The power to tax is the power to destroy. Even Pharaoh, 3000 years ago, was aware of this wise saying. Unfortunately, it seems to have been forgotten by some of the more influential modern economists. But, what is destroyed? What is destroyed are economic incentives for business formation and growth.
With Congress and the White House talking sporadically about another stimulus package to spur economic growth, it is important to distinguish what tax policies will work and what is sheer political puff and business as usual (increase spending) disguised as an economic stimulus package. With this in mind, you might say that this article is a short primer on understanding the growth aspects of tax policy.
Taxes, broadly speaking, can be categorized into two types of headings— taxes on capital and taxes on labor. Since this article will be dealing with taxes on income, capital taxation would be identified with the corporate income tax. Similarly, a tax on labor is equivalent to the personal income tax schedule. Now the sixty-four thousand-dollar question. Which one is more important in helping to stimulate economic and business growth?
As President Lincoln stated in one of early speeches as president, the tax on labor is of more importance than the tax on capital. Why? Economic growth is driven by net new business formation. Or, to put it another way— the economy is driven briskly when everyone wants to be a business owner. When entrepreneurs (risk takers) start an enterprise, their business income tax is initially reported on the personal income tax schedule. As the business grows, the owners may incorporate and file using the corporate tax rate. (As a reminder, when individuals start businesses, they hire people. Businesses with less than 100 employees are responsible for 75% of the net new job growth. Net new business formation should be the goal of tax policy designed to stimulate economic growth.)
Since the tax on labor is more important than the tax on capital, the top marginal income tax rate on labor should be less than the top corporate rate. Presently, the top corporate tax rate is 35%, while the top tax rate on labor is about 35% and possibly going higher. If policy makers are serious about providing incentives for stimulating vibrant business growth, the top personal income tax rate should be reduced to less than 35%. To provide a real fillip to economic growth, the top personal income tax rate should be significantly below 35%. It was no accident that President Regan, in his second term, reduced the top individual rate to 28%. This was a true top rate that did not include any phaseout of deductions or any of that nonsense that has the perverse effect of increasing the marginal rate.
Economic policy makers, whether they are in an administrative or legislative position, like to take the path of least resistance—- similar to electrons in a circuit. Their path of least resistance to stimulate economic growth is to increase spending. It doesn’t work! (If it did, many of the major European economies would be booming by now. Instead they have been in the doghouse for the past ten years.) The money for their increased spending is just sucked-out of the private sector. The net effect is zero.
Providing financial incentives for individuals to take business risks by significant and immediate reductions in the top individual marginal income tax rate is the best way to promote sustained and vibrant economic growth.
My latest book is The Thirteen Great Economic/Business Myths That Dominate Our lives.The book is available on most popular book web sites (amazon.com).