The tax cut and the ongoing reflation have been the driving forces behind the recent stock market surge — a full $750 billion increase in U.S. equity market capitalization. They have helped extend the stock repricing that took place when Iraq uncertainty diminished, and have more than offset the damage from expensive oil.
For some time now, reflation, the tax cut, and Iraq repricing have been enough to lift stock prices. Lower oil prices, proof of future earnings growth, higher Treasury bond yields, and/or some improvement in the economic data will sustain this process. All of these should occur over time. More, the cost estimates done by Congress in evaluating the tax cuts explicitly excluded any consideration of the benefits of tax cuts — including equity gains in the stock market, added capital-gains taxes, and faster economic growth.
Indeed, the tax cut is still being underestimated. The top marginal rate on federal income will decline from 38.6 percent to 35 percent, meaning taxpayers will keep 65 percent of additional income, up from 61.4 percent. This is a 6 percent increase, not the widely cited 3.6 percent benefit.
Those receiving dividends will keep 85 percent, up from 61.4 percent — a 38 percent increase in after-tax dividend income. Those earning capital gains will keep 85 percent, up from 80 percent, for a 6 percent increase. These figures don’t take into account state and local taxes, which would subtract a bit — up to one-third — from the benefits. But there should still be a more-than 12 percent gain in disposable personal income over the next twelve months.
Since the tax cut suddenly became a reality late last month, U.S. equities have gained some $750 billion. Comparing this gain to the $300 billion net present value of the ten-year cost of the tax-cut (at a 5 percent discount rate), the gain is 2.5 times the cost — or a 150 percent return on investment. This doesn’t count in any GDP growth due to the tax cut, which will be material as the reduced obstacles to labor, capital, and innovation spur the economy.
Why didn’t equity markets price in the tax cut earlier? Until the end, there was skepticism about the Senate finding the 50 votes that were needed to pass a growth-oriented bill. The surprisingly powerful solution was a tax cut that was bigger, more growth-oriented, and earlier than almost any expectations. The tax-cut drama followed the same script as the Iraq war — markets depressed during the uncertainty phase and repriced within weeks.
Oil prices, meanwhile, are still important to the the growth outlook. However, the current damage from expensive oil is more than offset by the tax cut.
U.S. oil usage (import and domestic) now amounts to 7.1 billion barrels, $213 billion at $30 per barrel. A 30 percent price decline would reduce that dollar figure by $64 billion per year, about a quarter of the annual gain in disposable personal income from the tax cut.
Expensive oil is also driving up the cost of other forms of energy, and is diverting investment to unproductive activities (i.e., Siberian exploration). Yet the tax cut still provides substantial incentives for new investment in the U.S., offsetting the oil-price damage. So, if and when oil prices decline, there will be a substantial additional stimulus to the economy.
In his June 1 New York Times piece that was critical of the tax cut, columnist Paul Krugman stated that, as a share of GDP, “federal taxes will be lower than their average during the Eisenhower administration.” This may be true for 2004, but it is misleading.
First, government receipts in 2004 will still suffer from unusually depressed capital gains, so it’s not appropriate to compare 2004 to an average level in the 1950s. It’s clear from the full data that tax receipts bubbled in the late 1990s and would only be brought back to normal by the three Bush tax cuts. Second, federal tax receipts in this decade should not necessarily be as high as they were during the Eisenhower administration. At that time, the U.S. was fighting the Cold War, which was arguably more expensive than the war on terrorism. More, state and local governments are bigger today, absorbing some of the federal burden for services.
So don’t be led astray. The surging stock market and rising economy will bear out the positive significance of this latest Bush tax cut.
— Mr. Malpass is the Chief Global Economist for Bear Stearns.