During his first presidential debate against President Obama, Mitt Romney was effective in promoting and defending his tax plan, which involves reducing all tax rates, but also eliminating loopholes and deductions available to upper-income earners. It was an illuminating moment when Romney pointed out that his "tax cut" was designed not to reduce the amount of revenue the government collects. He then posed the very important question: "And you think, well, then why lower the rates?"
Unfortunately, most politicians, conservative and liberal, discuss cutting tax rates as if their primary purpose was to "put money in people's pockets." By that standard, Romney's plan would be a failure on aggregate. But that's not his goal. Like Ronald Reagan long before him, Romney aims to make the tax code less punishing for businesses at the leading edge of economic growth. According to his vision, the tax man should show fewer preferences for government-endorsed behavior -- such as installing solar panels, for example, or deducting mortgage interest on a vacation home -- instead save the rewards for those who take the incredible risk of investing in a business.
Entrepreneurship is a high-risk, high-reward business. When you use your life's savings to start a small business, it isn't enough just to expect that you can make a profit. There must be a potential rate of return that justifies the enormous risk involved. Thus, if the federal government stands to take from you 40 cents of every additional dollar you make -- as it will under President Obama's vision -- you will be less likely to risk everything in launching a new business or expanding the business you already have.
But if, instead of the 40 percent rate, you expect to pay the 28 percent rate in Romney's plan, then your potential return immediately grows by 20 percent, without having to take any additional risk -- that is, instead of keeping 60 cents of the next dollar you earn in profits, you stand to keep 72 cents. That makes the investment more attractive. This is why marginal tax rates matter so much to the economy.
"[S]mall business pays that individual [tax] rate," Romney explained in that first debate. "Fifty-four percent of America's workers work in businesses that are taxed not at the corporate tax rate but at the individual tax rate. And if we lower that rate, they will be able to hire more people."
Romney conceded that 97 percent of businesses are not taxed not at the corporate rate but at the lower individual rate. Then he made a vital point that seemed to get lost in the back-and-forth: "But those businesses that are in the last 3 percent of businesses happen to employ half of all the people who work in small business. Those are the businesses that employ one-quarter of all the workers in America. And your plan is to take their tax rate from 35 percent to 40 percent."
Tax rates are not the sole or even the primary consideration for business owners as they make plans. But they are an important consideration. The reason Ronald Reagan and other politicians have treated tax rates as central to government economic policy is that they are one of the very few factors in a business environment over which government has absolute control.
The last four years, in which government intervention has repeatedly failed to solve the economy's problems, offer a clear tutorial on this last point. The 2009-2010 stimulus package failed to return unemployment to the reasonable levels Obama promised when it passed. Home and business loans continue to elude even the most worthy creditors today, despite TARP, low interest rates and government programs intended to encourage lending. And American green energy firms continue to fall behind foreign competitors (think of Solyndra and others), despite enormous federal subsidies.
In short, the Obama years have demonstrated that government cannot control hiring, lending, or innovation. But it can control the tax rate that entrepreneurs face when deciding whether to hire. As Romney knows, keeping those rates low is vital to a robust economic recovery.