REVIEW & OUTLOOK-SEPTEMBER 9, 2010
After 20 months and more than $1 trillion down the Keynesian drain, President Obama is discovering the virtue of tax cuts. Pass the smelling salts, we just fainted.
Yesterday the President proposed a $180 billion plan that includes a permanent research and development tax credit and a tax write-off for all business capital purchases in 2011. These are both sensible ideas that would counteract at least some of the damage from Mr. Obama's looming tax increase. John McCain could sue for plagiarism because versions of both ideas were part of his 2008 campaign platform.
The White House will deny it, but it's important to understand what a conceptual switcheroo this is. Mr. Obama's economic policies to date have been based on the belief that government can drive growth by handing out checks to consumers, who will then spend the money and increase what economists call aggregate demand. Missing was any attempt to spur incentives for business or individuals to invest and take more risks. Even if this policy reversal is motivated by election desperation, it is still a tacit admission of the failure of its growth model.
The biggest short-term boost would come from allowing business expensing of capital purchases—investment in new plant, equipment, computers, technology and so on—in a single year. Such spending is currently written off over three to 20 years depending on the industry and an estimate of how long that the asset's value depreciates. But especially in our information age with its premium on human capital, it makes less sense to depreciate one type of investment at a faster rate than another.
Immediate expensing would provide a powerful incentive for businesses to spend some of that $2 trillion or so in retained earnings that they are now hoarding out of fear and uncertainty. Labor will also benefit because encouraging capital investment makes American workers more productive on the job, which is the catalyst for higher wages.
When President Bush allowed large and small businesses to write-off 50% of their capital expenditures as part of his 2003 tax cut, business spending on equipment and software rose to $1.06 trillion by the end of 2004 from $821 billion in mid-2002, a near 30% rise, according to tax economist Steve Entin. U.S. employment grew for 46 straight months, with almost eight million net new jobs created.
The big flaw in this proposal is that it's temporary. If the tax cut is for only one year, businesses will move spending forward that would have happened in future years. The economy will grow faster in 2011, other things being equal, but some of that growth will be stolen from 2012 and 2013. We've seen this temporary effect before with the home-buying tax credit, cash for clunkers and tax rebates.
In the Keynesian world-view, this is no problem because the one-year policy is supposed to kick-start the recovery and the stimulus can be safely withdrawn because the economy will become self-sustaining. But in the real world, investment will be greater and growth will be faster with a permanent reduction in the tax penalty on capital that will permanently increase the value of that capital. The White House still has some tax learning to do.
As for the research and development tax credit, it dates to the hugely successful 1981 Reagan tax cut. Year after year Congress has extended this tax credit, but only after the annual ritual of extracting campaign contributions from corporate America in return.
Making this tax credit permanent is good policy, and we almost hesitate to point out that George W. Bush endorsed this every year, lest Democrats in Congress recoil in horror. A 2010 study by the Information Technology and Innovation Foundation, a nonpartisan think tank, found that the U.S. ranks 17th among major economies in the generosity of its tax policy toward R&D.
Which takes us to the contradiction at the heart of Mr. Obama's partial tax epiphany: He wants to cut taxes on capital because he says the economy needs the stimulus, even as he wants to raise other taxes on capital that he says won't hurt growth. Huh?
Yesterday in Cleveland, Mr. Obama said he still wants tax rates to rise sharply in January on small business profits, dividends, capital gains and high-income earners. These are marginal rate tax increases on the very capital and R&D that his new tax cuts are supposed to nurture. And while the expensing tax breaks would be temporary, the tax increases would be permanent.
Another problem is that Mr. Obama says he wants to "pay for" the corporate tax cuts with a so far unspecified list of corporate tax "loophole closings," such as hammering the oil and gas industry. This is one reason the reaction in the business community has been so lukewarm to the new incentives.
We'll nonetheless give the President and his economic team points for intellectual progress. Their proposals for corporate tax cuts are a de facto recognition that the 35% U.S. corporate tax rate is too high. The recent report by Paul Volcker's White House economic advisory group also does a first-rate job of dissecting the high U.S. corporate tax as a barrier to growth. Mr. Obama is essentially proposing to eliminate the corporate tax for one year on new investment. But a better idea would be to slash the U.S. rate to the developed world norm in the mid-20% range, or lower. The lower the rate, the less need for tax credits and other loopholes.
The timing of these proposals will lead some to dismiss them as an election year conversion designed to stop a Democratic stampede to extend all of the Bush-era tax cuts. No doubt that's part of Mr. Obama's calculation, but they are also a concession to better economic policy.
Now that Mr. Obama has conceded that tax cuts are good policy, Republicans should see him—and raise.
Printed in The Wall Street Journal, page A16Copyright 2009 Dow Jones & Company, Inc.
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