President

The Impact of Recent Tax ReductionsTaxes transfer resources from individuals to the government. The transferitself does not represent a net cost to society: any money given up by taxpayersis gained by the government and can be used to fund government programsor transfer payments. However, taxes impose a considerable burden on theeconomy for several reasons. First, taxes interfere with the efficient allocationof resources by changing the rewards from working, saving, and investing.In the absence of taxes, individuals and firms would allocate resources toactivities where they would be most productive. When taxed, individualsalter their behavior. For example, high tax rates on labor income induceindividuals to reduce their labor supply, because the incentive for workingis lower. High tax rates on capital income (the return earned on capitalinvestments) discourage investment in new capital. A reduction in investmentlowers the ratio of capital to labor and in turn reduces worker productivityand wages. As a result of these distortions to work, saving, and investmentbehavior, output is lost—output that would have created value for producers,consumers, and workers. This loss of output is called the deadweight loss oftaxation. As discussed above, raising an additional dollar via the individualincome tax imposes a direct cost of $1 on taxpayers (which merely representsa transfer to the government) and a deadweight loss of 30 to 50 cents fromthe lost value of output to society. Second, high tax rates may also encouragesome taxpayers to underreport their incomes, giving rise to equity concernsand requiring higher taxes on those who do comply in order to maintainrevenue. (While most taxpayers pay the taxes they owe, there is still a gapbetween the amount of taxes that should be paid and the amount that isactually paid.) Finally, taxes have large compliance costs that reflect theresources taxpayers use to determine and pay their tax liability (including thevalue of time spent keeping records and doing calculations). In 2004, compliancecosts were estimated to be $85 billion for individual income taxes and$40 billion for businesses other than sole proprietorships.The tax cuts of 2001 and 2003 significantly lowered the tax burden onlabor and capital income and reduced distortions. The dividend and capitalgains rate cuts enacted in 2003 had an additional benefit to the economyby improving the efficiency of the tax structure. By reducing the existingpreference for corporate debt financing over equity financing, these taxcuts reduced the distortion of corporate finance decisions and improvedcorporate governance.Chapter 5 | 121