One of the most impressive features of the Bush tax plan was the speech the President gave Tuesday at the Chicago Economic Club in presenting it. It is the first speech on economic policy he has given as President or candidate for President that sounds as if it was written by a supply-sider. No more “putting money into people’s pockets,” which was Larry Lindsey’s approach since he became the top Bush economist in 1999. Now it is “leaving more money in people’s hands to spend or invest,” which was always Ronald Reagan’s formulation, and is of course the formulation of Glenn Hubbard, the chairman of the Council of Economic Advisors, and a dedicated supply-sider.
For the first two Bush years, Hubbard has been more or less sitting in his office making paper airplanes, now and then going on television to say nice things about putting money into people’s hands. A former professor at Columbia where he and Bob Mundell have been on friendly terms, Hubbard had worked on this plan to end the double taxing of dividends in the last Bush administration and had it ready to go. I frankly was skeptical until I saw Monday’s NYTimes and saw the President was going for the whole kit and kaboodle instead of a halfway measure, one that would be messy in application and would confuse the public into thinking it was just a giveaway to the rich. There is now chatter on Wall Street that Mr. Bush went for 100% thinking he would have to negotiate away half to get the nine Senate Democrats he needs to get tax legislation to his desk. My sense is that the White House is fully prepared to go for it all, with the President and his team ready to do battle against Robin Hood to get there. It is more likely that the advertised help for state and local governments that had been floated was dropped from the plan so the Democrats would have something to demand in exchange for support of the whole.
My first preference was always for the elimination of the capital gains tax, but the President seems wary of that approach on the rich/poor arguments. It is much easier for everyone on the team to point out that it is not only a huge drag on investment to tax dividends twice, but also unfair. Paul Krugman of the NYT is outraged by this argument, saying income is also taxed twice, first as income and then on sales tax. But that means dividends are taxed three times, first as corporate profit, then as dividends, then on sales tax. The classical way to think of the reform is that it lowers the marginal cost of capital, which makes capital more plentiful as the economy can put more of its surplus time, energy and talent at risk. By Michael Darda’s calculations, reducing the maximum effective tax rate on dividends from 70% (top corporate rate + top marginal income tax rate) to 35% (dividends taxed once as corporate profits) boost after-tax returns by nearly 116% (investors will keep 65 cents on the after-tax dividend dollar from only 30 under current law).
The greatest beneficiary of an increased supply of capital is of course labor, not “the rich.” One of these days I expect the President to talk of the need to “drive up the capital/labor ratio,” and be able to explain that labor only benefits when it becomes scarce relative to capital. If a worker digs a hole with a shovel the C/L ratio is 1:1. If he digs with a backhoe, it may be 10:1. If he digs with a giant power shovel, it could be 100:1. At 1:1, the worker gets paid a subsistence wage. At 100:1, he can enjoy a high living standard, with a good slice of the 100, the rest going to pay capital. Because of the errors made in monetary and fiscal policy in recent years, the returns to capital have been falling and the economy has had to shed labor. Paul Krugman does not see things from that standpoint because the C/L ratio is not part of the everyday language of Keynesian or Monetarist Ph.Ds. The only member of Congress I’ve ever found who knew right off the bat about it is Rep. Bill Jefferson [D LA], a member of the Black Caucus, who went back to college at night to study tax law after he was appointed to the Ways&Means Committee several years ago. Some Democrats on Ways&Means are already conceding the ending of the double-tax is a good idea, but “not now.”
Gary Robbins of Fiscal Associates, who I noted in my Monday report is the best supply-side technician I know, today says he can’t find any flaw in the Bush plan. By his reckoning, the economic growth it would engender over a 10-year period would add $280 billion per year in constant dollars, against a static cost of $70 billion per year. With this kind of overwhelming effect, arguments about what kinds of changes it will bring about in the way corporations handle profits become insignificant. In other words, the flood of fresh capital that would be formed would dwarf any errors individual corporations make in allocating internal capital.
Right out of the box, there are complaints that the plan will adversely effect state and local governments. First, it is said, because tax-free municipal bonds used to finance state and local infrastructure will be less competitive with corporate equities. And secondly, because most state governments piggy-back their income taxes on the federal rates, which means they would not see dividend revenues when they are not taxed by the feds. Gary Robbins says the fears are groundless. The elimination of the tax on equities will drive up the price of equities, and at the higher price the marginal return on capital will drop to where it had been previously, so muni competitiveness with equities will remain the same, give or take one or two basis points at most. And the economic growth engendered by raising the C/L ratio would shoot up state and local tax revenues far beyond the little bit they get from the piggy-back tax on dividends.
In today’s WSJournal, you will see that Hubbard added another wrinkle that creates a 1:1 capital gains exclusion if companies re-invest after-tax income instead of paying dividends:
“Here`s how that part of the plan works: For every $1 a company retains as earnings instead of paying it out as dividends, a shareholder would be allowed to exclude $1 per share from his taxable gain at the time the share is resold. The purpose of the plan, Treasury officials said, is to prevent the pendulum from shifting too far in favor of dividends, and forcing companies to pay out dividends when they would prefer to reinvest the money. ‘What we're trying to do is get rid of the bias against dividends,’ said Assistant Treasury Secretary Pam Olson. But at the same time, administration officials ‘don't want to create a bias’ that pressures companies to pay dividends when they shouldn't.’”
It will take several months before the plan wends its way through the congressional process, so there is always the risk it could be disrupted by geopolitics. We still believe war with Iraq will be averted, as the UNSC will not have the evidence it needs to support a military action. The warhawks are now counting on a buildup by February to be so far along that Mr. Bush will pull the trigger anyway. This was the pattern in 1991, when Saddam Hussein raised the white flag at the last minute and the elder Bush decided it was too late for that, and that Iraq had to be driven out. (Which is why there were so few US casualties; the Iraqi army began to run before Desert Storm began.) The situation is different now and the force structure in the Gulf not nearly as large. So war can be averted.