The Democratic response to President Reagan's tax reform speech, delivered eloquently by Ways and Means Chairman Dan Rostenkowski, made it clear that the question is not whether there will be tax reform but which party will get the political credit for it. Although the administration's revised plan lacks several of the dramatic elements that made the earlier version appeal to some academic tax experts, the changes have been crafted in a way that improves the chance for bipartisan support.
In our opinion, the new tax plan is not only good politics but can be the basis for good economics as well. Its faults can easily be remedied in the legislative process without sacrificing the basic principles that guided the administration's tax designers.
The key idea in the president's plan is that marginal tax rates can be lowered dramatically without any loss in revenue by eliminating some of the deductions and exclusions and special tax rules of our current tax system. Unlike the 1981 tax cuts, the changes in tax rules mean that it doesn't take any supply-side miracles to keep total tax revenue unchanged. And even though the top rate comes down from 50 percent to 35 percent, high-income taxpayers won't pay a smaller share of the total tax collections because they are the ones who are affected most by the changes in tax deductions and special tax rules.
While part of the sales pitch for the president's plan is to emphasize the simplicity of having only three tax brackets instead of the current 14, it is the lower marginal tax rates that would be the real improvement to the tax system. Lowering the marginal tax rate, or the share of additional dollars earned that must be paid to Uncle Sam, means a greater reward for work effort, for saving and for risk-taking. It also means a reduced incentive for wasteful tax shelter investments that aim at reducing taxes rather than at making good use of scarce capital. In both of these ways, the president's plan for lower marginal rates would mean a strong and healthier economy.
Some of the proposed changes in deductions and in other tax rules not only raise the revenue needed to offset the lower tax rates but also improve economic incentives directly. The $5,000 cap on personal interest deductions limits the implicit subsidy that currently encourages excessive borrowing and a low national savings rate. And eliminating the deduction for state and local taxes ends the subsidy to excessive spending by state and local governments.
But not all of the sources of increased revenue are economically favorable or justifiable. Eliminating the investment tax credit and changing business depreciation rules will reduce the incentive to invest in plant and equipment. Even with the reduction in corporate tax rates, the net effect of the administration's plan is to discourage the kinds of investments that raise productivity and real wages. More of the capital stock will go abroad or into less productive uses at home. Although it is politically tempting to use an increase in business taxes to finance lower taxes on middle-income individuals, the long- term effect may be a fall in growth that more than offsets the temporary advantage of lower tax rates.
It looks to us as if there is a second serious problem with the president's plan in its current form. Even with the higher taxes on business and the changes in personal deductions and tax rules, the plan as a whole may lose money and therefore increase the size of the projected deficits. If personal taxes do eventually fall by an average of 7 percent while corporate taxes rise by 9 percent, as the Treasury has indicated, future deficits will clearly increase.
A primary reason for this revenue loss is the almost doubling of the personal exemption. The proposed increase from $1,080 per person to $2,000 per person would cost the Treasury $40 billion in lost revenue in the first year alone. Although it serves the useful purpose of exempting low-income families from any tax liability at all and substantially reducing the tax liability on families with modest incomes, the $2,000 personal exemption is an inexcusably wasteful way of achieving these goals. It not only costs $40 billion-plus a year but gives substantially bigger savings to high-income families than to those with lower incomes.
In a future column we'll discuss several alternatives that we think would be better than the proposed doubling of the personal exemption. And by trimming this loss of revenue, it would be possible to preserve more of the current incentives for investment in new plant and equipment and perhaps even to contribute to shrinking future deficits.
Tax reform is now clearly on its way. The president's plan has established the framework that will shape the debate and eventually the final legislation. With a few key changes, it could also provide a far better tax system for the American economy in the decades ahead.