At his confirmation hearing in 2001 to become George W. Bush’s first Treasury secretary, Paul O’Neill told the Senate’s tax-writing committee: “If you want to give me inducements for something I am going to do anyway, I will take it. But good business people do not do things for inducements.”
The outspoken former chief executive of two Fortune 500 companies was telling lawmakers something they rarely hear from the business community: Taxes don’t change behavior.
Just outside the Senate Finance Committee hearing room where O’Neill made these remarks, however, is the famous “Gucci Gulch.” That otherwise drab hallway in the Dirksen Senate Office Building is where high-priced lobbyists, with their fancy footwear, lurk when senators negotiate tax bills. These fixtures of the Washington tax scene would tell you that O’Neill is dead wrong, that tax breaks — particularly tax breaks for their clients — create jobs and boost the economy.
So, who’s right? Do taxes affect behavior or not? This is a key question now that Congress is looking over the fiscal cliff and gearing up for what could be a major overhaul of the tax code.
Clearly, taxes do matter. Stiff state cigarette taxes, for example, cut smoking habits. Higher gasoline taxes encourage people to buy fuel-efficient cars.
In the business world, too, some effects are clear. Multinationals move big chunks of their profits into overseas tax havens to avoid the high U.S. corporate tax rate. Changes in the capital gains tax rate have enormous effects on the timing of stock sales. The research tax credit expands the scope of activities that companies call research. And right now, many corporations are speeding payouts so that their shareholders don’t face the higher taxes on dividends that will probably take effect after Dec. 31.
But the more important question is this: Do taxes affect the things that are critical to our economic well-being, such as employment, investment, innovation and worker productivity? Where companies book their profits doesn’t matter as much as where they build their factories. When investors sell stock may matter to brokers, but what shapes the economy is whether lower capital gains rates affect investment and entrepreneurship. We want to know if the research credit increases spending on science and technology, and not just on accountants coaxing more tax benefits out of existing activity.
These are much tougher questions to answer. Despite thousands of economic studies, we are left with a mass of confusing and contradictory results. Some studies report large effects. Some report small effects. Some report no effects at all.
Why? It’s partly because economists, being human, often let their political views influence their analyses. The spectrum of their findings mirrors their wide political differences about the virtues or vices of taxes.
But even after setting aside personal bias, much uncertainty remains. Even the most sophisticated research can provide only clues, not definitive answers. We cannot, for instance, isolate the effect of taxes on business investment because so many other variables, such as interest rates and optimism, matter too. And even if these studies were conclusive, the effect of taxes in the future is not likely to be the same as it was in the past, given the tremendous amount of structural change in the economy.
If the experts are so uncertain, how can politicians and voters make up their minds about tax policy?
A little clear thinking can go a long way. Consider the example of how higher income taxes affect work and savings. Theory tells us that a higher tax rate reduces the reward for working and saving. And that reduces the incentive to save and work, and makes you more likely to head home early and put your feet up. But if you’re trying to maintain a certain standard of living or sock away money for your children’s college education, higher taxes might increase the amount you work. Given that many middle-class families fall into this category of “target savers,” it is hard to believe that tax increases can greatly reduce the amount of saving and investment in the overall economy.
It also helps to consider your personal experience. If income taxes go up next year, are you or any of your friends and family members likely to work less as a result?
Finally, look at history. The most relevant comparison for today’s debate is what the economy looked like before President George W. Bush’s tax cuts took effect. From 1993 through 2000, the top personal income tax rate was 39.6 percent, and the economy generated fantastic growth. To be sure, the economy may have grown even more if tax rates had been lower, but at a minimum, the Clinton era shows that a top rate of 39.6 ercent does not necessarily mean economic ruin.
So tax rates probably don’t matter a lot when it comes to such things as employment and investment — but they might. That’s not a crisp message that inspires confidence or sells books. And it’s not a talking point for any politician because it doesn’t help win elections.
Fortunately, while uncertainty wreaks havoc on tax politics, it need not alter the basic thrust of good tax policy.
Tax reform that lowers rates and limits breaks is clearly the right path. High rates and targeted breaks complicate the tax code. They encourage businesses to borrow more and use complex tax shelters — good news for the folks in Gucci Gulch. Tax breaks also unjustifiably favor certain sectors of the economy over others, often based on influence rather than worthiness. Worst of all, they unjustifiably favor certain individuals over others.
Yet it is important to be realistic about what tax reform can achieve. Mitt Romney and the Simpson-Bowles fiscal commission wanted to pay for a cut in tax rates by reining in all those tax breaks. But that amounts to wishful thinking because the vast majority of those tax benefits flow to the middle class. It’s politically difficult to go after popular deductions such as those for mortgage interest. Similarly, President Obama’s proposal to reduce the corporate rate from 35 percent to 28 percent is unrealistic.
The political conversation needs to start afresh. Democrats somehow have wedded themselves to the idea that rates on the wealthy must rise. But that’s the wrong approach, particularly at this stage. To achieve their political and policy goals, they need only to raise the tax burden on the wealthy — cutting breaks and leaving rates steady.
At the same time, conservatives could do everybody a favor by putting a lid on their often indefensible claims about the effects of higher taxes. Hardly a day goes by without Fox News stating as fact that Obama’s proposed tax increases on the wealthy would be economically “catastrophic” or “disastrous.”
It’s perfectly fine to oppose sharply higher tax rates on the wealthy on moral or philosophical grounds. But claims that we face economic doom if Obama’s policies become law simply are not grounded in reality. A change of a couple of percentage points in the income or corporate tax rate isn’t a religious issue; it’s an accounting matter.
The federal government’s books need to add up. The Paul O’Neills of the corporate world will make their business decisions largely the way they would have anyway, and most working people will wait until the end of the day before putting their feet up — at least the ones who aren’t wearing Guccis.
Martin A. Sullivan is chief economist for Tax Analysts, a nonprofit provider of news and analysis about tax and economic issues.