This New Year's resolution for Congress should be pro-growth tax reform. That means permanent, sensible tax laws -- not a system that lasts one year, two years or 10, sending us over a "fiscal cliff" at the end.
Since the onset of the Great Recession in 2007, American households have gone on a fiscal diet, getting rid of excess debt and getting their budgets into shape. It's time for the federal government to do the same. And tax reform is the first place to start.
Of primary importance in reducing our trillion-dollar deficit and paying down our $16 trillion debt is economic growth.
Economists of all political persuasions, from Obama's Council of Economic Advisers Chairwoman Christina Romer to Nobel Prize winner Edward Prescott, conclude that lower tax rates are associated with higher economic growth.
With investment, capital and even people (note French actor Gerard Depardieu's move to Belgium in response to tax hikes) mobile in a global economy, countries with higher tax rates face adverse consequences. Congress should embark on fundamental tax reform, keeping individual and corporate rates low, and broadening the base.
Back in July 2011, President Obama said, "And what I've also said to Republicans is, if you don't like [raising tax rates], then I'm happy to work with you on tax reform that could potentially lower everybody's rates and broaden the base."
Although Obama has changed his mind since the November election, he did spell out a recipe for pro-growth tax reform for 2013.
It's tempting for Congress to raise capital gains taxes, because capital gains form a larger share of income of high-income Americans. But this would slow economic growth, reducing economic activity and especially financing for private companies, innovators and small firms getting off the ground. Taxes on U.S. investment would be higher compared with taxes abroad, so some investment capital would move offshore in response.
There are good reasons for taxing capital gains and dividends at lower rates than earned income.
First, capital gains have a lower tax rate to encourage the risk-taking involved in investment. Investors supply the financial capital essential for investments that spur innovation, improve productivity and expand capacity.
Second, dividend income has already been taxed at the corporate level. The corporate tax rate is 35 percent and is taken out of gains distributed to shareholders. A 35 percent corporate tax rate on top of a 15 percent individual tax rate adds up to a tax on capital of 50 percent.
Finally, many people hold on to capital for years before selling it, and much of the gain they realize when they do sell it is merely due to inflation. Rather than calculate the inflationary gain from each holding, Congress decided to tax such gains at a lower rate.
America's corporate tax rates, at 35 percent, are more than 10 percentage points higher than most of our industrial competitors. Plus, we tax companies on a worldwide, rather than a domestic basis.
Lower corporate tax rates have bipartisan appeal and would attract back some of the $1.7 trillion in corporate earnings held offshore. But currently, if these assets were repatriated, they would be taxed at 35 percent.
A priority for Congress should be to fix the alternative minimum tax so that millions of low-and middle-income Americans are not at risk of being hit by a parallel tax system that was originally set up for the very top of upper-income taxpayers.
With capital mobile in a global economy, it is especially important to ensure that America's environment is hospitable to investment, so that economic growth takes place here rather than abroad. Fundamental tax reform is the place to start.