The Wall Street Journal reported this week that Senate Finance Committee chairman Charles Grassley (R., Iowa) has stepped back from pushing a two-year extension on tax cuts for dividends and capital gains. Instead, Grassley is pushing a one-year extension in hopes of capturing support from Republican moderates who are deterred by “demanding cuts in Medicaid and food-stamp benefits for the working poor” and the prospect of “voting to cut taxes for better-off households.”
While there is no shortage of waste in Washington, I’m not sure why the Senate majority would hold tax cuts on dividends and capital gains (which have brought in more, not less, revenue) hostage to Medicaid spending. This approach is all stick and no carrot. It is akin to placing a loaded gun in the hands of the minority who will have no problem telling the electorate that the choice is between widows and orphans or “tax cuts for the rich.” If the debate is framed this way, it likely will be curtains for the tax cuts, and potentially the Republican majority in November 2006 as well.
In order to shed some light on the current predicament, it is worth reviewing how we got here.
As an advisor to then-candidate George W. Bush, Larry Lindsey helped design a Keynesian tax cut in 2000, which was passed in 2001 after Bush was elected. It was heavy on consumer rebates and tax credits for the married with children, and light on supply-side incentives for growth.
And it was a flop. The 2002 “recovery” moved at the pace of a 40-yard dash in a geriatric ward: Real GDP averaged 1.9 percent annualized growth despite a fed funds rate that was below 2 percent. The equity market continued the decline that began in March 2000 while tax revenues collapsed. Business fixed investment and employment were negative.
After the 2002 mid-term elections, Bush fired Lindsey and Treasury Secretary Paul O’Neill and had a new team led by Glenn Hubbard design a tax cut focused on capital incentives and business. Modest income-tax rate reductions enshrined in the 2001 tax act, originally set to phase-in glacially, were made retroactive to January 1, 2003. Tax rates on dividends were cut dramatically and the top capital-gains tax was dropped to 15 percent from 20 percent. Bonus depreciation and expensing provisions for business were also included.
The stock market and economy responded: Since June 2003 real GDP growth has averaged 4 percent while growth in real business fixed investment spending has averaged nearly 9 percent on an annualized basis. Real equipment and software spending has averaged 11 percent annualized growth. The stock market is up 26 percent since mid-2003. Tax receipts have surged $275 billion over last year’s levels, the strongest rate of growth in 23 years, with notable strength in “non-withheld receipts” which are tied to capital assets. And the fiscal deficit, which reached 3.4 percent of GDP in 2004, has fallen by nearly $100 billion to 2.5 percent of GDP in fiscal 2005, in line with the 30-year average.
This is heavy ammunition that the Bush administration could have been using to amplify the policies that have sped the recovery. Instead, the public mood has been soured by two back-to-back natural disasters, an energy price squeeze, a Supreme Court nomination blunder, a Washington scandal, and additional difficulties in Iraq. The combination of these events, along with contingency spending for hurricane relief efforts, broke the previous momentum for extending tax cuts and thrust the administration’s approval ratings into the equivalent of an open elevator shaft.
At the same time, so-called conservative leaders have added insult to injury by playing host to a three-ring circus in Washington in which oil company executives have been hauled before Congress (and a national TV audience) to answer loaded questions from politicians who are long on hot air but short on the rudimentary elements of markets and incentives.
These trends are troubling.
A better approach would be to cancel the corpulent $286 billion highway bill and/or rescind the unpleasantly plump $12.3 billion energy bill and leave Medicaid alone until it can be addressed with broad-based reform. There’s still time for the Republican congressional majority to stitch a budget reconciliation bill together that at the very least extends pro-growth tax cuts by more than one year.
Looking further ahead, the 2003 tax cuts should be made permanent as a precursor to broader-based tax reform. The Bush legacy hangs in the balance. I remain skeptically hopeful.
— Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.