Tax policy is not just an economic tool. It's also a partisan weapon.

The New York Times, "Economic Scene" , January 01, 2003

Congress and the Bush administration are promising Americans tax cuts in the new year. What form those cuts take will spark fierce debate.

Tax policy is not just an economic tool. It's a partisan weapon. And its power, whether to improve economic performance or slay political opponents, depends on the details.

Political considerations are already distorting two good economic ideas. The permanent campaign is transforming potentially significant tax reforms into flashy favors that enhance press releases more than economic growth.

The first good idea is ending the "double taxation" of dividends. Under current law, a publicly held company calculates its pretax profit, pays its taxes, and then pays any dividends out of after-tax profit. Shareholders then pay income taxes on the dividends.

This tax treatment creates all kinds of distortions. Because interest payments are deductible and dividends are not, the tax code encourages companies to raise capital by borrowing rather than issuing dividend-paying stock.

The dividend tax also leads businesses to pile up retained earnings in cash -- and sometimes to use that extra cash for unwise acquisitions -- rather than turn over profits to shareholders.

With fewer companies paying dividends, investors who want steady incomes are pushed into bonds. Those who want to avoid high taxes look for capital gains rather than dividends. This, in turn, skews the market toward growth stocks rather than steady earners. And by discouraging payouts that require cash profits, the tax code implicitly rewards financial funny business that only looks good on paper.

Correcting the dividend-tax distortion is not simple, because the tax code affects both public companies and their shareholders. But many stockholders do not pay taxes on dividends, because their shares are in tax-sheltered pensions or retirement accounts.

The biggest distortions are on the corporate side, where the tax code biases decisions about how to raise capital. To spur better decision-making and, hence, economic growth, lawmakers should make dividends, like interest payments, tax deductible for corporations.

But getting rid of a big distortion requires a bigger tax cut than getting rid of a small one. Thanks to all those tax-sheltered accounts, exempting dividend income from individual taxes could cost only half as much as making companies' dividend payments tax-deductible. Exempting only part of the dividend from taxation, as the Bush administration is expected to propose, would cost the Treasury even less. And most policy makers would rather keep the money in Washington.

Giving individual investors a break on their dividend income already subjects politicians to demagogic attacks as friends of the rich. Cutting corporate taxes, even to eliminate distortions, is politically dangerous.

In a campaign, "my opponent supported tax breaks for giant corporations" is even nastier than "my opponent supported tax breaks for wealthy investors." Sounder tax policy hardly seems worth the trouble.

The second good idea gone bad is cutting the payroll tax, which takes 6.2 percent of everyone's paycheck from the first dollar of income up to a limit, set in 2002 at $84,900. Employers pay an equal amount for the privilege of employing people. The employer tax does not show up on the FICA line of your pay stub, but it nonetheless increases the gap between what you take home and what you cost the company.

Reducing the payroll tax would give every worker an immediate tax break and encourage companies to hire (or retain) employees. It's a winning idea whether you're looking for a Keynesian jolt to consumer spending or a supply-side boost to hiring. And it would particularly benefit low-income workers, who pay little or nothing in federal income taxes but still owe payroll taxes.

The problem arises in defining what it means to "cut the payroll tax." A permanent rate reduction, the ideal reform, is not what lawmakers have in mind. The most common suggestion is a one-year exemption on the first $10,000 or $15,000 of income. This idea has two problems.

To spur either spending or long-term hiring, income tax cuts need to be permanent, not short term.

Of course, employers and workers would appreciate even a one-year break, especially a large one. The idea is a political winner, but a temporary cut does little to encourage hiring or spending.

Companies aren't likely to expand their permanent work force if the after-tax cost of new workers is going to shoot up a year later. And consumers generally base their spending on what they expect to earn over the long term. They save windfalls, including tax rebates, and borrow to cover temporary shortfalls.

This principle, which is known in economics as the permanent income hypothesis, may explain why the 2001 tax rebates don't seem to have stimulated spending as much as boosters had hoped.

A temporary rate cut might not do much to help the economy, but at least it wouldn't do much harm. A lump-sum exemption, by contrast, could actually hurt low-wage workers.

Instead of hiring one full-time person for $20,000 a year, employers would suddenly find it much cheaper to hire two half-time employees for $10,000 each. There would probably even be less paperwork -- and fewer health benefits to cover.

A temporary lump-sum exemption may win some short-term good will among middle-income voters, who are less likely to lose their jobs to part-time workers. Lawmakers who care about spurring full-time employment, increasing consumer spending, or helping low-income workers would instead make a long-term commitment to lower payroll tax rates.

But politicians, like the rest of us, respond to incentives. Until voters reward subtle but sound tax reforms, lawmakers will keep turning out the flashy favors that pay.