Despite a last-minute narrowing in the generic ballot, I still expect the Republicans to lose the House of Representatives and hold the Senate by a slim margin. Online betting at Tradesports.com gives the GOP just over a 16 percent chance of retaining control of the House. However, trading action indicates a 69.2 percent probability that the Republicans will retain the majority in the Senate. In other words, gridlock is in the air.
Tax-hike risk would tend to rise with one or both Houses controlled by Democrats, but spending likely would be restrained due to gridlock. Divided government also would reduce the probability of an attack on Iran. At least this seems to be the message sent by the recent plunge in crude oil prices and a buoyant equity market. Stated differently, I don’t see a near-term threat to growth or the economy from divided government.
The largest risk to growth in my view would be a repeal of the 2003 tax cuts on capital and labor. Democrats argue that they wouldn’t try to overturn the tax cuts, but would simply allow them to expire in 2010 when legislative sunset provisions set in. The 2008 presidential election thus would become pivotal in determining whether growth-restraining tax hikes appear two years later. Republican front-runner Sen. John McCain (R., Ariz.) seems to be positioning himself as a pro-growth supply-side candidate. This likely will put some pressure on the Democrats to shy away from the robotic redistributionist root-canal politics of former Vice President Al Gore or the shrill triangulation of Sen. Hillary Clinton (D., N.Y.), and move toward a pro-growth, tax-cutting, expand-the-pie candidate such as Gov. Bill Richardson (D., N.M.).
In this context, it is worth pointing out that tax-receipt growth during the 12 months through September advanced 11.8 percent, well above historical norms. Government spending rose 7.4 percent during the same period, a pace well above the averages of the last two decades. Nonetheless, with receipts continuing to rise faster than expenditures, the fiscal deficit during the last 12 months plunged to $247.7 billion. This brought the ratio of the deficit to GDP back below 2 percent, which is also below the three-decade average of 2.4 percent.
An embarrassing fact for Republicans is that if spending growth had simply been held to the average rate of nominal GDP growth since this recovery began, the U.S. would have had a small surplus of $900 million as of September. If spending would have compounded at a much more conservative pace of 3.4 percent (the average under Gingrich/Clinton from 1994-2000), the U.S. would have had a fiscal surplus of $240 billion. In other words, a guns-plus-butter approach to U.S. fiscal management has created red ink that would not otherwise be there even though tax rates have dropped.
The drop in tax rates on labor, and especially on capital during 2003, has been a key pillar of this expansion, and an expiration of the lower rates would be a threat to growth. It may be no coincidence that the tightest labor markets in the last forty-five years have followed lower tax rates on capital. In other words, what worked for the Clinton economy after 1997 (when tax rates on capital dropped) has worked for the Bush economy since 2003 (when tax rates on capital dropped again).
Bitter left-wing Keynesians will of course deny any positive benefit from lower tax rates, but the carping looks increasingly silly in light of the fact that real non-supervisory wages now are expanding at an annual pace well above their thirty-five-year average. Not coincidentally, the unemployment rate has dropped to a historically low 4.4 percent while the employment/population ratio has risen to a five-year high. Broad measures of worker compensation are growing briskly.
If this isn’t indicative of a tight labor market lifting all labor-market boats, I don’t know what is. But one would never know it listening to an increasingly desperate and off-message GOP.
A demographic crisis looms absent serious reforms. But pushing up the highest tax rates on capital and labor (which would reduce the capital-to-labor ratio, dent productivity, and lower after-tax incentives to work and invest) is a reform we can do without. While divided government and gridlock are in the air for now, tax rates and growth will be a key issue in 2008.
– 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.