Politics & Policy

Supply-Side Smelling Salts

Kerry needs a whiff of taxation reality.

It now is almost certain that Sen. John Kerry will clinch the Democratic presidential nomination and advance to the general election where he will face President George W. Bush. While certain polls have Kerry beating Bush in a two-man race, the Massachusetts senator has key flaws in his fiscal program that could morph into a larger problem as the general election takes shape.

Kerry is proposing to cut the deficit in half by boosting the top two income-tax rates back to Clinton levels. This would lift the top rate to more than 39 1/2 percent from 35 percent and the second highest rate up to 36 percent from 33 percent. Presumably Kerry also would reverse Bush’s 2003 tax cuts on capital gains and dividends, clearly the most powerful and pro-growth elements of the Bush fiscal repertoire.

On the spending side of the ledger, Senator Kerry would use the assumed revenue gain to boost healthcare spending on the uninsured and expand education entitlements. According to the National Taxpayers Union, Sen. Kerry’s spending proposals would cost $265 billion per year, or more than $2.6 trillion over a decade.

If the Bush tax cuts are deep-sixed, investors would only keep 60.4 cents on the dividend dollar, down from 85 cents today, a drop of 29 percent. Capital-gains investors would keep 80 cents on the dollar instead of 85, a decline of nearly 6 percent. After-tax rates of return on labor would fall by more than 7 percent for top-rate payers. The combined result would be a 32 percent reduction in the after-tax rates of return to working and investing.

If it pays less to work and invest, less working and investing will be done. At a minimum, this would slow growth.

Even if Kerry pledged not to hike taxes, his resistance to making them permanent would constitute a large tax increase as soon as 2006. Since the Federal Reserve has maintained an extraordinary easy monetary policy, the Kerry tax hikes would almost surely collide with rising inflation. Since tax rates on capital are not indexed for inflation, the expectation of higher tax rates on capital against actual increases in inflation could be very detrimental to asset values.

The 2003 tax cuts on dividends and capital gains have coincided with a more-than $2 trillion increase in the value of the nation’s capital stock. At a price tag of $350 billion, this means the tax cut already has paid for itself nearly six times over. What is more, private-sector GDP growth has averaged nearly 6 percent since the second half of 2003, but grew at less than a 2 percent average annualized rate from the end of the statistical recession until the second half of 2003. Furthermore, a 1 percent increase in the rate of economic growth during the next decade would deliver about $1.4 trillion in additional cumulative tax revenues. Growth matters.

When Ronald Reagan came to office the top marginal income-tax rate was 70 percent and the top 1 percent of income earners shouldered about 9.3 percent of the total federal income-tax burden. By the end of President Bill Clinton’s term, the top tax rate stood just over 39 1/2 percent while the top 1 percent of earners shouldered just under 37 1/2 percent of the total federal income-tax burden. Some argue that the increase in relative receipts from top earners was due to the tax increases enacted by presidents George H.W. Bush and Bill Clinton, but this totally ignores the fact that nearly 70 percent of the increase in tax receipts from the top 1 percent of income-tax payers occurred prior to the 1990-93 tax increases.

While Kerry has promised to be Clinton-like by retaining the tax cuts for lower- and middle-class earners, the most recent data show that the bottom 50 percent of income-tax earners only pay 4 percent of the total federal income-tax take. The top 25 percent, meanwhile, pay about 83 percent of the total federal income-tax burden. Cutting taxes for those who actually pay taxes is the only way to reduce the wedge between effort and reward. If tax cuts are done correctly they do not have to come at the expense of tax-revenue collections or even the progressive nature of the tax burden.

Lower tax rates, faster growth, and a broader tax base is the only way to preserve Social Security and Medicare for future generations without a large-scale budget crisis. This was the message that Federal Reserve chairman Alan Greenspan brought to Congress last week when he testified about long-term budget issues. The Fed chief said in no uncertain terms that Social Security and Medicare could not be saved with growth-retarding tax hikes that wreck the tax base. Someone should tell this to Sen. Kerry. Then, after administering the smelling salts, someone should tell him again.

– Michael T. Darda is chief economist and director of international investment strategy at MKM Partners, LLC, an equity execution firm located in Greenwich, Conn. He welcomes your comments here.

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