Politics & Policy

Big and Bold

Bush's tax-cut package could be ten times better than expected.

President George W. Bush’s economic-stimulus proposal has far-reaching, positive implications for the economy and the stock market, both near-term and longer-term. Because the proposal is bold and just-emerging, its impact has not yet been fully valued or priced into the financial markets.

Today, questions as to the full impact of the proposal abound. Here’s what’s being asked, followed by my early answers.

How does the package compare to last week’s expectations? It’s much better. Income-tax rate cuts are a powerful incentive for labor and innovation. A 100% dividend exclusion is an order of magnitude more stimulative than the limited exclusion that had been expected. To get dramatic, this package may be ten times better than the one under public discussion last week.

What are the benefits from the 100% dividend exclusion? Eliminating the double taxation of dividends would unlock equity capital, lower the cost of capital, and liquefy the U.S. capital structure, adding dramatically to U.S. growth. Right now, there’s a tax wedge between corporate earnings and shareholders. This would eliminate that wedge, allowing a more efficient allocation of capital.

What about the “cost” of the tax cuts? People are underestimating the importance of this package because they are looking at the costs rather than the benefits. The “cost” of the Bush proposal is $670 billion over ten years. Expectations were for a $300 billion package. Nominal GDP over 10 years, assuming 5% nominal growth, is $132 trillion. So, some will argue that the package has doubled from 0.2% of GDP to 0.5% of GDP and is still not big enough to matter. Wrong. You can’t measure the benefit of a tax cut by the size of the cost because: 1) the computer models that measure the “loss” are notoriously inaccurate (overstating the loss); 2) the economic benefits from a better U.S. capital structure and from income-tax relief are large and aren’t included in the calculation of the “cost”; and 3) accelerating the income tax cut will be scored as a cost, but it probably has strong benefits for the economy because the phase-in was causing a delay in economic activity and created uncertainty about future tax cuts.

What’s the effect on the dollar? A bold tax-cutting process in Washington will boost U.S. growth prospects relative to Europe and Japan and will tend to strengthen the dollar relative to the euro and yen. To the extent that the demand for dollars goes up, it will be important for the Federal Reserve to supply more dollars. Remember that the tax cut of the early 1980s increased the expected U.S. growth rate, strengthening the dollar massively from 1981-1985.

What’s the deficit impact? The deficit issue is probably less important to the economy and the political situation than with past tax bills. The president is saying he will make tax decisions based on improving the economy and the tax code rather than green-eye-shade deficit estimates. He said: “They (the tax cuts) are essential for the long run as well, to lay the groundwork for future growth and future prosperity. That growth will bring the added benefit of higher revenues for the government, revenues that will keep tax rates low while fulfilling key obligations and protecting programs such as Medicare and Social Security.”

The president is on firm economic and political ground. The U.S. debt-to-GDP ratio is much lower than it was in the 1980s or 1990s. The fiscal deficit is very sensitive to economic growth and is easily financed at low interest rates. We all saw in the 1990s just how quickly the deficit turns to surplus in the event of economic growth. Congress’s Joint Committee on Taxation will eventually provide its own “cost” estimate, which may differ from the $670 billion 10-year estimate used on Tuesday, but these scoring exercises won’t play as big a role in the legislative process this year as they have in the past. Ten-year deficit estimates (even two-year estimates) have been very inaccurate, and the legal pay-go framework requiring their use expired at the end of the last Congress.

Chances of passage? There’s a high likelihood of a tax cut getting enacted. It will be different from the president’s proposal after it passes through the congressional sausage maker, but not that different. On his side, the president will have the boldness and substance of the proposal, his own popularity, majorities in both houses of Congress, progress on Iraq, and ample benefits across almost all the population. Some opposition may come from the class-warfare crowd, states worried about their monopoly on tax-exempt income, Democrats ideologically opposed to tax cuts, and perhaps REITS or others who didn’t directly benefit from the proposal. But in the end, a bill along the lines of the president’s request has a good chance of enactment later in 2003.

What’s the time frame? Enactment could occur by July, but that might slide. The president will set an ambitious timetable, but each congressional step is time consuming. Per the Constitution, the House initiates revenue measures. The Ways & Means Committee will hold hearings, review various proposals including the president’s, and then begin a markup process (structured decision-making using draft provisions and cost estimates). The markup document would most likely be based on the president’s proposal. Ways & Means would vote, then the full House of Representatives would vote, bringing us through April. The Senate Finance Committee would then hold hearings, markup a different legislative proposal, and vote. Then the full Senate would debate (sometimes at length) and vote. Then there’s a House-Senate conference to reconcile the House and Senate bills.

When will the tax cut take effect? The president’s proposal is to make some of the tax cuts effective January 1, 2003. Congress often chooses a later effective date, but might agree with the president on this. The stimulus effect depends on the effective date (the earlier the better) rather than on the cash-flow date. In his speech, the president said he would have tax withholding reduced upon enactment of the bill. This would add to cash flow in the second half of 2003. Some cash benefits would show up in taxes in April 2004.

Which type of company benefits? There are at least two types of benefits from the dividend reduction. The first-order effect is to re-rate upward companies with cash or with access to cash now (through borrowing) or in the future (through positive cash flow). The second-order effect is through improved capital allocation within the country, lifting most equities through improved growth prospects. Eliminating taxation of dividends would have far-reaching effects. Some other possibilities are that cash-rich foreign equities will probably benefit, and that merger-and-acquisition activity among big companies may decline.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.


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