A Gift for Investors

Now that President Bush has nominated a new economic team, it is time to start talking about a new tax cut package for his team to sell. While it is difficult to argue – and I won't attempt to do so here – against making the income tax cuts passed earlier in his administration permanent, or even accelerating the point in which they go into effect, it is more important that the next Congress be asked to consider a completely new package of tax cuts.

In short, this economy needs an incentive for investors. After all, this economy first began to falter with the dot com bust of the late '90s and has been characterized ever since by a sluggish stock market. As such, my colleague Bruce Bartlett has come up with four items that the Administration should consider as it prepares its new economic relief package.

First, the administration should propose that Congress increase the amount investors are allowed to "expense" for capital losses – now limited to $3,000 per year above realized gains. At present, Uncle Sam is like a partner who gets 20 percent of all profits but shares only $3,000 of any losses. Just indexing the loss limit to inflation would raise it to almost $10,000. To be fair, rather than merely indexing the limit to inflation, investors should be able to deduct their losses fully. Such deductibility would strongly encourage risk-taking and investment. Even with higher capital gains rates than we have today, investors would be much more willing to incur risks if they knew that Uncle Sam would share in them fully.

Second, the administration should propose an increase in the amount of money workers can contribute to their 401(k) plans – currently limited to $11,000. Workers need an opportunity – if only temporary – to catch up and raise their retirement savings to the levels they had before the stock market crash.

Additionally, the administration should propose relieving the over-taxation of corporate profits. With such profits taxed at 35 percent at the corporate level and as much as 38 percent when distributed to the company's shareholders, the effective rate on corporate profits is as much as 60 percent. By contrast, the profits of partnerships or Subchapter S corporations are taxed at personal income tax rates.

Economists have long condemned this system. It raises the cost of capital and depresses investment, encourages excessive corporate borrowing and discourages dividend payments. Furthermore, two businesses of equal profitability can pay sharply different tax rates on their earnings bases solely on their legal form of organization.

Finally, the administration should support cutting the capital gains rate – long a favorite of conservatives and for good reason. No other single action the federal government could take is more certain to have a positive impact on stimulating investment. This fact is borne out by long experience. When the capital gains tax was raised in 1969, the increase led to a flat to falling stock market for almost 10 years. When the rate was cut in 1978 and 1981, the decreases set off the greatest booms in history.

According to the Treasury Department, an almost exact inverse relationship exists between the long-term capital gains rate and investment realizations as a share of gross domestic product. When the rate goes up, realizations go down; when the rate goes down, realizations go up. Generally speaking, the magnitudes are such that the government makes money when the rate is cut and loses money when it is increased.

Economist David Malpass of Bear Stearns says that the markets would react favorably to such a package and President Bush's willingness to take on those who would inevitably argue against pro-growth tax cuts using class warfare rhetoric. An investor-oriented tax relief package would produce the gift to every American of a robust economy, jobs, investments, and growth!