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The Bush Bounce
Markets are looking up. But there's more work to be done.


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Larry Kudlow

Since early April, U.S. stock markets have been signalling strong approval of President Bush’s newly released pro-growth domestic and economic policy initiatives. The stock market is the best barometer of future economic growth and wealth creation. So, its reactions to government policy announcements should be used by officials and investors as a referendum on whether the nation is moving right-way or wrong-way.

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Over the past month the market signal is clearly flashing right-way. The risk-sensitive NASDAQ has gained 37%. The broader S&P 500 is up by 14%, with the Dow Jones increasing 15%.

Over the last two weeks, especially, the administration has gained ground on its tax-cut plan and has also unveiled policy statements on energy, Social Security retirement, SDI, and the China-Taiwan story. In each case, President Bush is increasingly perceived as a courageous, serious, and thoughtful thinker with decisive and well-organized management abilities. He is in charge.

Investors have always preferred Bush’s free-enterprise leanings, but were never quite certain if the Texan would clearly grab the reigns of government policy after the divided election. Nowadays, however, more and more equity-market participants believe that Bush is plenty-of-hat with a great many cattle.

Unquestionably, the biggest stock-market issue is the tax cut. Now it is clear that — at least in static-revenue terms — the president will be getting most of what he asked for. However, much more important than all these phony 10-year budget numbers — which really aren’t worth the paper they’re printed on — will be crucial questions as to the timing and structure of the tax cuts. In particular, will the administration be able to accelerate and front-load their proposed marginal-tax-rate reduction plan?

If lower personal tax rates take five years for completion, the full incentive effects for enhanced capital formation and growth will be delayed. But the more up-front the tax-rate cuts the faster the growth stimulus will kick in.

Right now, the key issue appears to focus on a debate between one-time tax rebates or quick marginal rate cuts that could be passed in June and made retroactive to January 1. Unfortunately, rate-cut supporters such as Sen. Charles Grassley appear to be leaning towards relief only for the lowest-15% bracket this year. While that’s still better than refunds, it would amount to nothing more than dropping helicopter money from the sky. It will barely have any impact on upper-income earners who would receive less than 1% incentive gains.

Much more promising is a possible reform of the capital-gains tax. This is a real sleeper issue that is beginning to matriculate through stock markets. Democratic support for cap-gains relief is growing in both the Senate and House. With Republican leader Trent Lott strongly behind cap-gains relief, the probability of success on this front is growing.

A senior Senate budget-staff member told me Wednesday that a cap-gains reform plan could include two key revisions. First, a 50% exclusion may be in the cards. This would mean, for example, that if the top income-tax rate is dropped to 33%, then the new capital-gains tax rate would fall to 16.5% from the current 20% rate. Should the top income-tax bracket be paired down to only 36%, then the basic cap-gains rate would be 18%.

Additionally, cap-gains reform could include a repeal of the 12-month holding period necessary to realize the lower cap-gains tax rate. This would be a huge plus for the stock market. It would expand much-needed liquidity and would encourage investors to move out of money-market cash funds and back into equities without fear of paying a tax penalty should markets suddenly reverse course and decline from another energy shock or other unanticipated threats.

One thing is becoming certain: The nation is heading for the first income-tax cut since 1987. And as far as those phony budget-revenue scoring baselines are concerned, increased growth from higher after-tax capital returns and lower investment costs will recoup at least 50% of the so-called static revenue loss within five years of full implementation.

Apart from stock-market approval, the strong performance of the U.S. dollar is another hint that markets are incorporating lower U.S. tax rates in their future. Look for King Dollar to appreciate by 10% as income-tax-rate reduction is implemented. If a surprise cap-gains cut is included in the final package, then the dollar will gain even more and next year’s economy could climb back to 3.5% growth.

Elsewhere among the Bush policy proposals, investors are giving Dick Cheney’s recent energy speech high marks. The veep emphasized that energy production — not conservation — is the answer to shortages in electricity, natural gas, and other power providers. Even liberal Democrats like Sen. Chuck Schumer are signing on to the concept. The high-tech wired economy is a big user of electricity, which has risen to 40% of total energy from 25% only 10 years ago. Cheney included nuclear energy in his package of proposed power-supply sources, a long-overdue idea.

Then there’s Social Security reform, which is pro-saving, pro-investing, pro-capital-formation and pro-growth. Add to this House passage of pension reform to expand IRAs and 401(k)s. Nothing will happen immediately, but the good news is that Bush & Co. are putting personal retirement accounts front and center on their economic agenda. No wonder Democrats led by Sen. Tom Daschle are screaming like stuck pigs.

Not only would private investment accounts with a 2% or 3% putback of payroll taxes amount to a tax cut on lower income Americans, but the reform plan implies major political realignment. Of course, Bush will strengthen his ties to the investor class, but Social Security reform will play well among heavily Democratic voting groups such as blacks, Hispanics, labor, and senior citizens.

Ownership is a key theme here, along with economic growth. Share-holding owners will lean Republican and favor free-enterprise over government intervention. And, of course, they’ll have a source of high-yielding retirement funds without paying higher payroll taxes in the future.

In coming weeks, President Bush would be well advised to link personal tax cuts with Social Security retirement accounts. The distribution tables change radically when private investment accounts are added to the calculus. Folks at the low end of the income distribution hardly pay any income taxes, but they are increasingly overburdened by big payroll taxes paid on the first dollar of income earned. That group includes any number of stay-at-home moms or pops who have been forced to work during the early child-rearing years because of increasingly onerous payroll taxes which fifty years ago were only 4%, but today are over 15%.

All in all, Bush is having his way. And it’s the right way. The administration is moving to reform U.S. economic policies in a 21st-century direction. Market-oriented individual choice, ownership, and wealth, supply-side incentives for investment and production, and reduced government planning and regulating — the stock market loves it. And well it should.



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