The Biden Task Force on the Middle Class

January 31, 2009

Joe Biden’s new task force on Issues of the Middle Class will be considering ways to improve living standards for Americans. It might be worth pointing them in one direction that they might otherwise overlook: There is considerable evidence that reductions in the tax on capital income can have a pronounced positive effect on living standards.

The U.S. tax system taxes capital income in a number of different ways. Capital income can be subject to the corporate tax, investor level taxes on dividends and capital gains, and the estate tax. Indeed, investment in the corporate sector can be subject to three different layers of tax, first at the company level under the corporate income tax, then at the investor level through the taxes on dividends and capital gains, and, then yet again upon death of the investor through the estate tax.

Reducing any of these taxes can help reduce the negative effect of taxing the return to saving and investment on the economy. Consider the following dynamic analysis of various approaches to reducing the tax on capital income produced by the U.S. Treasury Department over the past several years:

  • Permanently extending the lower tax rates on dividends and capital gains can be expected to increase the size of the economy by 0.3 percent in the long run. This result holds up whether financed with a future increase in taxes (a 0.3 percent increase in output) or lower government spending (a 0.4 percent increase in output) (see Table 3 of the July 2006 Treasury Report). (Note that the model used for this analysis got to about three quarters of the long-run result within ten years.)
  • Replacing the income tax with a progressive consumption tax could increase output in the long-run by 2.8 percent. (See Table 3 of the May 2006 Treasury Report).
  • Replacing the corporate income tax with a consumption-based tax, such as a business transfer tax or value-added tax, could increase output by 2.0 to 2.5 percent in the long-run. (See page 22 of the December 2007 Treasury Report or page 32 of the printed version).
  • Repeal of the estate tax could increase output by 0.7 percent in the long-run assuming repeal is financed with an offsetting increase in taxes generally. The increase is 1.1 percent if repeal is financed with lower government spending. (Craig Johnson and David Joulfaian, “A Dynamic Analysis of Estate Tax Repeal,” U.S. Department of the Treasury, Office of Tax Analysis, (unpublished manuscript), November 2008).
  • Broadening the business tax base by eliminating most special business tax preferences and lowering the business tax rate (the tax rate applied to both corporations and pass-through entities) could increase long-run output by 0.5 percent. (See page 49 of the December 2007 Treasury Report or page 69 of the printed version).

The common theme that runs through all of these policies is that by lowering the tax on capital income they encourage additional saving and investment and increase capital formation. The higher level of capital formation increases labor productivity and when workers have more capital with which to work, real wages and living standards rise.

Hopefully, Vice-President Biden’s Task Force will take a look at how the current tax system hinders economic growth and how living standards, an issue of vital interest to the middle class, can be further increases by fundamental reform.

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