Turning slogans into tax policy.

TABLE OF CONTENTS I. INTRODUCTION 747 II. ESTATE TAX REPEAL 749

A. The Economic Case Against the Estate Tax 750

B. The Rhetoric of Fairness 755

C. Budget Politics 759 III. DIVIDEND TAX CUTS 762

A. Ecconomic Effects 763

B. Perceptions of Fairness 769

C. The Fifteen Percent Solution 772 IV. CONCLUSION 780

I. INTRODUCTION

Throughout his presidency George W. Bush has embraced tax cuts as the hallmark of his domestic policy agenda. During the early years of his administration he signed an unprecedented series of annual tax reduction measures into law. The Bush tax cuts have proved highly controversial. Sympathizers herald them as part of a grand strategy to promote capital formation and fundamental tax reform, (1) while critics decry them as symptoms of a fiscally reckless assault on progressive taxation. (2) At this point, it is probably too early to reach definitive conclusions about the long-term effects of the Bush tax cuts, especially considering the uncertain prospects for extending those cuts beyond 2010. Nevertheless, it is possible to evaluate the rationales articulated by the Bush Administration for its tax cutting proposals, to compare those proposals with the outcomes that ultimately emerged from the legislative process, and to draw some preliminary lessons about the Administration's approach to tax policy.

This article examines the Bush Administration's tax cutting agenda by focusing on two discrete episodes: the 2001 quest for estate tax repeal, and the 2003 attempt to eliminate the shareholder-level income tax on corporate dividends. These seemingly disparate episodes reveal a common pattern in the Administration's portrayal of its proposals. In both cases, the Administration offered simplistic economic rationales based on speculative argumentation and unrealistically optimistic assumptions, without acknowledging the revenue costs and regressive distributional effects of its proposals. The Administration also diverted attention from risks and tradeoffs by using populist slogans to pitch its proposals in terms of fairness and economic opportunity. Despite the Administration's uplifting rhetoric and rosy economic assumptions, the legislative outcomes in 2001 and 2003 were driven largely by budget constraints and interest group politics. As a result, the final bills that President Bush signed into law fell far short of the lofty expectations raised by the initial proposals. In the face of rampant budget deficits, urgent claims on public resources, and growing inequality of income and wealth, the Administration's tax cutting agenda may be better understood in terms of politics and ideology than conventional tax policy.

The article proceeds in two parts. The first part analyzes the campaign to repeal the estate tax, focusing on economic rationales and rhetorical claims, and explains why the Administration was unable to achieve its goal of complete, permanent repeal in 2001. In a parallel fashion, the second part explores the Administration's proposal to eliminate the shareholder-level income tax on dividends, and describes how the proposal was transformed almost beyond recognition as it wound its way through the legislative process. The article concludes with a brief assessment of prospects for making the Bush tax cuts permanent and the resulting implications for federal tax policy.

II. ESTATE TAX REPEAL

During the 2000 presidential campaign, George W. Bush embraced tax cuts, including repeal of the estate tax, as a signature issue. Upon his inauguration as President in January 2001, President Bush lost no time in putting those tax cuts at the top of his Administration's legislative agenda. Although his economic advisers were primarily interested in reducing income tax rates and viewed the estate tax as a relatively minor issue, his political advisers insisted on making estate tax repeal a centerpiece of the Administration's proposals. (3) With both houses of Congress under Republican control and budget projections showing unexpectedly large surpluses, the political climate for tax cuts was especially favorable. The focus of controversy was not whether to cut taxes but rather which taxes to cut and how radically to cut them. In its first major test of political will, the Administration put together a coalition of large and small business owners to promote its agenda, ensure unwavering loyalty, and fend off competing proposals. (4) The strategy paid off, and within five months President Bush signed estate tax repeal into law as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Act). (5)

The campaign to repeal the estate tax did not originate with the Bush Administration. Opposition to the tax gathered momentum during the 1990s, and bills to repeal the tax passed Congress in 1999 and again in 2000, but President Clinton vetoed the legislation on both occasions. By 2001, the arguments against the estate tax were already well rehearsed. For convenience, the case for repeal can be broken down into two sets of arguments relating to economic effects and fairness, respectively.

A. The Economic Case Against the Estate Tax

Capital Formation. At the heart of the economic case against the estate tax is the claim that the tax discourages work, saving, and investment, thereby reducing capital formation and impeding economic growth. (6) Although it is tautologically true that the estate tax reduces the amount of wealth passing from a deceased donor to noncharitable beneficiaries, the charges leveled against the tax rest on several crucial but unstated (and highly questionable) assumptions concerning the motives and behavior of donors and donees. For example, a prospective donor contemplating the estate tax might respond in either of two ways. On one hand, she might seek to mitigate the impact of the tax by choosing leisure over work and consumption over saving, even though this would constrain the total after-tax amount available for noncharitable bequests (a substitution effect). On the other hand, she might work harder, save more, and consume less in order to maintain a desired level of noncharitable bequests after taxes (a wealth effect). A priori, it is impossible to say which effect predominates. (7)

The effects of the tax also depend on the donor's motives for giving. If the donor accumulates wealth primarily to provide for her own future needs (a precautionary motive), any bequests are essentially accidental and the estate tax should not affect the donor's propensity for saving. If bequests are viewed as a deferred payment to the donee for services, companionship, or other signs of respect and affection (an exchange motive), and if the wealth effect predominates, the estate tax may actually increase the donor's saving since larger accumulations of wealth are needed to secure a desired level of benefits. Even if bequests are motivated by pure altruism, the effects of the tax are ambiguous. (8)

The donee's behavior must also be considered. A donee who receives a bequest may work less and consume more than she would in the absence of a bequest, or she may respond by investing the inherited funds and redoubling her work effort. Again, the effect of the estate tax is ambiguous. (9) The donee's use of inherited property should be compared with the government's use of funds collected through the tax. If the beneficiary would squander her inheritance while the government would use tax revenues to pay down the national debt or build infrastructure, the estate tax could actually increase total national saving. (10) Opponents of the estate tax refuse to acknowledge such a possibility, however, because it does not support their dogmatic assertions about the harmful effects of the tax. The point is not that the estate tax has no effect on capital formation, but rather that the current state of economic knowledge about bequest motives and saving behavior does not support the simplistic and exaggerated charges levied by the tax's opponents. (11)

Double Taxation. Another line of attack asserts that the estate tax amounts to improper double taxation of wealth that was already subject to income taxation when it was earned. (12) Despite its force as a rhetorical gambit, the charge of double taxation is inaccurate and misleading in two respects. First, the underlying assumption that all accretions to wealth are subject to income taxation during life is simply not true. To be sure, the estate tax base includes the value of wealth transferred at death, and a portion of that value may consist of amounts saved from previously taxed wages and investment income.

In estates with appreciated assets, however, the unrealized appreciation is not subject to income taxation during life and would go completely untaxed but for the estate tax. (13) Capital appreciation appears to be heavily concentrated among the wealthiest households, which also happen to be most likely to incur an estate tax. (14) Conversely, the vast majority of estates with relatively little capital appreciation--the supposed victims of double taxation--fall completely outside the reach of the estate tax. If the problem is that the estate tax functions poorly as a backstop to income taxation of unrealized appreciation, the obvious solution would be to replace the existing estate tax with a deathtime capital gains tax, but this is hardly what the advocates of repeal have in mind. (15)