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Gentlemen Prefer Bonds
(Ladies, too, of course.)


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Larry Kudlow

There is some debate in Washington and the media over income-tax rate cuts. Some people aren’t sure how rate cuts affect economic growth, and there are still many elected officials — especially the Democrats — who don’t think tax cuts work at all. Well, let’s look to the most recent example — President Bush’s 2001 tax cut.

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John Makin of the American Enterprise Institute has done some great work analyzing the 2001 rate reduction. In a recent article he looks at actual personal tax payments to the Treasury between the end of 2001 and the end of 2002. Makin estimates that President Bush’s first tax-cut plan added slightly over $200 billion to gross domestic product. Without this GDP boost, the economy might have remained in recession over the past year.

Taking Makin’s analysis even further, the drop in tax payments means that the tax share of personal income dropped from 15.1 percent to 12.2 percent. However, if the tax bite had remained at 15 percent — the average for the 1999-2001 period — the increase in personal income would have yielded only a $172 billion increase in disposable personal income — or the money that Americans have left after-tax for spending, saving, and investing. Hence, the reduced tax bite boosted disposable income by $228 billion.

Linking this back to personal spending, the smaller tax bite enacted in 2001 provided an additional $215 billion to economic growth through consumer spending.

This, of course, is the cash-flow view of the impact of lower income taxes. There’s nothing wrong with cash flow, is there? We all could use a little more. But there’s also the marginal rate incentive effect of an income-tax cut, which is the supply-side view.

Lower tax rates provide higher returns, after-tax, for work and investment (also for small-business expansion). When it pays more to work, after tax, people will log in more overtime hours. Sure enough, the jobs data show that weekly overtime hours in manufacturing moved up substantially from a 20 percent decline-rate in the middle of 2001 to a 7.7 percent increase-rate for the twelve months ending in February 2003.

Lower personal tax rates also spur saving and investment. Amidst widespread gloom over the stock market, it has been little noticed that people are investing their extra dollars in bonds. Not just safe-haven Treasurys, but corporate bonds that carry handsome interest-coupon payments.

According to the Wall Street Journal bond index, investment-grade corporate bonds have returned 3.4 percent year-to-date. Last year corporates returned 11.3 percent. So far this year the Goldman Sachs high-yield bond index has returned 5.3 percent. Even the JP Morgan index of international Brady bonds is up 8.6 percent this year. So, it would seem, gentlemen prefer bonds. (Ladies, too, of course.)

These corporate-bond rallies also reflect positive market forecasts for the future economy. People are choosing bonds over stocks today because bond coupons pay cash that can be taken to the bank. This is exactly how investors want to invest. Today, they insist on a decent cash yield when they loan their money to businesses. Soon, they’ll invest more in stocks when corporations start paying higher dividends.

Tax-free investor dividends, the centerpiece of the president’s plan, will light a fire under shareholders to invest in company stocks that pay out juicy dividends, after tax. In fact, tax-free dividends for investors will shift shareholder interest away from bonds and back to stocks.

And while we wait for Congress to act on the president’s dividend-reform plan, the stage is being set for a substantial stock market rally. Since last summer, the major indexes have been forming an extended bottom which — despite the fog of war — reflects some important changes in the economic outlook: The Federal Reserve has ended deflation. Profits are rising, as is productivity. Inflation and interest rates are near zero. And taxes are coming down in stark contrast to the increase in tax burdens that occurred prior to the Gulf War twelve years ago.

War uncertainties and a temporary energy spike have prevented an upside breakout in the stock market, but the pieces are falling into place for what could be a much greater stock market rally than anyone believes possible. Of course, a successful military campaign to depose Saddam Hussein and disarm Iraq still needs to happen. After that, all that’s needed is the completion of President Bush’s second pro-growth tax-reform plan.

Economist Arthur Laffer put it best: If you tax something more you get less of it, and if you tax something less you get more of it. Since President Bush’s plan is to tax the private sector less, we’ll get more from the private sector.

A buoyant stock market will tell the story.

Mr. Kudlow is CEO of Kudlow & Co.



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