pass the test, such as corporate tax cuts, are not in the package. Here are the problems:

- Refundable credits. Half the tax cut would be a refundable, "make work pay" credit of $500 for a single worker and up to $1,000 for two-worker families, offsetting payroll taxes on the first $8,100 of earnings. It would be phased out over a range of household income from all sources, not just wages, starting at $75,000 for single filers, $150,000 for couples.

The credit would encourage work at the margin only for people who produce and earn less than $8,100. But it operates as a tax-rate hike for those in the phase-out range, discouraging work, saving and investment. The effect on GDP would be negative, just as it would for proposed expansions of the income-capped refundable Earned Income Tax Credit, and the refundable part of the child credit.

- Carry back losses. Except for firms getting TARP money, businesses could carry back losses for five years instead of only two years against past profits to get a refund. The carry-back would give businesses cash. But unless taxes are cut on future earnings, it would not encourage more investment and hiring.

- Energy Tax Incentives. Mr. Obama and Democratic congressional leaders talk of creating several million green jobs through tax credits and grants to generate electricity from alternative fuels and encourage energy-efficient vehicles, and to retrofit government buildings and low-income housing to save energy. To date, however, alternative fuels and green vehicles require more resources to deliver less energy and transportation at greater cost. By raising costs they will lower employment, output and income. In short, these green policies would cost jobs, not increase them.

- Expensing. The plan currently under consideration temporarily restores the expensing provisions of the 2008 stimulus package. These were partial expensing for equipment for businesses of all sizes (50% of equipment spending could be written off immediately instead of being depreciated over time), and a temporary increase in small business expensing limits to $250,000 from $175,000.

Expensing is good policy: Depreciating investment outlays over time for tax purposes delays deductions that lose value with time and inflation, understating costs and overstating (and overtaxing) real profit. Enhanced expensing more fully reflects the real cost of equipment than depreciation, raising after-tax returns on investment. It would boost capacity and employment. But the provisions in the stimulus package would work much better if they were made permanent.

If the tax provisions of the stimulus program will not fix the economy, neither will the spending programs.

Some $550 billion is slated for federal spending and shoring up state budgets -- for Medicaid, infrastructure, schools and unemployment programs. But most federal and state spending merely displaces private activity by taking money and resources from the market.

Worse, each dollar spent eventually costs the public collateral economic damage due to tax-generated disincentives and distortions. In his "Reflections of a Political Economist," William Niskanen found that "the marginal cost of government spending and taxing in the United States may be about $2.75 per additional dollar of tax revenue" under one set of simulations, and as high as $4.50 under other tests. To make up for this dead-weight loss, government spending must be worth much more than its apparent budget cost to be good for the country.

To be sure, some infrastructure projects might pass that cost-benefit test (perhaps electric grid modernization, or unclogging strategic rail bottlenecks). Some might keep worthwhile construction going on projects that states might otherwise cancel. But the pork projects on the governors' and mayors' wish lists serve no national purpose.

Ultimately, labor and capital must shift from declining industries and areas to expanding ones -- but intercepting people as they make the shifts and parking them in government projects for a year just delays the adjustment. And the debt and future taxes raised in the process become permanent burdens that shrink private output and income forever after.

We need a permanent improvement in the production climate. What would help? A lower corporate tax rate, as well as a permanent extension of the 2008 expensing provisions and the 2003 dividend and capital gains and top marginal income tax rates. On the regulatory side, lifting the burdensome auto fuel economy standards and alternative fuel requirements would help, as would an elimination of restrictions on oil drilling.

Taxes and regulations raise the bar for investment to be profitable after-tax, and they fall especially hard on capital-intensive industries such as manufacturing and resource extraction. We have the second-highest corporate tax rate in the developed world (after Japan). A lower rate would make us a more attractive location for business. Similarly, the excess of the U.S. corporate tax rate over the foreign rate is imposed on repatriated earnings -- keeping foreign-source earnings abroad exactly when domestic credit is hard to get. To spur investment in 2004, Congress declared a partial tax holiday on repatriated earnings. Now would seem an opportune time to do so again.

Mr. Entin is president and executive director of the Institute for Research on the Economics of Taxation.