Capital Notes Jude Wanniski October 10, 1991

LONDON: As previously reported, the Tory government of John Major has decided to phase out the U.K.'s oppressive capital gains tax, which was hiked to 40% on indexed assets more three years ago. The bad news is that Chancellor of the Exchequer, Norman Lamont, is afraid of announcing the move prior to the national elections, and as the Tories have been sliding in the opinion polls because of the problems in the economy — caused primarily by the capgains tax -- the Prime Minister has decided to postpone elections until next spring. He hopes his position will be stronger, when it's more likely he will be weaker. The situation is reminiscent of India in 1977. In 1975, Indira Gandhi had suspended democratic rule in an economic and political crisis. Her finance minister dictated a cut in the top income tax rate to 77% from 97 1/2%, cutting the wealth tax to 2 1/2% from 8%. The economy immediately began to improve, civil discontent abated, foreign reserves grew. In April 1976, the finance minister dictated a 66% rate, revenues climbed, and so did Ms. Gandhi's popularity. So much so, she called for new elections in March 1977.1 was told the finance minister, C.V. Subramaniam, planned a 50% top income tax rate, but it would not be announced until after the election. Ms. Gandhi ran on a campaign platform defending her suspension of civil liberties, lost the elections, and the tax reform was scrapped. India has never gotten back on the correct reform track.

NEW DELHI: Every now and then India shows signs of wanting to get back to growth, but they have too many economists in New Delhi trained at the London School of Economics. In the last several months, new rules on liberalized foreign investment have perked things up a bit. India's Growth Fund, traded on the NYSE, has lifted to 15 3/4 from a 52-week low of 9 3/4, but it has now sagged to 14 3/8. What happened, I think, is that the capital inflow resulting from the liberalized investment rules inevitably produced a trade deficit on current account. To get exports up, the government turned to the same old nitwit Keynesian scheme of cheapening the currency, devaluing the rupee by 27%. As the effects ripple through the national economy, inflating prices and the cost of capital, I would expect increased political discontent. Bring back C.V. Subramaniam!

BRASILIA: When Marcilio Marquez Moreira was named economics minister of Brazil in early May, I applauded lustily. I'd been waiting for him to get the appointment since 1987 and thought the move the best thing to happen to Brazil in more than a decade. The Sao Paulo stock exchange surged 5% on the news. The Brazil Fund, also traded on the NYSE, began climbing, from 11 1/2 to a high of 18 3/8 several weeks ago. It's now all the way back down to 11 7/8. The same thing happened in Brazil as in India. Moreira began with a series of small moves to liberalize foreign investment. He should then have gone on to domestic tax reform. Instead, the Collor government decided to force fiscal reform on the Brazilian states. This would mean deep spending cuts in the national budget and pressures within the states to raise taxes, a zero-sum game. I faxed Moreira a letter a month ago urging him to abandon this losing effort which requires the people, instead of the state, to take the risks of reform. He should go immediately to tax reform, I counseled, but never got a reply -- I expect because he could not reverse the decision. Now Brazil has devalued its currency by 17%, on the grounds that it had no choice, the Brazilian Embassy in Washington tells me. Foreign reserves were dwindling (as the smart money saw a devaluation coming) and the business elites complained the currency was overvalued for export purposes. Moreira has not answered my missives. He's now in Bangkok, I'm told, attending the annual meeting of the International Monetary Fund.

BUENOS AIRES: The Argentina Fund comes to the NYSE this week. We'd advise you to get a prospectus, if you have not already. Argentina has been in the same leaky boat as Brazil and Mexico for the past 15 years, but finally climbed out earlier this year when Domingo Cavallo was named Finance Minister. The bad news about Cavallo is that he got his PhD in Economics from Harvard. The good news is that his roommate and best friend at Harvard was Carlos Salinas de Gortari. I'm told they remain good friends and that Cavallo, who was foreign minister for Argentina in 1989-90, has also been in close contact with Mexico's Finance Minister, Pedro Aspe, who we continue to believe is the best in the world. Cavallo has embarked on a series of supply-side reforms, including tariff reductions and currency stabilization, fixing the austral to the U.S. dollar. Cavallo, who headed the central bank in 1982, seems to have learned something about devaluation. He has said if he is forced to devalue the austral he will resign! Maybe we can believe him. The potential of Argentina is beyond dispute. Thirty two million people in a lush, temperate climate on 1.1 million square miles. Hey, that's 142 times the size of New Jersey!

MOSCOW: The USSR approaches political and economic paralysis as Gorbachev and Yeltsin stand aside and allow Harvard's protege, Boy Wonder Grigory Yavlinsky, to do the talking. Yavlinsky is trying to verbally hold together the economic union, at the same time doing everything he can to block the one thing that can do the job: a gold ruble. On September 19 The Journal of Commerce reported there were plans afoot to monetize the gold reserves, although no plan and no specific exchange rate was mentioned. A few days later Yavlinsky "revealed" that the USSR only has $3 billion in gold reserves. This is Harvard's Jeffrey Sachs at work, I suspect, attempting to destroy the gold-convertibility solution. There are surely free gold reserves of at least $10 billion. But even $3 billion is enough to do the job. I met last Friday in Washington with Valeri Chernagorodsky, one of Yeltsin's economic ministers in the Russian Republic. All he wanted to talk about was the gold/ruble idea, how to fix the ruble. He assured me practically everyone in Moscow, Yeltsin included, knows Yavlinsky is a fraud, the creation of his own public relations machine on the Charles River. Chernagorodsky delivered his impassioned critique of Yavlinsky in a semi-formal setting with a high-level official of the Bush Administration in attendance and two dozen people listening. So I took him seriously. Our State Department continues to insist that Yavlinsky is the key to success. Meanwhile, Boris Yeltsin is said to be off on vacation, writing a book on how he defeated the August coup, for hard currency royalties. (We actually think Yeltsin is recovering from a heart attack.) As further paralysis creeps into the system, we should not be surprised if there is soon another coup by the military, this time the genuine article.

MEXICO CITY: This is to remind you Polyconomics has its second annual Mexico client conference in Mexico City October 30, at the Camino Real Hotel. There is room. Top officials of the government will be there to give us a sense of what lies ahead. Someone asked me the other day what is the biggest downside I see in Mexico. After a moment trying to think of one, I answered: "The U.S. economy."

WASHINGTON, D.C.: We hear House Speaker Tom Foley told the Evans & Novak Forum Wednesday morning he would accept a cut in the capital gains tax if the Bush Administration would accept a small increase in the income tax. It was all pretty vague. Wednesday afternoon, Budget Director Dick Darman was asked if he would accept the tradeoff Foley mentioned. Absolutely not. The right answer, the one Darman should be giving, is that it depends on how deep the cut is in capital gains and how high the tax is on income.