Capgains, the Culprit Jude Wanniski October 16, 1989

We have not the slightest doubt that the Bush administration's agreement with the Senate leadership Friday afternoon was the overwhelming reason for the stock market collapse that followed. Our FYI of Friday, "Capgains, What's at Stake," written in the morning, warned of a market decline if the administration would lose on capgains, but we banked on Richard Darman's assurance that he saw a way to win. He still assures me he thinks a win likely, with capgains attached to the debt ceiling bill later this month. But this is a fallback position, a gamble that had to be taken because Senate Democrats had thwarted him by aggressive use of procedural obstructions. When I spoke to him at his office late Wednesday afternoon, he said he'd just returned from the Senate, where he'd obtained a favorable ruling from the parliamentarian. The ruling would have permitted addition of the capgains amendment to the reconciliation bill by 50 votes, not the 60 votes the Democratic leadership has arranged as the chief obstacle. The Democrats learned of the ploy before it could be sprung, and pressured the parliamentarian into reversing himself.

At this point, there were only two options left to the administration: a) accept the deal the Democrats had offered a week earlier, stripping the reconciliation of the liberal's pet child-care program, or b) letting the Democrats pass reconciliation without White House support and then vetoing it. It was the prevailing assumption at this point that the White House would go the veto route unless there was some assurance from Democrats a vote would be permitted on the debt ceiling, that it would not be filibustered. The U.S. Chamber of Commerce, which has been in the forefront in lobbying for capgains, had advised the White House that it would swallow child-care if it had to, but would not trust the Democrats on Plan (a). The reasoning is that if the Bush Administration did not have the brass to veto the reconciliation, when it has the political high ground, it would not have the brass to veto a debt-ceiling bill that would squeeze Social Security recipients.

The news Friday afternoon that Darman had swallowed Plan (a) without any assurances he'd get a vote on substance in the Senate, was a shock. As the lobbyists pored over the deal, it was clear that the White House had given up much more than capgains. It allowed the R&D tax credit to expire, left the Section 89 health care provisions in place, and dropped the plan that would increase permitted wage earnings for Social Security recipients. In addition, junk-bond financing was bashed without the compensating relief of equity finance, via a lower capgains rate. A double-barrelled blast at entrepreneurial capitalism. Richard Rahn, chief economist for the U.S. Chamber, immediately telephoned Darman and left a message accusing the OMB director of a sellout. To Rahn, it was as clear as it was to us, that the market nosedive was due to this shock, preposterous that the UAL financing snag was the trigger.

The financial press might as well have been on the moon, unable to see the connection smack under its nose. Then again, the financial press has almost totally missed the link between the robust advance of the Dow since January and the growing chances that George Bush would win on capgains, an item said to be a non-starter early in the year. Wall Street "spokesmen" are no better, the equivalent of foxhole soldiers trying to figure out why they're winning or losing the war.

I reached Darman in his office late Saturday afternoon, and he insisted the capgains vote was merely delayed by the Friday agreement, and it was his judgment it would wind up sooner on the President's desk than if the administration had gone with Plan (b), the reconciliation veto, which would drag things on until Christmas. He advised that insofar as the market decline was due to discounting failure on capgains, it was wrong, and it would soon become clear that capgains was alive and well. Darman made it clear that he viewed Senator Bill Bradley of New Jersey as the administration's chief adversary in the Senate, that it has been Bradley who has been most determined to defeat the capgains cut on any grounds whatsoever. Bradley, of course, was a principle in the '86 tax-reform, which he helped sell to liberals by winning agreement from the Reagan Treasury to treat capgains as ordinary income.

I'd argued with Bradley last spring that the Bush victory over Dukakis nullified the '86 capgains agreement via force majeure, since capgains was part of the Bush mandate. I reached Bradley by telephone Friday afternoon, moments after the market closed, advised him of the 190-point decline, and cheerfully suggested that he and his fellow Democrats were responsible, by blocking a capgains vote in the Senate. Bradley, who receives and reads all of our material, is well aware that we have all year connected the stock market advance with capgains progress on Capitol Hill and have warned of a market decline if its progress was set back. He had no rejoinder.

Instead he insisted that a capgains cut would be bad for the economy in the longer run. It would inevitably lead to an increase in marginal income-tax rates in 1990, he said, this being the nature of politics on Capitol Hill. He explained that the White House next year will be forced to ask for higher taxes to meet budget targets, and that if capgains has been cut, the glue of the '86 accord will be gone, and income tax rates will be pushed up. I predicted that if capgains is cut, Treasury will get a revenue bonanza $20 billion more than it now estimates, and there will be no need for George Bush to move his lips in a different direction.

On the other hand, if Bradley is successful in filibustering capgains, the revenue gap will open up tremendously in 1990 because of the weakened economy, and there will be no serious consideration of the budget targets. The Democrats will only be able to claim credit for the weakened economy, and the White House will be happy to agree. I said I hoped he would not work to prevent a vote on capgains, which a majority of his fellow senators clearly favor. In our 20-minute conversation, I got the impression that Bradley still does not see the difference between the capgains cut, which benefits entrepreneurial growth generally, and tax loopholes, which serve specific interests only.

My general outlook for capgains remains optimistic for this year, accepting Darman's confident estimate that it no longer has to be tied to reconciliation, his original strategy, because his original strategy succeeded in achieving its original goal, which was to demonstrate the latent appeal of capgains in the House.

The Friday market tailspin is greatly different than that which preceded Black Monday in 1987. Then, the market was crumbling in fear that Treasury Secretary Jim Baker would cave in to the dollar devaluationists, which he proceeded to do over the weekend. In this market episode, Friday fears that Darman had sold out on capgains have been greatly tempered by his weekend assurances that it remains in good shape. It should also help that Senator Bradley is in a position to seriously consider our view on why the market crashed and thereby reconsider his own views on capgains.