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Volume III, Number 220 January 2003

A Stimulus Only Humpty Dumpty Could Love

Tim Francis-Wright

Earlier this month, the Bush administration proposed a truly laughable plan to stimulate the economy. Most of the tax cuts in the plan would go to the wealthiest Americans, not to Americans who are unemployed or struggling to make ends meet. Instead, the proposal is larded with provisions that benefit the natural constituents of today's Republican party.

The official White House biography of George Bush lauds him for "ushering in the responsibility era in America." In 2001, George Bush claimed that his $1.6 trillion tax cut plan would use only a portion of the budget surpluses expected over the next ten years. Current government projections now show deficits for that period, even without the cuts in revenue that the stimulus package would entail. The economic stimulus plan makes clear that it certainly is the beginning of the fiscal irresponsibility era.

Dubbing this melange of tax cuts as an economic stimulus bill is a case of life imitating art. In this case, the art is Humpty Dumpty's explanation to Alice that when "I use a word, it means just what I choose it to mean—neither more nor less." Through the Looking Glass hardly represents the literature that leaders ought to invoke.

Precious little of the Bush stimulus plan will stimulate the economy in the short term. Two of the largest components would permanently change the federal tax code to reward certain classes of taxpayers. By the administrations's own figures, the $674 billion cost of the plan over the next ten years would have only a $98 billion effect over the next sixteen months. On the whole, the stimulus plan is really a tax reform plan in another guise, and it requires consideration on its merits.

The largest component of the stimulus plan is the elimination of the federal income tax on corporate dividends received by individual taxpayers. Republicans have complained for years that dividends are taxed twice, first when corporate profits are taxed, and second as investor income is taxed. To a certain extent, they have a point. Corporations can deduct their interest expenses, but not their dividend payments. Exempting some dividend income from taxation certainly has precedent; countries like Australia allow companies to pass tax credits along to shareholders to the extent that they paid corporate income taxes.

Such a deceptively simple proposal has a host of complications associated with it. First, determining the benefit to a dividend holder is far from easy. While the marginal tax rate for most American corporations is 35%, many corporations pay at a lower effective rate thanks to a host of corporate tax breaks. Since effective rates can vary from year to year, the amount of a company's dividends that are exempt from tax can vary as well. Second, a significant portion of the dividends paid by corporations go to entities that do not pay taxes: qualified retirement accounts like 401(k) accounts and IRAs, or charitable organizations. When a worker starts withdrawing the dividend income received by a 401(k) account, it will be taxed as ordinary income (as it is under the current tax code). The Bush proposal would undermine the tax advantages behind retirement accounts. Third, despite the administration's proclamation that the dividend tax cut will benefit the elderly, there are clearer winners. According to Internal Revenue Service data from 2000, 62% of the dividends reported by individual taxpayers went to the richest 8.4% of taxpayers, those with over $100,000 in adjusted gross income. The only major classification of income that skews more toward the wealthy is income from capital gains. And the Bush proposal even has a way to cut capital gains taxes. When companies do not pay dividends, they can declare "deemed dividends" that reduce the capital gain associated with sale for stockholders. Again, this provision does nothing for the saps who decided to buy stocks in their retirement accounts, but it rewards those souls who own stock outright. In 2000, the IRS data show that about 50% of capital gain income went to taxpayers with adjusted gross incomes of over $1,000,000.

Fourth, eliminating the tax on most dividend income will discourage investments by middle-class Americans. The cost to the government of the tax cut should show itself in a concomitant rise in stock prices. But the amount of the increase will be a factor of the taxes saved by a typical investor. A stock at $50 per share that pays a $1 annual dividend per share should enjoy an increase in price associated with the tax savings of the typical investor, who is in the topmost bracket (now 38.6%, but 35% if President Bush has his way). An affluent investor in future years may pay more for the stock than he would now, but the tax-free nature of the dividend will make up for the difference in price. A less affluent investor, or an investor using a tax-deferred retirement account, would then need to overpay for the stock. Right now, the stock market is incidentally weighted toward the rich. In essence, the Bush plan would make the stock market inherently like the current market for municipal bonds, which are rational investments only for the well-off.

Finally, cutting the tax rate on many dividends is trying to fix a problem that is far from the worst part of the tax code. The tax code if rife with situations in which income by one party in a transaction does not generate a tax break for the other party. Most individual taxpayers can deduct only a small set of expenses from their gross income—their state and local taxes, their mortgage interest, their —and only if they itemize their deductions. Rent, utilities, credit card interest, and a host of other worthy expenses receive no special consideration, yet there is no charge to end the "double taxation" of rent or heating bills.

Owners of small businesses generally elect "S corporation" treatment: the owners recognize a share of the corporation's income or loss every year, and the corporation itself does not pay taxes or make taxable dividend payments. In exchange, distributions from the S corporation to its owners are not taxed. Even large corporations can have excellent reasons not to pay dividends. A dividend payment is, in essence, an admission to the stockholders that the corporation has no productive use for the money.

Another key provision of the Bush stimulus plan is the elimination of the "marriage penalty" built into the tax rates. In general, a single man and a single woman will pay less in overall federal income taxes than the same man and woman will if they are married. For couples who make very similar incomes, the marriage penalty can be significant. But for many Americans, the marriage "penalty" is really a bonus. If only one spouse has income, or if one spouse has comparatively little income, then merely by being married, almost every provision of the tax code—the standard deduction, the income tax brackets, the phaseouts for most credits and deductions—automatically becomes more favorable. The Ozzie and Harriet plank of the Bush plan would only increase the marriage bonus for millions of Americans. Republican plans to eliminate the marriage "penalty" are not solely aimed at married working women; they are also aimed at conservatives who rue the days that women ever got the notion to start their own careers.

The Gas Guzzler plank of the Bush plan calls for an increase in the cost of equipment that businesses can write off, instead of depreciating every year. The current limit is $25,000; Bush would increase this to $75,000. This provision is manna from heaven for Ford and General Motors, both manufacturers of luxurious vehicles like the Cadillac Escalade, Hummer H2, and Lincoln Navigator. Normally, Section 280F of the Internal Revenue Code limits the annual deprecation of cars and trucks, and prohibits expensing of them under Section 179. The limitation, however, contains a loophole that one can drive a Ford Expedition through. If, and only if, a vehicle has a gross vehicle weight rating of 6,000 pounds or more, it is exempt from the limitation.

If a public purpose is served by facilitating the purchase of huge, gas-guzzling behemoths, I cannot fathom it. If a small business, like a one-person legal or medical "firm," buys a $53,000 Hummer, the Bush plan would allow an immediate $53,000 deduction against gross income. If that same business were to buy a $15,000 Ford Focus, the deduction would come over six years, with no more than a $7,000 deduction in the first year.

Two aspects of the Bush stimulus plan together comprise the Dark Side of Federalism plank. Virtually every state government is currently in the midst of a budget crisis wrought by declining tax revenues. Unlike the federal government, each state government tries to balance its budget every year, lest its bond rating fall and the cost of servicing its debts rise. First, many states adopt by default the determination of taxable income in the federal Internal Revenue Code. Exempting much dividend income from federal taxation would immediately lower tax revenues in states that do not take positive action to disavow the tax cut. Second, one of the advantages that states and municipalities enjoy under the current tax code is that they can issue bonds that are exempt from federal and state income taxes. The tax exemptions allow many state and local bonds to borrow money cheaply. If corporations can raise money by issuing preferred stock that pays generally tax-exempt dividends, the demand for tax-exempt bonds will decrease and states and municipalities will need to pay more in interest, through no fault of their own.

A more basic problem with the entire plan is the ephemeral nature of any government stimulus through the tax code. In late 2001, the federal government sent check of up to $600 to millions of American families, but much of this money went into savings accounts, toward credit card bills, or into the coffers of charities. Paying down credit card debt is a worthy use for the money, but it is hardly something that directly stimulates the economy. And if direct payments to the masses can lack stimulating effect, what are we to make of the Bush stimulus plan? Most of the tax breaks occur in 2004 or later. Much of the money goes to the investor class, who are likely to expand their speculative investments rather than spend the extra money.

A sad truth of American politics is that if this plan is scuttled, the likely reason is that a few moderate Republicans will refuse to support their party's leaders. The days which had Democrats willing to risk their political hides to prevent the worst Republican policies are over. Instead, the future of the stimulus plan depends on whether Republicans like Charles Grassley regret overestimating the surpluses that the 2001 tax cut was supposed to use but not wipe out completely. From an academic point of view, the battle in the Republican Party between the true fiscal conservatives and those who wish to cripple the government with deficits should be interesting. From the point of view of a citizen, the Democratic Party should be speaking about the inequity of both the 2001 and 2003 tax plans.

Anyone interested in a more equitable American society has to realize two truths. First, there is a real difference between the Republican and Democratic parties. No national Democratic figure would have offered as president the 2001 Bush tax cut or the proposed 2003 Bush tax cut to the American public. But, second, the Democrats are far from a clear voice for the poor and working-class. That so many Democrats supported the 2001 tax cut, and are silent about even the worst aspects of the 2003 plan, speaks volumes about who really has clout.