Squandering the Surplus Jude Wanniski February 17, 1999

Can you imagine the board of directors of one of the hot Internet stocks deciding to use a windfall of profits to buy back the equity shares at astronomical PE ratios or pay down debt that had been arranged at 5.3%? No, you can’t. It is not possible to imagine such mismanagement, which amounts to a decision to liquidate the enterprise in its gloriously promising infancy. Shareholders would be perfectly justified in dumping the company’s assets upon hearing of such stupidity. Only mature companies that have nothing better to do with windfall profits will be rewarded for making the decision to liquidate. This was the insight of Boone Pickens and his United Shareholders of America, who were justified in condemning major oil companies for acquiring department stores and circuses when they should have been using their cash hoards to liquidate.

Why then would the board of directors of the U.S. government -- the President and the Congress -- be justified in using the magnificent budget surpluses now cascading into the U.S. Treasury to pay down the national debt? With the tax code of the federal government still so burdensome to the national economy after evolving into a seven-million-word monstrosity, it makes no sense to earmark these trillions of dollars of surplus to liquidate debt when there are better uses with much higher rates of return. Both the stock market and bond market would be justified in marking down the price of all U.S. assets, including U.S. government bonds, if the government were to squander the surpluses. Better, though, that we pay down debt instead of opening up new social entitlements and targeted tax credits for liberal or conservative social engineering. Fixing the tax system should be at the top of the national agenda, then refurbishing the federal infrastructure. These are the two problems most neglected during the Cold War.

Just as Wall Street is able to discount signs of mismanagement in the private sector by knocking down a company’s stocks and bonds, it is able to favor a government’s good management of public finance by putting a premium on its bonds. After the Cold War ended, the political counselor at the Soviet Embassy in Washington told me that what really broke Moscow’s spirit was observing President Ronald Reagan. He cut taxes by 30%, dramatically increased spending on defense, ran  up the federal deficits, and all the while interest rates on government bonds were in decline. “It was a magic we could not understand,” he recalled. The answer was provided by Robert Mundell, who taught me in 1974 what seems so obvious but which still eludes most economists and policymakers: If a tax rate is reduced, the economy only has to respond to the lower rate with enough growth in revenues to cover <I>the interest</I> on the bonds needed to finance the cuts. If you cut tax rates where they are too high, interest rates will fall while the deficit increases. If you cut tax rates where they are not too high, interest rates will rise with the rising deficit.

 This is why I object to Federal Reserve Chairman Alan Greenspan making the blanket statement that he would pay down debt before he would cut tax rates. So would I, if the only tax cut I was offered was a family-tax credit, a “fixing” of the marriage tax penalty, or a tax cut targeted to the inner city designed so nobody with capital would be interested in investing there. In each case, the return on the investment would be negative, which means the resources would be better spent paying off debt. In April 1994, Felix Rohatyn wrote on the WSJournal editorial page that he finally came to see that the tax code only should be used to raise revenue, and Congress should then decide how to divide the revenue among debt service, domestic spending and national security. He had the insight when the budget was still in deficit, but we are no closer to acting on the principle in this era of surplus. Democrats and Republicans are dueling with different versions of tax credits and entitlements, with no signs of supply-side analysis anywhere.

A month ago, we criticized The Wall Street Journal for lavishing praise in a lead editorial on Senate Budget Chairman Pete Domenici for his plan to cut income-tax rates by an insignificant 10% across-the-board over the next four years. Not percentage points, mind you, which would not even bring the top marginal income-tax rates to where they were when Reagan left office. Just ten percent off the rates themselves, which would bring the top rate down from 38.6% to 35% by the year 2003. Even if Domenici and his fans at the WSJ think it’s a good idea to shave tax rates instead of cutting them, they have to insist on 30% in order to negotiate with the smarter Democrats down to 10%. Without saying a word, the Democrats already observe Senate Majority Leader Trent Lott, in a Michigan town meeting on Monday, conceding 10% may be too high. According to the NYTimes: “Mr. Lott voiced a willingness to compromise on the amount of any reduction, saying that a slightly smaller tax cut could be paired with a few targeted tax cuts, notably an elimination of estate taxes. ‘I’m not dug in or locked into this number or that number -- maybe it should be 8.7 percent,’ he said.” He’s practically on all fours, eating out of Clinton’s hand.

And he’s not alone. GOP Senate and House leaders are proving themselves to be totally incompetent in dealing with Clinton and the Democrats in the politics of surplus. They have caved in up front by “setting aside” 62% of the projected surplus to “fix Social Security.” Senate Republicans especially have been rolled a dozen times in the last 20 years on this ploy. Democrats swear an oath to set the funds aside, then spend the money anyway, creating new entitlements that get tacked onto emergency legislation. No money down, expanding to a zillion dollars in ten years when the program is off the screen. Senate Appropriations Chairman Ted Stevens already is screaming about how the Democrats are doing this again, but he too is pushing targeted tax cuts for his Alaska constituents. In 1982, remember, President Reagan agreed to raise taxes by a dollar for every three dollars of spending cuts. When the Democratic Congress finished, it delivered the tax increases, but not the cuts, and Reagan said it was the worst mistake he made in his presidency. Someone in Washington has come up with the line that the Democrats are the Evil Party, the Republicans are the Stupid Party.

We’d hoped one good thing to come out of the end of the impeachment process would be a refocus of the energies of the WSJournal editorial page. As the one place where Reagan conservatives could go for sustenance and guidance on matters economic, the page became indispensable to the supply-side revolution in economic policymaking. For the last six years, the economy has been a secondary concern to editors of the page, who have concentrated on bringing down the Clinton presidency. In its glory days, we would see four out of five editorials a week educating the flock and shepherding it in the right direction. Without that, we have Domenici as the “leader of the growth wing” of the GOP, and Lott talking like a Keynesian, cutting taxes to put more money into people’s pockets -- when the right reason is to increase the productivity of the national economy. If the rhetoric and policy soon do not improve, expect a long, slow erosion in the value of financial assets.