Taxes and Tax Politics Jude Wanniski January 19, 2001

To: Students of SSU
From: Jude Wanniski
Re: Taxes and Tax Politics

The best question I’ve had this week is from an economist who will be working in the Bush administration, and having some responsibility in selling the Bush tax cuts to the public and to the Congress. He wanted to know how Jack Kemp sold the idea of tax cuts in the 1970s. This led to a long discussion about politics and taxation that I believe you will find useful for this last lesson of the fall semester. It will lead nicely into the first lesson of the spring semester next week, a semester devoted to the political side of the political economy.

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The key was Kemp’s motivation for “selling tax cuts” to the Republican Party. In his first contact with the supply-side ideas of the economist Robert Mundell on The Wall Street Journal editorial page, Kemp saw a way to reduce the unemployment rate of his congressional district in western New York, the blue-collar Buffalo area. When he read a piece I’d written about Mundell in the fall of 1974, “It’s Time to Cut Taxes,” the Buffalo unemployment rate was roughly 18%, the highest of any urban area in the country. If Buffalo had a low unemployment rate, we might never have heard about Kemp, or as a new congressman representing Buffalo, he might have decided to make health care or education or outer space his cause. But he was at the margin of the spreading national problem of “stagflation,” the combination of unemployment and inflation that was not supposed to happen in a Keynesian demand model. In his first election to Congress in 1972, he won very narrowly. In his subsequent elections, the blue collar Democrats and Republicans of his district sent him back with landslide victories exceeding 80%.

From the very beginning, then, the Kemp argument for tax cuts was never a goal unto itself. He never talked about giving money back to the people who were overtaxed. He never talked about shrinking government because he liked smaller government. He never spoke of denying the central government tax revenues in order to starve Congress of revenues it would like to spend for wasteful social programs. Like the tax cuts espoused by John Fitzgerald Kennedy, Jack French Kemp’s goal was to get the country moving again. Both JFKs argued the dynamics of lower tax rates -- that over time they would produce a broader revenue stream. This is the most critical element in selling tax cuts, because it elevates the debate out of the zero-sum partisan swamps. Of course, if you are going to argue that tax rates of one kind or another are higher than they need to be to produce a given revenue stream, then you had better be right, or the electorate will punish you and your political party for wrecking the public finances. In 1962, JFK proposed cutting the top tax rate on personal income to 70% from 90% to get the country moving again. Kemp sold the idea to Ronald Reagan and the GOP, when the top rate was 70%, but swollen by several years of inflationary bracket creep. The goal of economic expansion was matched by an obvious instrument to bring it about, something that would benefit everyone, especially those at the bottom of the economic pyramid.

Most people at the bottom of the economic pyramid really do not pay taxes, at least not directly. So the politics of tax cutting must take that into account. In 1994, House Speaker Newt Gingrich rallied the Republican Party behind his 10-point “Contract With America,” and the Republicans won control of the Congress for the first time since the 1952 elections. One of the 10 points was a cut in the capital gains tax, to 15% from 28%. The grave political mistake Gingrich made was in deciding to cash in on the tax cuts without the use of “dynamic” scoring. In other words, there was no attempt made to argue immediately after the election that the lower capital gains tax would inspire an expansion of the economy and bring in a broader revenue stream than the higher rate. Gingrich and the other GOP leaders decided to use “static analysis,” which would mean there would be a dollar-for-dollar revenue loss for their overall tax plan. It would have been easy to get the capgains tax reduced, because even static analysis would show it would produce more revenue in the early years as individuals sold assets earlier than they otherwise would have done. What messed up Gingrich was his commitment to the Christian Coalition to have a “tax cut” for children, a $500 kiddie credit. This enormously expensive idea would have no supply-side effects and would show red ink under a “dynamic” or a “static” basis. So the decision was made to do it all static.

When Democrats have a static proposal to cut tax rates, they immediately swing into motion with their constituents. Oh? A tax cut for people who pay taxes? The rich pay most of the taxes, don’t they? And where is the money going to come from to put more money into the pockets of the rich? Why of course, out of Social Security, out of Medicare, out of the school-lunch program! Widows and orphans will have to go without so that the top 1% of the privileged class will have even more money for their pleasures. It does not take much political intelligence to see how much sense this makes in a political campaign, especially if it happens to be true. You cannot please either the financial markets or the political markets with a “tax cut” that is really not a tax cut at all, but a conservative attempt at social engineering. Newt Gingrich is gone because at the moment he came to the Speakership, he abandoned supply-side economics and dynamic scoring.

The 1996 presidential race showed how not to sell a tax cut, with Kemp again figuring in the action. The GOP nominee, Bob Dole, invited Kemp on the ticket after the Dole campaign had picked a tax program that Kemp already had publicly criticized as being ineffective. Kemp’s supply-side friends tried to point out to the Dole team that the idea of cutting the income-tax rates by 15% just for the sake of cutting rates was not terrible, but the design contained flaws involving the alternative minimum tax that would actually increase taxes on millions of middle-income Americans. The advice was ignored. Kemp was asked to put on an old Buffalo Bill jersey with his old No. 15 on it and to be a team player in selling it. Cutting the 39% top rate by 15% would not even get it back to where it was before President Clinton was elected and it certainly could not be sold as a growth measure. In his debate with Vice President Gore, Kemp was helpless against the Gore charge that it was a “risky scheme” that contained the flaws which Kemp had publicly criticized.

George Bush easily could have won the presidency this year, but he barely made it, and without a majority of the popular vote. His $1.6 trillion tax plan was not designed for any purpose but to return surplus taxes to the people. At the time the plan was designed by the demand-side economists in the Bush entourage, the economy was expanding. Indeed, several of the same economists who were involved in the design of the Dole 15% plan had come up with the tax package for the Texas Governor. So it was “sold” without regard to economic growth at all. The Bush economists decided that since the economy was booming under Clinton/Gore, they could not sell it as a growth measure, but as a “fairness” measure. It specifically excluded a cut in the capital gains tax. Its centerpiece was, and remains, a “fixing” of the marriage-tax penalty, another favorite of social conservatives and the Christian Coalition. Like the $500 kiddie credit, it is very expensive when reckoned both on static and dynamic analysis and comprises a significant fraction of the proposed $1.6 trillion total cut. Once again, the Democrats during the presidential campaign warned that the money to pay for all this would come out of the fixed pool. No matter how George W. Bush struggled to sell his tax plan as being fair to the people who had produced the surplus, Gore and the Democrats were able to rally their political base with the argument that the funds would come out of the Social Security/Medicare pool -- which then would be empty in the future when current workers became old and/or ill. With all his appeals of compassionate conservatism, Bush lost the black vote by a larger margin than any Republican since Barry Goldwater in 1964. Conservatives find it convenient to forget that Goldwater campaigned against the Kennedy tax cuts of that year as being fiscally irresponsible.

If tax cuts are to be politically “saleable” they have to have a purpose that makes sense to the broad electorate -- the national family. If the basic problem is that the black family has been destroyed over 40 years of inflation, destructive welfare rules, and declining real wages, the solution involves the creation of capital that will reach every corner of the country. Ask black and Hispanic leaders what they want most for their people and they will answer “Access to capital and credit!” The Keynesian argument on how to do this is to pass a law or a regulation that requires banks to lend to blacks and Hispanics, an affirmative-action, zero-sum measure, which is the favored solution of President-elect Bush’s Keynesian economists. This approach requires banks to lend to sub-optimal minority borrowers and withhold capital from optimal white borrowers. It further drives a wedge between the races, while reducing the overall efficiency of the economy. The most direct positive-sum solution would be an elimination of the capital-gains tax, which would dramatically expand capital formation and make it so plentiful that sub-optimal borrowers would become optimal. By increasing the capital/labor ratio, productivity would expand with the economy and so would real wages. The black family would be able to finance the household budget with the after-tax earnings of one breadwinner.

By “positive sum” we go back to John Kennedy’s metaphor of “a rising tide lifts all boats.” When it becomes possible to argue that reducing certain tax rates that now are damming up a wider or deeper revenue stream, the Democrats can no longer make the case that the scheme is risky or that it threatens to dry up the future sources of revenue for Social Security or Medicare.

This is essentially the answer I gave to the economist who called me last week with the question of how to sell the Bush tax program. Of course, I also advised that in order to sell the program, it had to be altered in order fit the appropriate sales argument. Paul O’Neill, who has been nominated to be Treasury Secretary in the Bush administration, was unable to make a positive-sum case for the $1.6 trillion plan he has to sell to the Congress. He had to fall back on the “fairness” argument, that the surplus should be returned to those who had sent it, not to those who hadn’t paid any taxes. The argument was as polished as it could be, but still ineffective. Senator Trent Lott, who will be majority leader after the Inaugural, has proposed a capital-gains tax cut to 15% as an amendment to the Bush plan, but the Bush economic team has plainly indicated that is not its preference.

Trying to sell a $1.6 trillion tax plan that is fundamentally flawed, I suggested, is similar to a manufacturer of dog food who hires the best advertising firm on Madison Avenue to sell fundamentally flawed dog food. If the dogs won’t eat it, their owners will not buy it, no matter how many nifty commercials they see.

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Thanks for your participation in the fall semester. I do hope you are back next week for the start of the spring session. Please spread the word to others who you think might be interested. The politics of an almost precisely evenly-divided government and the continuing battle between supply-side and demand-side economic theories will present many opportunities for our SSU lessons..