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Gotta Grow
Tax cutting in a time of war.


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Larry Kudlow

Tax cutting is a contact sport in Washington, but the Bush economic team appears not to understand this. They have been mau-maued by Democratic class warriors into accepting demand-side tax cuts, and ignoring one of the wise insights that won Milton Friedman a Nobel Prize — that people will not permanently alter their spending behavior in response to temporary government cash injections. The Bush team should have learned its lesson when the $600 consumer-rebate plan failed to stimulate growth this summer. While after-tax disposable income did rise — temporarily — the cash was quite predictably used to pay down credit-card and household debt instead of to make new investments.

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Unchastened, the White House is now angling for a congressional deal for yet another temporary consumer tax rebate — this one aimed primarily at low-income earners, most of whom pay only Social Security and other payroll taxes. What the Bush team is forgetting is that profitless companies are rapidly laying off employees, and that worker incomes lost through increased joblessness will overwhelm any tax-rebate benefits. More generally, the administration fails to see that this is not a consumer-led recession, but one led on the supply side by investors and businesses. For a supply-side problem, supply-side incentives — not demand-side tax rebates — are the cure.

The facts are well known and undeniable: Over the past year, consumer income has actually increased by 3 percent, but business income (net of taxes and inflation) has plunged 15 percent. With profits hemorrhaging, investment has collapsed. During the year’s first half, overall domestic business investment dropped an annualized 12 percent, with technology investment falling by an unbelievable 48 percent annual rate. By contrast, inflation-adjusted consumer spending increased during this period at a modest but still respectable 2.7 percent annual rate.

One of the problems is Treasury secretary Paul O’Neill. If O’Neill had spent this year telling the business-recession story in speeches around the country, he would have had a much better chance of moving the policy agenda toward seriously reducing the corporate tax burden. O’Neill, however, was too busy marketing Fed chairman Alan Green­span’s argument that consumer tax rebates and lower interest rates would lead to a second-half recovery. When that forecast proved wrong (even before the September 11 attacks), O’Neill proposed to Bush a near halving of the corporate tax rate from 35 percent to 20 percent, but Greenspan blew that idea out of the water in various meetings on Capitol Hill.

One concrete measure O’Neill should be pushing right now is depreciation reform for tech-equipment purchases. Massive technology spending in the 1999 runup to Y2K was borrowed from 2000 and 2001; it was this, along with an unprecedented Federal Reserve deflation, that wrecked the economy and the stock market. By next year, however, obsolete tech equipment will need to be replaced, and accelerated write-offs will make it cheaper for businesses to purchase new equipment. This, in turn, will allow business-equipment manufacturers to reduce their selling prices.

More broadly, the White House needs to talk more often about investor confidence. The 100 million-plus investor class has taken a $5 trillion hit during this bear market, now the second worst in post-World War II history. Exit polls last November showed that more than 60 percent of voters owned shares, yet the Bush administration has never truly reached out to this group. That they do so is more necessary now than ever before. The nearly unprecedented un­ certainties accompanying this war and recession have generated exceptionally high risk premiums; this is why risk-averse investors have put their cash in money-market funds and bank savings accounts. In order to get this money moving back into the economy to fi­nance a new round of entrepreneurship, we have to overcome the unusually high degree of risk — and to do that, we will need to hold out the prospect of greater after-tax rewards on capital.

For this reason, we need to cut the capital-gains tax rate substantially; I would suggest we cut it to 10 percent. But if Democrats stonewall cap-gains relief, then why not increase the capital-loss deduction to $10,000 or $15,000 (from the current $3,000)? And why not eliminate the complicated holding-period provisions of current law that have removed much-needed liquidity from the market? Let’s get rid of the five-year holding period that, under current law, qualifies an investment for an 18 percent cap-gains rate; and let’s also scrap the one-year-holding-period requirement that forces investors to pay a 40 percent cap-gains tax on stocks they sell after less than a year.

White House economist Larry Lindsey wrote one of the best books (The Growth Experiment) about the success of Ronald Reagan’s tax-rate-­reduction plan, but Lindsey seldom talks anymore about the incentive virtues of reducing high marginal tax rates. Lindsey used to make the case for dynamic scoring of supply-side tax incentives; nowadays he never mentions the fact that lower tax rates are directly related to higher economic growth and tax revenues. Lindsey should be out there doing battle for these and other supply-side ideas — particularly, for making the income-tax reduction (including the cut in the top marginal rate from 40 percent to 35 percent) effective immediately, rather than in 2006.

Sadly, instead of jostling for its product in the marketplace of ideas, the Bush economic team has conceded the media high ground to the class warriors. Surely most of the 112 million workers employed in the private-sector economy know full well that businesses create jobs; and just as surely does the 100 million-plus investor class understand that businesses require capital in order to turn new ideas into commercial products. That’s how a slow economy is transformed into a rapid one. The Bush administration needs to make the case that instead of fighting each other, investors, businesses, and workers need to realize that they are all in this to­ gether, that each needs the others’ re­ sources to increase the economic pie. As a matter of economics, this is always true. But today — when maximizing growth is a weapon in winning the war against terrorism — it’s a more important point than ever, and the administration ought to stress it, repeatedly and vigorously.



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