The Budget Battleground
Jude Wanniski
July 16, 1993


In three days of meetings in Washington, I met with senior people in the White House and Treasury, Democrats and Republicans in the House and Senate, four Federal Reserve governors, and several key staff people in Congress who are involved in the budget reconciliation process. What I found encourages me to believe that the President's budget, as it is now conceived, will in the weeks ahead give way to a bipartisan compromise that will be viewed positively by the financial markets, increase the level of economic growth in the years ahead, and of course "save the Clinton presidency." The most important single fact I learned is that Senate Minority Leader Bob Dole and several important House Republican leaders are now indicating they can no longer simply criticize the President's plan. If the President's plan fails to win sufficient support in Congress, they know they must be ready to present the country with a reasonable alternative that could form the basis of a bipartisan compromise -- which means it has to be one President Clinton can work with. If such an alternative can be fashioned and made known before the House and Senate are forced to vote on the Clinton budget, it should have the effect of aborting the Clinton plan in committee with the President's approval.

The confident face the President's team is putting on the prospects of writing a compromise that could pass without any GOP votes masks a despair over the predicament they know they are in. Congressional Democrats had the ten days of the July 4th recess to check with the grass roots and what they found was not encouraging. The people think the Clinton plan "stinks," which seems to be the adjective of choice. The White House is arguing that this is because the President hasn't gotten his message out, to counter GOP attacks, but few really believe this tired party line. They know they have a stinker on their hands. When Sen. John Breaux, Democrat of Louisiana, suggested this week that the $500 billion deficit-reduction bogey the President is trying to hit be reduced to $400 billion over five years, it revealed the precise sentiments running along the Democratic back bench. The White House reacted furiously against the Breaux suggestion, believing such a retreat would add the wrath of Ross Perot to the scathing denunciations of the GOP. Senator Dole wouldn't be surprised if they had to water the budget down to $350 billion to get it passed.

The best vehicle the Republicans have is the outline of a bipartisan plan being worked out by Rep. Charles Rangel, the New York Democrat who may be the next chairman of the House Ways & Means Committee, and Sen. Malcolm Wallop, the conservative Republican from Wyoming. The plan is built around the critical insight of Fed Governor Wayne Angell -- that by combining the complete indexation of capital gains with the ending of the step-up in basis loophole, the Treasury would not only be flooded with revenues, but the economy would boom as well. Angell's insight is easily grasped by Rep. Dick Armey, the Texas Republican, who, like Angell, had once been an economics professor. Armey understands that as soon as the Rangel-Wallop alternative would be publicized, the American people would flood the Capital with support. A plan that would lift from the backs of the American people the tax implications of $7 trillion in inflated assets would cause dancing in the streets, on Main Street and on Wall Street.

The idea fascinates David Gergen, President Clinton's newest counselor, whom I've known for more than 20 years, who had been plugging the idea of indexing capital gains even before learning of the Rangel-Wallop initiative. Clinton actually stated his opposition to taxing inflated gains during last year's campaign, but indexation does not figure in his budget because it loses tax revenue in the static model used for scoring by the Joint Tax Committee of Congress. It had not occurred to anyone to think through the implications of combining with the step-up provision, as Angell has. Rangel, chairman of the Ways & Means tax subcommittee, last month asked Joint Tax to score the Angell idea, and this week it reported its conclusion that it would lose $14 billion over a five year period: Indexation would cost $20 billion, the step-up would gain a mere $6 billion.

We had forewarned Rangel, Wallop and Dole that the Joint Tax methodology would likely produce unsatisfactory results, and that we had to bring into the picture a portfolio theorist of recognized reputation: Harry Markowitz of the City University of New York, who won a Nobel Prize for studying exactly the kind of question that the Angell insight would pose. Clearly Treasury would over time gain close to $200 billion by ending the step-up provision, but Joint Tax makes the simple assumption that individuals would first sell assets heavy with inflated gains, which when stripped out would produce no tax consequences, and hold on to assets with greater tax consequences. This seems common sense to an economist, but experts in finance, like Angell and Markowitz, observe the opposite. That is, investors now behave as Joint Tax assumes, holding gains with greater tax consequences and selling those with lesser, because they are locked into inflated gains. Over the last 20 years of inflation, inflated gains have piled up year after year like water against a dam, Angell argues, and once the dam is removed, the first year would produce the highest revenue gains to Treasury.

The Joint Tax economists have not been exposed to the concept that any portfolio which has a "locked-in" asset is riskier than the investor would like it to be. This means that when the step-up loophole is closed, investors will sell all locked-in assets they have been holding simply to avoid tax consequences. With adoption of Rangel-Wallop, aggregate portfolios would swiftly become much less risky, and aggregate investors would swiftly seek to increase risk in order to increase reward, and the capital markets would be flooded with funds to finance fresh entrepreneurial activity. Rep. Bill Jefferson, Democrat of Louisiana, another member of Ways & Means and the Black Caucus, understands that the revenue effects from this increased economic activity would be several times the amount simply due to the unlocking of past capital gains. Angell believes the federal government alone would realize not $6 billion in five years, but $100 billion in the first year, from unlocked gains and economic action. State and local governments would of course experience revenue surges on the federal piggy-back. I'm getting closer to persuading Rangel that with or without special enterprise zones, capital would flood into the inner cities as well as small-town America, financing the new jobs and job-training that build human capital.

It is of course not possible for Dole to get behind any plan with a $500 billion target as long as Joint Tax methodology is used in scoring. He could, though, back a Rangel-Wallop plan scored at a $350 billion target by Joint Tax and simply announce to the nation that his experts score it at, say, $1 trillion. If President Clinton thought for three minutes on which scoring method was closer to reality, I think he would agree that the finance people are right. Bob Rubin, who is out of his depth in macroeconomic analysis, but knows finance, would also side with Angell and Markowitz. In fact, so would Ross Perot. At the White House, I argued the President has been misled by Rubin into thinking the bond market is the better guide to future economic activity than the stock market. The bond market is where old wealth is protected. The stock market is where new wealth is created. The bond market was never stronger than it was in the 1930s, I reminded Gergen, when interest rates were 2% and the unemployment rate was 20%. Meanwhile, the stock market did not reach its 1929 peak again until sometime in the early 1950s. The Clinton budget, which reduces the rewards to risk, will drive down the stock market if it is somehow rammed through Congress. 

As I've argued all along, the Clinton plan is going nowhere. The media blitz they are planning will only get the message out to more people that the plan stinks. Jim Carville, the President's chief political advisor, is much too smart to believe his own propaganda at this point. He has now begun quietly telling people he thinks the President has to get behind the indexation of capital gains. We advised you last fall that the best thing about Bill Clinton was that, like his hero FDR, he didn't believe in anything particular, which meant he would be willing to try anything -- as it turned out, even David Gergen.

  Gergen has already pulled the President back from the brink of total disaster. The resumption of the bond market rally is almost totally due to Gergen's influence in shutting off administration criticism of Alan Greenspan. As a result of having a champion in the White House, Greenspan can now afford to take greater risks than he has thusfar in shaping the President's thinking. In this regard, his testimony before House and Senate banking committees next week may be worth its weight in gold. There is still some way to go before we can rest easy -- as the forces of darkness never sleep. But it's tremendously encouraging to be reassured this week that so many people in both political parties still want to put the country first.