A Supply-side Tax Bill Jude Wanniski May 2, 2003

The $550 billion tax package that House Ways & Means Chairman Bill Thomas has now floated would be just fine with us, given all the constraints he faces. If it passed into law as is, it should send the major stock indices up by another 10%. And while that won’t happen given the constraints faced by Senate Finance Chairman Chuck Grassley, it is ever more likely that the final result will pack a supply-side punch. The most startling feature of the chaotic deliberations on Capitol Hill over this tax legislation is how thoroughly in control the Republican supply-siders seem to be at the staff level. With every development it has been the case that the growth measures in the legislation have fought their way to the core, pushing the social measures to the fringes.

The biggest bang in the Thomas package would be an immediate reduction in the maximum tax rate for stock dividends – to 15% from 38.6%, and capital gains – to 15% from 20%. The financial press has been sorting out the “winners” and “losers” in this so-called 5/15 scheme – the “5” being the rate charged investors in the two lowest income-tax brackets on both dividends and capgains. That’s because practically all their analysis is done in a cash-flow demand model, which tries to follow the money from government coffers into the pockets of various classes of taxpayers. In that mathematical model, the impact of $550 billion on a $10 trillion economy over a decade would be insignificant. The classical supply model is not mathematical, but behavioral, and as it assesses the nation’s economic system as it currently exists, the tax rates on capital are preventing fresh capital from coming off the sidelines and forming to expand the system.

One of my earliest lessons in supply theory from Robert Mundell, almost 30 years ago, was that the object of policy should be to increase both savings and consumption – by making the economy bigger. The Bush tax package that passed in 2001 was not designed to make the economy bigger, but to give consumers money to draw down surplus inventories. The net effect of shifting money around the various pockets was to make the economy marginally smaller, with a significant decline in the employed work force in this downsizing. It was exactly the kind of policy then favored by the neo-Keynesian economists who still dominate the Democratic Party, and when it did not work it left Democrats intellectually bankrupt. All they can do now is insist on no further tax cuts and repeal of those pieces of the 2001 tax act that do have growth elements – the lowering of marginal tax rates on ordinary incomes. Here too, the GOP is sticking to its guns, with the Thomas proposal cutting the top rate to 35% from 38.6% retroactive to January 1.

With the contours of the House tax bill now firming, how might this play out in the Senate? Senator Grassley has identified perhaps $100 billion in offsets that might boost the Senate version to $450 billion from the $350 billion “ cap” which he promised two GOP Senators in order to get the Budget Resolution passed – with Vice President Cheney providing the tie-breaking vote. The administration now seems willing to go along with “sunsetting” some of the tax cuts – as the Thomas package increases the tax credit for children to $1000 from $600 for only one year, at which time it reverts to $600 unless Congress makes it permanent in 2005. (Which a re-elected President Bush would insist upon, perhaps with a bigger GOP majority in the Senate.) With this kind of sunset gamesmanship, the Democrats would of course squawk about foul play in giving benefits to the “rich,” but who will pay any attention to them or their presidential contenders as the Dow Jones Industrial skip past 9000 back on the way to 10,000? (Asked by a client this week on whether I believed Bush would win re-election, I said he could not lose if he does not have an opponent; that’s how weak the Democratic field is at the moment.)

The painful fact is that the budget deficits at all levels of government cannot be reduced without these cuts in capital taxation. The argument that the economy can expand without such cuts – as it had done in the 1990’s – fails to appreciate the expanding drain on revenues from Social Security and Medicare trust funds. In the ‘90s, the federal budget went into surplus to such a degree that the Clinton Treasury projected it into the future as far as the eye could see, took credit for it, and even talked of wiping out the national debt by 2015. Remember? But the real reason for all that black ink had been the errors made by the Greenspan/Moynihan Social Security Commission 20 years ago, when they raised payroll taxes excessively on the assumption that economic growth would be as slow as it had been in the Nixon/Ford/Carter years of demand-side economics. When the Reagan tax cuts provided the foundation for the entrepreneurial rebirth that followed, the economy swelled and so did the work force – just as the baby boomers were hitting their peak in productivity and earning power and flooding the trust funds with payments.

In other words, demographics + higher incomes + capgains + monetary stability produced those mammoth surpluses, not the Clinton tax increase of 1993. From this point forward, the equation will have demographics as a negative, not a positive. Federal funding just for nursing homes hit $42 billion last year – and the boomers won’t begin retiring until 2012. As is, the general fund will be hit by $1.5 trillion in the intervening years to pay back loans from the trust funds so they can make their payments. The only way to make the equation work in the years hence will be with higher incomes and monetary stability. Any taxation on capital formation will be a drag. The way demographics can work in a positive direction is to redirect a chunk of the work force out of the Chaos Industry into productive occupations. Lawyers and accountants become doctors and nurses.

How does the Pentagon fit into this financial picture? It had better make more use of diplomacy, which is a lot cheaper than war. UN weapons inspector Hans Blix earlier this week was asked what he thought of the failure of the Pentagon to find any of the weapons of mass destruction they insisted were hidden in Iraq. He replied dryly the Pentagon inspectors were not finding weapons at the same rate he had not been finding them, and his way was not as costly. The hawks always insist any consideration of financial costs be put aside when the nation is at war, and that’s true enough, but it is looking more and more as if war could have been avoided by permitting Blix to proceed. Adding the costs of war and occupation to the retirement of the baby boomers provides a commitment of public funds that can be handled only with supply-side macro policies in Washington. Adding more unnecessary wars could not be handled by any known economic theories.