A Defining Moment
Jude Wanniski
September 19, 1990

 

The culmination of the year-and-one-half ideological struggle over the capital gains tax is upon us. Perhaps coincidentally, the same fundamental struggle is taking place in Moscow: A ferocious clash between the forces of economic growth and the forces of economic redistribution. The socialist idea itself has lost, but its practitioners cling to power in both Washington and Moscow, knowing the only way they can retain power in the future is to block economic growth that springs from the release of individual efforts through entrepreneurial capitalism.

The liberal Democrats understand this, as they are the remnants of the New Deal coalition, which was glued together by economic depression. The coalition would dissolve if the White House would win a 15% capgains rate with indexation against future inflation -- which would unlock frozen pools of capital while preventing government confiscation of future capital formation. If President Bush can be persuaded to relent at this defining moment, accepting a sickly budget compromise loaded with higher taxes and social spending cuts, we can expect a lengthy period of economic decline and a revival of the liberal agenda as well.

Not many Republicans understand this, certainly not many within the Bush Administration, although it is beginning to take hold with the realization that the Democratic leadership is not receptive to negotiations on capital gains. A week ago, I put it as plainly as I could to a White House official: "The United States cannot exist as we've known it with the capital gains tax where it is." His nervous, incredulous answer: "Well, now, that's pretty strong." For many, victory on capgains would be nice to have, a feather in the President's hat, something good in the long term. But not a panacea. The conservative Keynesians and Friedman monetarists are whispering that the supply-siders are "over-selling" capital gains, that it is not that big a deal. It's not a panacea, they say.

A panacea is a cure-all. Insofar as the economic body has a variety of afflictions, it's true that a lower, indexed capgains tax will not cure all of them. It will only keep the body alive, the equivalent of removing a blockage in the patient's respiratory system. There is a chance the cancer in the banking system can be cured if capgains is cut, no chance if it is not. In a letter to White House Chief of Staff John Sununu, I put it this way:

You and the President should understand why so few economists understand the magnitude of the problem: Almost all economists have been schooled in a demand model which is indifferent to the method by which an income stream reaches a consumer's pocket. That is, the CBO, OMB and Treasury econometric models do not distinguish between sources of income. The following flows to the consumer's pocket are all the same to these models: A government subsidy, a welfare check, a pension, a week's paycheck, an annual bonus, or a capital gain on an inflated 15-year investment.

All that concerns the Democratic economists is that the President's proposal means a heavier flow into the pockets of rich consumers! Most Republican economists prefer a lower capital gains tax for the same reason!!  (Herb Stein actually supports the current rate.) They simply believe it is better for saving and investment, which is a demand concept. This is why OMB and Treasury economists see such a small effect on the economy of a lower capgains rate.

Saving and investment, you see, can only occur after income arrives in a consumer's pocket. It cannot arrive in his pocket from the realization of capital gains if it is first diluted by inflation and then taxed away. Capital formation will grind to a halt, except insofar as the government invests tax and bond receipts via "industrial policy" which is of course what the liberal Democrats want. To see our near future we need only look north to Canada, where both the inflation rate and the capital gains tax have been higher than in the United States since January, 1989. The highest is in Quebec, 38%. The only way the Bank of Canada can prevent a steady bleeding of its dollar assets is to notch interest rates higher and higher. Monetary inflation is no answer, as this simply confiscates capital assets at a more rapid rate. A lifetime tax-free allowance of $100,000 per person on equities, $500,000 on farmland, is the only relief.

New capital growth has halted, the work force has become surly, Quebec separatists are on the march again, the budget deficit is racing ahead, and the "conservative" Mulroney government has a political crisis on its hands as it tries to impose a new general sales tax on January 1, in yet another futile attempt to contain the budget red ink. By one account, federal and provincial taxes in Ontario have been raised 32 times in the last six years of the Mulroney government. As in the United States, the only thing that will avert economic implosion in Canada is a cut in its devastating capital gains tax. Nobody in Canada seems to realize this, and there is no public discussion of it that I can see, but at least I'm told that if President Bush succeeds in the United States, Mulroney may propose a lower rate for Canada.

President Bush cannot succeed with the mess that has been created at the Budget Summit. As long as the President's chief strategist, Richard Darman, has permitted the Democrats to argue within the rich-poor framework, they have had the advantage. The idea of capping state and local deductions, swallowing 10% luxury taxes, and dealing on income-tax surcharges for the rich rich is the net result. In the end it's a useless exercise anyway, because the Democrats will not relent on capital gains unless the President beats it out of them with the biggest stick he has -- his political stick. In the last few days, finally, he has been tying capital gains to economic growth, but as yet there is no stick no threat to the Democrats to hang the coming recession around their necks unless they drop their class warfare and deliver on capgains.

The most likely scenario now is a mini-deal on Gramm-Rudman that avoids budget sequestration October 1. This is the least attractive, because it signals the President's willingness to do business as usual, without the capgains cut. It would then be clear to the world at large that he gave up his no-tax pledge of 1988 for nothing at all. He would, however, be able to run around the campaign trail promoting capital gains, and he would surely do so. But at that point, it would be painfully clear he had simply lost the showdown with the Democrats in a test of political nerve. If he was not willing to accept a painful sequester, which would have gotten the public's attention and alerted voters to the seriousness of the tax issue, why should GOP candidates for House and Senate stick their necks out on this "rich-poor" issue? We would be back to square one after Election Day, with two years before there is another opportunity to confront the Democrats over this defining issue. Bear market.

The decision to exclude Rep. Newt Gingrich from the continuing Budget Summit was a setback for the Forces of Growth. But not a total loss as Sununu remains an insider. Sununu is now a stronger advocate of the issue itself than he was when the process began, and also has a keener sense of the political opportunities, where Darman sees only political risks. And Gingrich is already at work among the rank and file House Republicans, rallying them for a political showdown. He can get so far, but only the President will be able to get the troops behind him on sequestration. It is his domestic mid-East crisis.

The next deadline is a week from Friday, September 28, when Bush will decide whether or not to permit sequestration to take place. In the next week, if he acts and sounds as if he is ready to do so, getting his congressional ranks psychologically prepared, he could still crack loose Democratic resolve. And if he can't, at least Senate Majority Leader George Mitchell, like Saddam Hussein, will know the struggle ahead will be tougher than he bargained for.