Plenty to Worry About
Jude Wanniski
November 29, 2000

The only good news we have this week was from Republican leaders in the Senate, who remain guardedly optimistic that the tax bill still could be passed and signed into law before the end of the year. I am told the administration has no objections to any of the tax cuts, excepting repeal of the telephone tax and a measure having to do with writeoffs of long-term health care. We have seen in recent television interviews with Senate Minority Leader Tom Daschle and House Minority Whip David Bonior that there is genuine willingness to concede on these tax issues and perhaps even go further on repeal of estate taxes for all but the wealthiest 1% of Americans. Everything else being equal, we would expect positive changes this year or next, whomever is elected President, but then must point out that everything may not remain equal. Things can go wrong, especially if Vice President Al Gore remains bent on winning the White House at any cost to his own career, his party or the country. The biggest threat to the tax bill getting done during this yearís lame-duck session clearly is Goreís request for a seven-day Florida recount, which could reduce the degree of bipartisan spirit in Congress.

The fact that the stock market has not produced any net capital gains this year is something else we have to worry about, because the flood of revenues into the U.S. Treasury and state treasuries is largely a function of the enormous capital gains realized in 1999 and taxed this year. Payroll tax revenues only increased by 6% while total revenues increased by more than 10%. When the Treasury finally sorts out where the money came from, it is likely to attribute the difference to income associated with the stock market boom. With the Dow Jones Industrials down 8.25% from the beginning of the year and NASDAQ down 30%, Treasury may be disappointed in the cash flow next April 15. The Congressional Budget Office and Office of Management and Budget are now in the process of adjusting economic projections for the next decade upward, to an annual rate of 3.3% from their current assumption of 2.6%. They have been wrong so often in the 1990's in underestimating the growth rate that now they are pushing it up, just at the time when monetary policy is working to pull down nominal GDP.

The political consequence of lower than expected tax receipts would be increased calls from the budget balancers in both parties to insist there can not be any tax cuts, because we can not afford them. They will insist we really have to lock away any remaining revenue surpluses to pay for Social Security and Medicare. It has not reached the stage where this kind of pessimism is baked in the cake, but it makes it all the more imperative that the pending tax cuts make it into law this year. It also is necessary to have some sort of real fiscal expansion to offset the continued monetary deflation. Here are some problems associated with the deflation, from Spencer Reibman, who studied under Art Laffer at Chicago and now teaches supply-side theory at Georgia State University.† I asked him for his thoughts on where we stand now:

1) In an economy-wide deflation there will be downward pressure on share prices. Companies that are capital intensive and have low debt-equity ratios will outperform the market. For such companies depreciation write-offs will, for once, cause taxable profits to be understated. The market will see through the accounting numbers and will proceed to award higher PE multiples for what will be, in real terms, higher after-tax cash flows. And of course not being debt laden during a deflation is always the preferred position.

2) Software companies will suffer relative to debt-free large-cap companies because they have little to depreciate. And although many workers will experience the benefits of reverse bracket creep, that is until adjustments are made in the opposite direction, those workers, especially at software companies that had garnered and expected to exercise their options when share prices rose, will suffer the equivalent of a confiscatory tax increase on their previous and ongoing efforts. They only temporarily escaped the 39.6% marginal tax bracket with stock options. But no matter how hard they work in the fields, there will be little harvested fruit to take home even after loading the baskets if there is an economy-wide deflation. Many people will be frustrated. This may pave the way for calls for tax-rate reductions. Ironically, falling nominal share prices will result in fictitious capital losses thereby driving down the effective tax rate. When coupled with the decline to 18% on the tax on the sale of capital assets, in real terms, this may bode well for the overall stock of capital in the economy. Nevertheless, unless the deflation is anticipated and factored into wage negotiations, the streets will be littered with the unemployed who refused to accept lower wages when prices in the system fell.

Reibmanís insights on depreciation are helpful in seeing why there are differing effects of the deflation on different sectors, Old Economy and New. As the NASDAQ continues its slide, with the semiconductor index leading the way, it is a marvel there is so little discussion of the culprit: monetary policy and Alan Greenspan. Our analytical framework tells us the only way out of the deflation is an explicit change of philosophy at the Federal Reserve, with a goal of getting the price of gold at least back up to $300. At the $265 level, the deflationary grind goes on bit-by-bit, a week and a month at a time, until a new equilibrium is reached. If the tax bill is scrapped, on the other hand, the price of gold may inch its way back by $15 or $20, relieving a bit of what is practically an invisible mechanism, which few see or understand.

Governor Bush is proceeding with his transition plans, sorting through possible Cabinet choices. When it comes to economic policymaking, there are a dozen key positions in the White House, the Fed, Treasury and State, and as far as I know there are no Reagan/Kemp types thus far being considered. The NYTimes today says Jack Hennessy of Credit Suisse First Boston is being mentioned for Treasury by voices in Austin, along with Donald Marron of Paine Webber. Hennessy at least served in the Reagan Treasury and gets good marks from some supply-siders we talk to. Before the next few days are out, we should be getting a firmer feel for the shape of a Bush administration, if there is going to be one. That is something we worry about most of all. A Republican President with a bum economic team can do as much damage as a Democrat, as we have seen in the administrations of Herbert Hoover and Richard Nixon, with GHWBush not that far behind.