Maneuverings on Taxes/Fedwatch Jude Wanniski October 5, 1995

MANEUVERINGS ON TAXES

The continuing weakness in NASDAQ is almost entirely driven by uncertainty with capital gains. Until the legislation is locked in, all we get in the economy by way of expansion is tied to an inventory build-up. Semiconductor manufacturers, who lead the way in betting on the come, are getting hammered hard, but would recover as soon as capgains was locked in. We continue to believe retroactivity to January 1 will be part of the deal and have learned since our last report that House Speaker Newt Gingrich remains committed to prospective indexation. The nervousness in the markets is now tied to the latest maneuver from the GOP, led by Senate Majority Whip Trent Lott, Connie Mack of Florida, Spence Abraham of Michigan, and Larry Craig of Idaho, which would convert all the tax cuts into a four-year mode instead of the seven-year framework that governs all the spending bills. This would enable Congress to pass all the tax goodies promised in the Contract and passed by the House, with a $177 billion price tag instead of $245 billion. 

The idea is built on the assumption that the cuts almost certainly would be extended in 1998, before they expire. With one exception, the idea is creative and sound, notwithstanding the criticisms of Sen. Phil Gramm [R-TX], who says he will not stand for a temporary cut. Majority Leader Bob Dole is obviously behind the strategy, but is standing back and watching what happens to this trial balloon. The one problem is with the capital gains provision, inasmuch as a temporary cut in capgains would have only marginal effects on capital formation. The promise of extension in 1998 is worthless to the capital markets, which have no reason to trust politicians any more than the ordinary Joe. But the incidence of all other tax cuts (the $500 kiddie credit, estate tax changes, etc.) occurs within each of the four calendar years. The benefits, such as they are, are realized. 

The capgains tax is a tax on future success. Most risk that leads to failure (capital loss) or success (capital gain) takes more than five years to unfold. It is like saying the tax on a race of 9 furlongs will be reduced only for the first 7. The betting public will have no trouble seeing there ain’t no tax break on that race. Horses that have already been running for 7 furlongs, like General Motors, may get some benefits on risks recently taken. The “window” would also unlock and cash previous gains not yet realized, but the winnings would not go into new races, which is what this is supposed to be about. The tax cut should create new capital that flows through the financial system to the longshots, those who now have no capital or credit that would enable them to compete. 

If capgains were treated separately, making the exclusion permanent, the rest of the package would make perfect sense. The good news is that there are now supporters of favorable treatment of capgains at the highest levels of the Clinton Treasury, prepared to argue that the primary gains will accrue to ordinary people, not the rich. We also assume that the President’s chief political strategist, Dick Morris, is working on this with his old friend Senator Lott, who is behind the four-year plan. Better yet, Rep. Bob Torricelli [D-NJ], is not only making the rising-tide-lifts-all-boats arguments on capital gains inside the White House, he is also urging the President to sign on to retroactivity, which CBO scores at a measly $300 million. A lot of smart people in both parties are suddenly working on this from the right direction.

FEDWATCH

Fed governors for 30 years have been obfuscating as a condition of employment. They decide what they wish to do as a matter of policy, then contrive the rhetoric to satisfy their various audiences: 1) Elected politicians; 2) The Fed bureaucracy; 3) Wall Street opinion leaders. Because there are so many voices that have to be satisfied just to arrive at Policy, the back-up rhetoric at times borders on the fantastic. It is now such a time. The minutes the Fed released Friday are written in almost archaic Keynesian language, which we know would give Chairman Alan Greenspan a fit of giggles if he were outside looking in. At the August meeting, the Fed decided to condition another cut in the federal funds rate on the completion of a budget-balancing package in Congress. The panel was unanimous in voting to hold rates steady "pending a clearer assessment of the outlook for fiscal policy," according to the FOMC summary. "Over the longer term, the members generally believed that consideration would need to be given to an adjustment in the committee's policy stance, especially if substantial fiscal restraint were to be enacted," the document stated. 

What is really going on here is that Greenspan & Co. are promising to cut interest rates as a reward to Congress for avoiding a trainwreck. Greenspan knows he could cut fed funds right now with salubrious effects on the financial markets and on economic growth. But he lives in a world that requires him to converse with and satisfy the officials of our government who were actually picked by voters. We must assume he has implicit marching orders to hold back on another fed funds cut until a flag goes up over Capitol Hill signaling budget reconciliation. This permits the leaders to assure the elected politicos who are making sausage/legislation that their agreement will be occasion for a celebration at the Fed as the good times roll again. 

These signals are having the desired effect on the bond market, as the yield on the 30-year Treasury yesterday dropped to 6.43%, its lowest since February 1994. The Fed cannot do much to cheer up the stock market with these rhetorical flourishes. Unless we get a meaningful cut in the capital gains tax, the Dow and NASDAQ will move in the opposite direction. Fed Gov. Larry Lindsey, who we surmise believes very little of what he publicly pronounces, has publicly argued for a "preemptive" rate cut in anticipation of congressional budget action. “Other things being equal, a fiscal tightening will lead to a lower rate of nominal GDP growth, and I am a believer in targeting nominal GDP,” Lindsey said in a speech earlier this week. “I think there is a possibility that a rate reduction would be needed, because nominal GDP would be lower than it otherwise would have been.” The phrase “other things being equal” is what permits him to obfuscate. He wants to cut the rate, knowing it would be a good thing, but can’t speak plainly without getting a lot of his colleagues mad at him. 

Our observations on budget reconciliation and capital gains, in conjunction with cutting through the Keynesian crap at the Fed, leads us to believe the Beltway Boys are getting their act together in their own twisted way. What a country!