House and Senate negotiators are hammering out details of a tax bill that would extend the 15 percent tax rate on dividends and capital gains for two years. Failure to reach an agreement would result in a major tax increase beginning January 1, 2009, when the capital gains tax rate would climb to 20 percent and the top tax rate on dividends would rise to 35 percent. These increases in the double-taxation of dividends and capital gains would slow economic growth and undermine America's competitiveness in the global economy.

Lawmakers should make these tax cuts permanent. Ever since they were enacted in 2003, the economy has performed remarkably well. Growth and job creation both have been impressive. For instance:

• Inflation adjusted economic output (real gross domestic product) has jumped by about 3.5 percent annually ever since the 15 percent tax rate on dividends and capital gains was enacted. This is particularly impressive since growth fell to anemic levels during the last two quarters of the Clinton Administration, remained low in 2001, and was modest in 2002.[1]

• Job creation skyrocketed once the double-taxation of dividends and capital gains was reduced, with more than six million jobs created since the beginning of 2003.[2] The unemployment rate, not surprisingly, has fallen dramatically. After peaking at 6.3 percent in mid-2003, it is now 4.7 percent.[3]

To be sure, there are many other factors that influence economic performance and it is very difficult to isolate the precise impact of any policy change on economic performance. The strong growth and job creation since 2003, for instance, may have been positively affected by the lower income tax rates that were implemented that year. Monetary policy, trade policy, regulatory policy, and other economic choices also impact the economy.

Good in Theory

While it may be impossible to pinpoint the economic impact of a policy change, sound theory makes a powerful case that the lower tax rate on dividends and capital gains is a huge success. From a theoretical perspective, there ideally should be a zero percent tax on dividends and capital gains. Both levies represent double-taxation, which occurs when a second layer of tax is imposed on income that is saved and invested. A capital gains tax involves another layer of tax on individuals who choose to invest after-tax income productively; there is no second layer of tax on those who consume their after-tax income. Moreover, the capital gains tax also is a form of double-taxation on the reinvested profits of a company, which already have been hammered by the 35 percent corporate tax.

Just as is the case with the capital gains tax, the dividend tax imposes another layer of tax on individuals who choose to invest after-tax income productively; again, there is no second layer of tax for those who consume after-tax income. The dividend tax is a form of double-taxation on the distributed profits of a company, which already have been hit by the 35 percent corporate tax.

These extra layers of tax on income that is saved and invested discourage people from accumulating capital, much as tobacco taxes discourage people from smoking. This has adverse consequences for economic performance, of course, since every economic theory-including socialism and Marxism-agrees that capital formation is the key to long-run growth and higher living standards.

While the ideal tax rate on dividends and capital gains is zero, the perfect should not be the enemy of the good. The 2003 legislation dramatically improved the structure of the tax code by significantly reducing the level of double-taxation on income that is saved and invested.

Good in Practice

Real-world data also make a powerful case for the success lower tax rates on dividends and capital gains. The economy's strong performance since 2003 certainly suggests these lower rates have a positive effect. Opponents argue, of course, that the robust economy is a coincidence, but this argument does not explain why the United States is performing so much better than other industrialized nations.

Whether measured by economic growth rates, job creation, productivity, wealth creation, financial markets, or unemployment, the United States is easily out-performing nations such as Germany, France, and Japan. Indeed, per capita GDP in the United States is about 40 percent higher than it is in the European Union.[4]

While critics fumble for possible alternative reasons for strong U.S. performance, there are other compelling numbers they should try to explain. For instance, America's financial markets have dramatically risen since the 2003 tax cut. The number of firms paying dividends has increased, as has the size of dividends. Capital gains realizations (selling of assets) have jumped as investors are now more willing to allocate their capital more efficiently since the tax penalty has been reduced. These are just a few of the positive effects of better tax policy.

Revenues are Up, Not Down

One of the more bizarre arguments against extending the lower tax rates on dividends and capital gains is that it would be "too expensive." This argument presents a moral problem: it implicitly assumes that private income belongs to government until and unless politicians decide they can "afford" to let taxpayers the money they earn.

This entire argument is moot, however, since there has been a huge "supply-side" response to the 2003 tax cuts. Strong economic growth means people have more income, and more income means a larger tax base. And even though, or perhaps because, tax rates are lower, the government is collecting a lot of additional money. Revenues have been pouring into the Treasury at record rates. In the last 12 months, tax receipts have skyrocketed 14.5 percent, more than four times faster than inflation. And in the previous 12 months, they jumped nearly nine percent, almost three times faster than inflation.[5]

It is especially worth noting that the government is collecting more money from capital gains taxes and dividend taxes. As the Wall Street Journal noted, "…capital gains receipts from 2002-04 have climbed by 79% after the reduction in the tax rate from 20% to 15%. Dividend tax receipts are up 35% from 2002 to 2004, even though the taxable rate fell from 39.6% to 15%."[6]

Opponents of good tax policy make a mistake, perhaps deliberately, by assuming that tax policy has no impact on the economy. They always estimate that higher tax rates will bring in more revenue and would even embrace the absurd notion that a 100 percent increase in tax rates would translate into a 100 percent increase in tax revenues. In the real world, taxes affect incentives to work, save, invest, and be entrepreneurial. Tax rates also affect decisions to engage in taxable and non-taxable activities, and also determine the likelihood of evasion and avoidance. All of these factors help explain why revenues have jumped since the enactment of the 2003 tax cut.

This does not mean that tax cuts necessarily "pay for themselves," but it does mean that the right kind of tax policy-one that lowers tax rates on work, saving, and investment-will lead to faster economic growth. And faster economic growth means more income for the government to tax. In other words, the best way to generate tax revenue is to expand the "tax base."

But the purpose of good tax policy is not to give politicians more money to waste. Pro-growth tax cuts should be implemented to boost economic performance and expand individual opportunity. Indeed, to the extent that pro-growth tax cuts generate more income and a larger tax base, any additional revenue should be used to finance further tax rate reductions on productive behavior.

Not all Tax Cuts are Created Equal

It is not enough merely to cut taxes. In general, tax reductions only benefit the economy if the "price" of engaging in productive behavior is reduced. This is why the 2001 tax cut did not have a noticeable affect on economic performance while the 2003 tax cut has worked very well. The bulk of the 2001 tax cut contained provisions such as a tax rebate, an increase in the child tax credit, and a 10 percent tax bracket for modest levels of income. These provisions may have non-economic merits, but they largely do not improve incentives to work, save, and invest.[7] The 2003 tax cut, by contrast, lowered marginal tax rates on dividends and capital gains-and also made immediately effective the lower marginal income tax rates that were approved in 2001 but not scheduled to go into effect until 2004 and 2006.

The Class Warfare Distraction

Some critics complain that lower tax rates on dividends and capital gains provide too much benefit to the so-called rich. This assertion is based on the mistaken notion that the economy is a fixed pie and that any increase in income for upper-income taxpayers is at the expense of the less fortunate. This is a grossly flawed assumption. The rapid growth since 2003, as well as the millions of new jobs that have been created in the last few years, illustrates how good tax policy benefits all of society.

A smart country is one that relishes and celebrates the creation of more rich people. This is one of America's great strengths. It is worth noting that a society that allows upward mobility produces better living standards for average people. As noted above, Americans have per capita economic output substantially higher than their European counterparts. Average Americans enjoy better housing, more amenities, and greater opportunity.

Conclusion

The lower tax rates on dividends and capital gains have been enormously successful. America now has a stronger economy that is more competitive in the global economy. These beneficial lower tax rates will expire in about two-and-a-half years if lawmakers do not vote to extend them.

The ideal public policy is a zero percent tax rate on dividends and capital gains. A permanently reduced rate of taxation is the second-best option while a temporarily extended 15 percent rate is the bare minimum.

Daniel J. Mitchell, Ph.D., is McKenna Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.