1/18/01 2:00 p.m.
A Cure for Mutual-Fund Malaise
Happy New Year! You just lost $5,000.

By Stephen Moore, president of the Club for Growth & NR contributing editor

ast week I, like millions of other Americans, received my mutual-fund statement for 2000 in the mail. It read something like this: Happy New Year! You just lost $5,000. Ouch!

Yes, the economic slowdown is finally hitting home. Most of us have become so accustomed to double-digit percentage increases in our retirement nest eggs during the 1990s that it seems those gravity defying rates of returns are a quasi-entitlement. To actually lose money feels like being a victim of armed robbery!

Alas, I'm not alone. In the last six months Americans have lost more than $1 trillion in financial wealth. Those are mountainous losses: larger than the entire GDP of all but a handful of nations. If you're unlucky enough to have heavily invested in Internet stocks, you're experiencing a family financial depression. X recently reported on the returns on the 10 Internet stocks with the largest market caps in January 2000. The average return in 200 was a negative 45 percent. Here were the returns for some blue-chip stocks.

These days the paramount question on the mind of most investors — and that's now about 85 million of us — is: What's George W. Bush going to do to get our mutual funds back in the black? Herein lies a big problem: The single most effective policy tool to revive a sagging stock market, particularly for the high-tech firms that have tanked the most, is a capital-gains tax cut. Yet the Bush economics team has strangely not yet called for capital-gains tax relief in their trillion-dollar tax plan.

This is a nearly unforgivable oversight, because the evidence is so compelling that the last capital-gains cut had universally favorable economic and fiscal effects. In 1997 the congressional Republicans enacted a reduction of the capital gains tax from 28 to 20 percent. Here's a quick review of what happened.

The latest tax collection data from the Treasury Department indicates that capital-gains revenues have exploded. In 1996 the last year with the 28 percent rate, the government collected $62 billion in capital-gains receipts. Since then, in '97, the rate has been at 20 percent, and receipts have risen from $79 billion in '97 to $89 billion in '98 and to an estimated $110 billion in '99.

The 1999 estimate is based upon IRS tax withholding data collected by ING Barings economist Larry Kudlow. In the three years since the tax-rate cut, the tax receipts are up an astonishing 74 percent even though the tax rate is down by almost 30 percent. This is the legendary Laffer curve (lower tax rates equals more revenues) in spades. To be sure, in 2000 the revenues from capital gains will be down, but still a lot higher than in 1996.

The capital-gains tax cut corresponded with two other positive economic trends. First, risk capital funding for new business start-ups increased by nearly 50 percent between 1997 and 2000. If we want an investment-led recovery, then capital-gains cuts are crucial.

Second, the stock market soared after the capital gains cut of 1997. In 1997, for example, the Nasdaq stood at 2,400. Three years later it was at 5,000. It now sits at below 3,000. Nothing could pull the Nasdaq out of its gloom more efficaciously than a tax rate cut made retroactive to the beginning of 2001.

Why should we expect lower capital gains tax rates to inspire a chain reaction of greater investment spending and higher asset values? The straightforward answer is that when Congress chops the capital-gains tax, it increases the after tax rate of return on real assets (like plant, equipment, and technology) and thus the value of the stock rises. Remember: a capital gains tax is merely a punitive second layer of tax: the value of a capital asset is no more nor less than the discounted present value of the revenue stream it produces. Under a rational tax system, we would tax the income stream or the asset value, but not both.

The biggest obstacle to another rate cut to 10 or 15 percent on capital gains is the Joint Tax Committee (JTC). You see, the JTC still uses an obsolete economic model when it tries to predict how much a capital-gains tax cut will cost. It's called static revenue scoring and it produces absurd results. Back in 1997 the JTC model predicted we would lose $75 billion if we cut the capital-gains tax, when the Treasury's actually gained about that much in receipts. If you were to take a plane trip from Chicago to Detroit and somehow ended up on a different continent, you'd be dealing in roughly the same magnitude of miscalculation. Unfortunately, the JTC is still using the same garbage-out model. Ask them what happens if we now cut the tax rate to 15 percent and they reflexively respond that the government loses revenue.

Bush should insist that the rate be lowered immediately and that the JTC use a model that actually has some predictive power in terms of the impact of the rate cut. The tax should also be indexed for inflation as a matter of basic tax fairness.

If the market doesn't turn around soon, there will be hell to pay in the elections of 2002 — and Republicans will be the target of voter agitation. Mr. Bush should seize the moment and doggedly press for deeper capital-gains tax reductions with indexing for inflation. The new president not only has history solidly on his side — but also 75 million nervous investors, as well.