Politics & Policy

Good, Bad, and Ugly?

Surely the economy can't be all these things.

Back on January 18, the Wall Street Journal published three stories that, taken together, painted a confusing picture of the current economic environment. The headlines set forth the muddle: “Tax Cut, Shareholder Pressure Stoke Surge in Stocks Dividends”; “The Housing Market’s Dangers”; “As Dollar Weakens, Hidden Strengths May Stave Off Crisis.”

These appear to be three distinct stories without a significant common thread, the first telling of the economic “good,” the second of the “bad,” and the third of the “ugly.” However, when you take these stories together, clean up the episodes of flawed analysis, and fill in the serious omissions, a new, single story emerges — and a very bullish one at that.


The Journal’s article on stocks nicely documents the surge in dividends since the Bush administration lowered the tax rate on dividends. It points out that 24 additional companies in the S&P 500 are now paying dividends with 421 companies announcing dividend increases. It also mentions that U.S. companies paid out a record $113.6 billion in dividends last year. For 2005, dividends should increase more than 12 percent for S&P companies. The numbers clearly document that people respond to incentives.

It is unfortunate that the article falls short after telling such a great supply-side story. The piece points out that the current dividend yield of 1.8 percent is much lower than the prevailing levels of the 1950s, when dividend yields ranged from 3 to 6 percent. But this analysis fails to take into account the effect of taxes on the net dividends received by shareholders.

During the 1950s the top personal income-tax rate was 91 percent, thus a 6 percent dividend yield before taxes produced a 0.54 percent after-tax yield. On the higher end today, at a 15 percent dividend tax rate, a 1.8 percent dividend yield produces a 1.53 percent after-tax yield. On an after-tax basis, the 1950s were not better than today.

Effective tax rates on capital gains and dividends have steadily declined since the 1960s, increasing the after-tax “keep rate” for investors. With the second Reagan tax-rate cuts, capital gains had an advantage over dividends, which explains why the number of companies in the S&P 500 paying dividends declined from 469 to 351 during a 25-year span. It also explains why returns in the 1990s were mostly generated in the form of capital gains, why corporate structure changed to take advantage of the new tax laws, and why corporate behavior also changed, with some companies going over the line.

So, if the tax-rate changes of the 1980s help explain the decline in dividends as well as the corporate malfeasance that followed, you can also say that today’s lower dividend tax rate eliminated the capital-gains tax advantage, and, as a side benefit, improved corporate governance. This is a bullish story.


Home ownership, according to the Wall Street Journal, has risen to a record 69 percent of all households, while housing prices, in constant dollars, have experienced the steepest boom in the last 50 years. In constant dollars, the median home price has risen well above 20 percent during the last few years. You’d think such stellar performance would draw rave reviews from the financial press. But newspapers seem more interested in a “housing bubble.” There’s even some talk about an impending burst of that bubble.

The financial press is once again having trouble handling the good times.

Not only has the demise of the housing market been wrongly predicted many times, so has the explanation for the housing boom. Most attribute the boom to low interest rates. However, during the 1950s, rates were just as low and housing did not perform as well as it has in the last few years. The answer is not interest rates — it’s tax rates.

Real estate has become an extremely tax-advantaged activity. A married couple can now pocket up to $500,000 worth of capital gains tax-free every 2 years. In addition, residential real estate is a leveraged investment, so it does not take much of a gain in the value of a home to match the higher numbers generated by a bull market. A 20 percent down payment generates a 4 to 1 leverage factor. Another plus is that the “cost of carry” is deductible from income taxes. A final advantage is that one can borrow against the equity of a home without any prepayment for early withdrawal. The tax treatment of real estate is superior to that of any Roth-IRA.

According to newspaper reports, President Bush has instructed his tax-reform panel to preserve tax breaks for homeowners. If the tax story is correct, a lower tax rate for other activities will not hurt real estate on an absolute basis. Rather, a lower tax rate on other activities will confer these other activities some of the tax advantages enjoyed by real estate. The “ownership society” just may be the rising tide that lifts all boats. The bullish story continues.


“As Dollar Weakens, Hidden Strengths May Stave Off Crisis.” What crisis?

You’ve probably heard about the so-called “twin deficits” (trade and the budget), which the worriers say will result in a crisis that will produce a further decline in the U.S. dollar as well as a spike in inflation and interest rates. The argument presumes that foreign and domestic investors will dump stocks and bonds in order to avoid the losses of dollar depreciation. As everyone moves away from the U.S. dollar, the demand for money will decline, creating an excess supply of dollars. Since inflation is too much money chasing too few goods, the end-result of a run on the dollar will be a rise in U.S. inflation and nominal interest rates. Or so the argument goes.

The current organization of U.S. monetary policy precludes such a crisis.

The “twin deficit” crowd usually points to the U.S. experience during the 1970s as an example of what could go wrong. But the monetary system back then was organized in such a way that it was susceptible to speculative attack and/or runs on the currency.

During the 1970s, the U.S. was inadvertently the most important member of the OPEC cartel. Its conservation, environmental, and trade policies effectively had two distinct effects on the demand for foreign oil. First, since domestic exploration was restricted, the demand for foreign imports increased. Second, the inability to substitute alternative sources of energy brought about by regulations reduced the U.S. import elasticity of demand for oil. In effect, these policies enhanced the OPEC monopoly power and the cartel took advantage of the situation.

The oil shock and other bad policies led to a U.S. recession and a decline in the demand for money both in the U.S. and abroad. However, U.S. monetary policy continued to be expansionary and the excess domestic-money creation ultimately resulted in too much money chasing too few goods. Inflation and interest rates rose and the dollar declined. In an un-indexed tax system, rising inflation led to a decline in real rates of return in the U.S. This in turn produced a currency flight away from the dollar.

The present-day parallels with the 1970s are not appropriate. Recall that the solution to high inflation was Paul Volker. While changing the operating procedures at the Federal Reserve, he came to adopt the domestic price rule. This is where the Fed focuses on guaranteeing the purchasing power of the dollar. By targeting the price level, or inflation rate, the Fed can gauge when to add or withdraw money from the system.

The Volker price-rule policy stopped inflation and thus stabilized the foreign exchange value of the dollar. In the years that followed, the dollar continued rising — all the way up to February of 1985, which was well after the inflation rate had been stabilized. More important, between 1985 and 1987 the dollar declined as much as it climbed during the Volker years, and yet the U.S. inflation rate remained unchanged. The domestic price rule worked. By controlling the purchasing power of the dollar, fluctuations in the exchange rate ceased to be the result of monetary mismanagement.

You might also recall that the “twin deficits” existed during this period. Under a price rule, the twin deficits have no impact on the underlying inflation rate. Any concerns about a dollar crisis resulting in higher inflation are unfounded as long as the Fed remains on a price rule.


Things are not as ugly as some may lead us to believe. In fact, if you add in the overwhelmingly positive experience of the dividend tax cut, the tax-advantages that are keeping the housing market strong, and the tremendous increase in after-tax returns that are sure to be part of the Bush “ownership society,” things are actually quite bullish.

– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.


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