Politics & Policy

A Capital Offense

Is Greenspan looking at the same economy as the rest of us?

Why is Alan Greenspan sabotaging the president’s tax cut?

In recent remarks to a group of U.S. senators, the Federal Reserve chairman reportedly said the economy was not in need of any stimulus and that the elimination of the double tax on dividends was unnecessary. What could he be thinking?

The economy is clearly soft. The growth of our gross domestic product — the measure of the economy — is running behind the rate of productivity. This is pushing down jobs and bringing the unemployment rate higher. Corporate profits are starting to recover, but companies are still not sufficiently confident to embark on new spending of their own — spending and investment that would mean business expansion and more jobs. Consumers have carried the day so far during this soft recovery, but even shopping rates look to be a bit tired of late. Is Greenspan looking at the same economy as the rest of us?

Today we are in a three-year-old trend of below-par economic activity that has in large part been caused by the destruction of wealth, especially business wealth. As a cure, an elimination of the investor dividend tax would amount to a 30% reduction in the tax burden on capital. It would be a real game-changer.

By reordering investment incentives, the dividend tax cut will de-leverage corporate balance sheets and reduce wasteful corporate spending on stock buy-backs and empire-building acquisitions. Business tax compliance will replace tax evasion schemes because after-tax retained earnings will be “deemed dividends” that lower the tax basis of an investor’s capital gains.

Simply put, Alan Greenspan should see that the tax bite on capital will decline with the dividend tax cut and that the value of future returns will be greatly boosted by the reduced marginal tax rate on those returns. This will send plenty of new money into the equity markets and raise share prices.

Since the economy is suffering from a dearth of capital, a basic supply ingredient that is vital for economic growth and job creation, economic policy should be aimed at a supply-side tax cut to cure the problem. Demand-side solutions, such as those proposed by Sen. Tom Daschle and other leading Democrats, have been proved ineffectual time and again. The Democrats call for tax rebates, but less than one-fifth of temporary tax rebates are ever spent. Economic theory and real-world evidence teach us that temporary tax changes have no permanent effect on individual behavior.

George W. Bush’s plan to remove the tax on investor dividends and speed up income-tax cuts across-the-board will have both supply and demand effects. More disposable income will be spent. Lower tax-rates and higher after-tax rewards to work and invest will motivate people on both fronts.

The Federal Reserve has rightly been pumping new cash into the economy in recent months, as evidenced by the dollar exchange rate, which has eased, and the price of gold (even non-war-threatened gold), which has moved up. These are positive signs in the fight against deflation. And this is where Alan Greenspan and the central bank should continue to aim their artillery.

In general it appears that deflationary pressures are waning, but businesses have still not regained pricing power.

During the recession and this oh-so-slow recovery, the market value of business wealth, which is the principal collateral behind business loans, has plunged so very far. Not until this collateral is revalued significantly higher will business borrowing and equity-raising power be restored.

Right now nearly all the business fund-raising windows are closed. Initial public offerings and venture-capital investments are nil. Bank lending for business purposes is scarce. Homeowners can get plenty of mortgage money because real-estate markets are strong. But businesses in search of liquidity remain empty handed because stock markets are so weak. The problem today is capital, not consumption.

Rather than lobby senators to do nothing — a reckless position — Fed chairman Alan Greenspan should throw his weight behind the president’s dividend tax cut. That’s the best tax incentive to restore business capital formation, and the surest way to put the stock market back on track. While he’s at it, he should also make sure to keep the Fed’s monetary spigots open. That will finance today’s new tax incentives and guard against any dangerous relapses into deflation.

Get with the growth plan, Alan.

Mr. Kudlow is CEO of Kudlow & Co.


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