A Tax Cut Like It's 1986


Dean Baker
TomPaine.com, December 5, 2005

In the coming two weeks, Republicans in the House and Senate desperate to pass tax cut bills will be repeating their mantra that tax cuts “stimulate growth” in the economy. Before Thanksgiving, Sen. Bill Frist and Treasury Secretary John Snow both pushed that line as they argued for tax cuts on capital gains and dividends for the rich, which would be financed by cuts in Medicaid and other programs that give a helping hand to low-income Americans. The Senate ended up passing a bill that omits the capital gains and dividend cuts, but GOP leaders insist they’ll add them when the bill goes to conference. The House is still debating its tax cut bill, having postponed a vote so that they wouldn't be passing another tax cut for the wealthy in the same day they slashed funding for domestic safety net programs. This is a debate that really needs to be turned around.

In addition to opposing these harmful tax cuts, Democrats should put forward their own plan for tax reform. As painful as it might be to acknowledge, Ronald Reagan’s tax reform would be a good place to start. I don’t mean the big tax cuts for the rich that he put in place when he came into office; I mean the tax reform bill that he signed in 1986. In fairness, Sen. Bill Bradley and Rep. Dick Gephardt probably deserve more credit for the ‘86 tax reform, but this is a case where we should opt for efficiency over fairness. Let’s give Reagan credit if it helps get a hearing for an ‘86-style bill.

The key idea behind the ‘86 reform was not to lower tax rates, but to eliminate loopholes. It also took a key step that stands in opposition to the current flavor of Republican tax breaks. The ’86 tax reform treated all types of income—wage income, capital gains, dividends and rents—the same way. This meant that a person who earned $70,000 from working would pay the exact same tax as someone who got $70,000 in dividend checks or who made $70,000 in profit on stocks.

Taxing all income the same way meant that there was no money to be made by gaming the system—for example, by disguising wage income as capital gains income. Reagan proudly boasted when he signed the bill that people would now make money by working and investing, not gaming the tax code.

This spirit behind this approach to taxes runs counter to the current tax cuts being pushed by President Bush and the Republicans in Congress. Sen. Frist, in particular, has pledged that he won’t bring back a conference committee on the tax cuts to the Senate floor without the capital gains and dividends provision. Frist and his colleagues think it’s unfair that people who get money from dividends or profits on stock pay the same tax rate as people who earn their living working as truck drivers or schoolteachers. The Republicans want to extend their tax breaks from 2003, under which the maximum tax rate on dividends and capital gains would be just 15 percent. This compares to the 25 percent rate paid by many middle-income workers.

The loopy logic they use to justify this special treatment is the claim that taxes on dividends and stock amount to “double taxation.” The argument is that corporate profits are already subject to the corporate income tax, so we are taxing the same money a second time if the profits get taxed when they are paid back to individuals through dividends or higher stock prices.

The problem with this logic is that the corporation is a separate legal entity from the shareholders. Furthermore, we know that shareholders hugely value the privileges they get by virtue of the fact that the corporation has a separate legal status—otherwise, corporations would not exist. People can, and do, form partnerships to run businesses. Partnerships are not subject to the corporate income tax.

In this sense, the corporate income tax is a completely voluntary tax. By forming a corporation, or owning stock in a corporation, people have indicated that they consider the privileges gained by having corporate status are greater than the cost of the corporate income tax. It is totally understandable that corporate shareholders would like to get the privileges of corporate status for free, just like most of use would rather not pay for our groceries or gas, but there is no moral or economic rationale for giving shareholders a tax break on their income.

The whines about double taxation are not the only trick used by the Republicans to push this tax cut. They also claim that most people benefit from tax breaks on dividends and capital gains, because we have become a nation of stockholders. This claim not only ignores the fact that the vast majority of shareholders own very little stock, but also the fact that most shareholders will not benefit at all from their tax break.

Most people hold their stock in 401(k) type retirement accounts. The money earned in these accounts is taxed as normal income after retirement, regardless of how it was earned. This means that when a schoolteacher or firefighter pays taxes on the dividends earned by the stock held in their 401(k)s, they will pay the standard tax rate—quite possibly 25 percent. The special 15 percent tax rate is reserved for that relatively small group of wealthy people who have substantial stock holdings outside of retirement accounts.

The country can do without the tax gimmicks that President Bush and congressional Republicans want to give to their wealthy friends. We can stand with Reagan and demand a tax code that treats the income of workers and wealthy shareholders the same way.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, DC.