Politics & Policy

Wrong Ailment, Wrong Cure

Tax-rebating Democrats should open their eyes.

After all the gnashing of teeth, it turns out that consumers turned in a positive performance during the holiday season. Retail sales increased more than 1% in December, yielding a near 5% pace over the past year.

Consumer spending has been the backbone of our economy for the last two years. In that time it has grown at about a 3% rate, despite the stock market collapse and the deep business-and-profits recession. This is a solid consumer performance — yet once again Democrats mistakenly insist on giving consumers a quick one-shot of adrenaline via temporary tax rebates. Wrong ailment, wrong cure. If the Democrats would merely open their eyes they would understand that rebates don’t stimulate the economy, and that consumer spending is not a problem today.

Take a look at the last tax-rebate experiment in 2001. Several studies have shown that it yielded only 17% in consumer spending. The remainder was saved, used to pay down debt, or put in the rent envelope. There’s nothing morally wrong with any of this, but the rebates didn’t spark economic growth.

Milton Friedman taught us long ago that temporary increases in after-tax income neverbecome part of the regular consumer-spending flow. Average people are smarter than politicians think — they know that rebates run out. Only a permanent income increase — like a salary raise or a permanent reduction in one’s marginal tax rate — will permanently change consumer-spending behavior.

The true cause of this recession was the stock market collapse, not a consumer collapse. Companies used their share prices to back their heavy debt. However, when the stock market crashed, and their loan collateral was eviscerated, they were in big trouble. No more loans were possible, and the debt became more burdensome as business prices fell. In deflation-adjusted terms, debt burdens became more onerous, debt payments became punishingly higher, and collapsed stock prices gave firms nothing to fall back on.

Eventually cash-strapped businesses had to roll back operations and lay off workers. Their wealth dropped out of site and their liquidity dried up. Sinking business prices for commodities, goods, and equipment wiped out profits, too. And all this was triggered by the three-year stock market plunge.

So let’s be perfectly clear: Not until this stock market virus is cured will business and the economy ever truly recover.

This is why President Bush’s tax-cut plan is so important. By abolishing the double tax on dividends, it aims directly at the stock market — the real source of the current economic funk. Additionally, across-the-board tax-rate relief for individuals and families will shore up shopping, small business growth, and stock market investing. Bush has outlined a two-pronged growth solution. His target, correctly, is the 40% drop-off in stocks and the related 11% fall in business capital-goods spending — not a slide in consumer spending (which doesn’t exist in the first place).

Of course, the Democrats have unleashed a myriad of class-warfare attacks, saying the Bush proposal will only help the rich. But it turns out that almost three-quarters of dividend recipients, or 70 million Americans, earn less than $100,000 a year. They also receive 54% of total stock dividends, meaning the Bush plan even gives shoppers a nice after-tax spendable-income boost.

But the true worth of Bush’s tax-free dividend proposal is that it will lift stock market values and wealth. Stock prices will rise, investor returns will increase, old capital will be unlocked, and new liquidity will be reinvested. Businesses, meanwhile, will become more creditworthy with a stronger stock market to serve as collateral. This business wealth effect, along with the likelihood of dividend reinvestment by shareholders, will enable companies to expand their operations, update their computer and equipment needs, and start rehiring workers.

Already, the mere mention of tax-free dividends by President Bush has driven up stock market prices by 5% in the new year, brightening the outlook for a business recovery. Yes, the Bush plan will benefit consumers too. But the real story is that Bush has the right cure — investor-targeted tax relief — for the real economic ailment: a disastrous three-year stock market decline that dragged American business and jobs down with it.

Democrats refuse to understand that in today’s investor-class economy, it’s the stock market that drives business production and investment, and it’s business that triggers jobs, salaries, and consumer spending. The longer Democrats remain in the dark on this point, the longer they’ll try to sell America on do-nothing, one-time tax rebates.

Thankfully, the investor-class voter majority is no longer buying what the Democrats are selling.

Mr. Kudlow is CEO of Kudlow & Co.


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