War and taxes

Posted: Mar 27, 2003 12:00 AM

Will the president's tax plan be counted among the first casualties of war?

A week after stocks staged a prematurely optimistic war rally, the Dow retreated 307 points in just one day, back to 8214.

That was up from the prewar blues, but it is still awful. After all, the Dow bottomed at 8236 shortly after the horror of Sep. 11, 2001. And the Dow was a thousand points higher last June, before Congress promised to "restore investor confidence" by burdening business with new regulatory and legal risks. Surprisingly, the latest setback occurred despite the fact that Coalition troops took control of Iraq's largest oil fields, pushing oil prices back below $30.

The stock market and military setbacks were immediately followed by a setback for the president's tax plan in the Senate. Only four days after decisively rejecting by 62 to 38 a proposal to shrink the 10-year tax cut to $350 billion, more than a dozen senators suddenly changed their minds about that. The president's plan would otherwise have "cost" about $663 billion ($388 billion from eliminating the second individual tax on dividends), according to the Congressional Budget Office, although serious newspapers have been uncritically echoing an unserious $726 billion figure.

The wayward senators seized upon the president's request for an extra $75 billion for temporary war-related expenses as a handy excuse for permanently trimming the tax cut by more than $300 billion. Nobody who passed the fourth-grade math could fall for that story.

You have to wonder if those senators would have been so fickle about suddenly withdrawing support for the president's tax plan if news from Iraq and the stock exchange had not just as suddenly turned against the president. A timely cut in tax rates and dividend taxes would boost investor and consumer spirits, and the resulting stock market rally would boost the president's clout with Congress -- and such presidential popularity would make it professionally risky for any senator to oppose sensible cuts in tax rates and dividend taxes. But that chain suddenly has a weak link: the Senate.

Another weak link is the fact that supporters and critics of the president's plan keep talking as though estimated revenue is all that matters, regardless of which tax is cut or how or why. What should be a thoughtful examination of the cost and benefit of each item in the tax package -- and perhaps adding a few other improvements -- has degenerated into a primitive Keynesian feud over its sheer size.

There are odds and ends in the president's package that have no meaningful impact on marginal incentives and could harmlessly be postponed. Accelerating the marriage penalty scheme, a 66 percent increase in the child credit, enlarging the 10 percent tax bracket and the AMT exemption -- together these account for $242 billion, nearly 40 percent of the Treasury's estimate of the total.

Letting such warm and fuzzy social policies take place gradually, as they will under the 2001 tax law, would certainly not be "a large economic setback." Yet even carving out that $242 billion would not meet the Senate's super-frugal standard. You can bet that the senators favoring the tight dollar cap are the same ones who would vote to keep the ineffective fuzzy stuff and discard the economic substance. And you can also bet that not one of them is nearly as frugal when it comes to spending the taxpayers' money as they are when it comes to letting taxpayers keep it. American families, farms and firms have budget problems, too.

From a supply-side (i.e., correct) perspective, only two parts of the Bush tax plan really matter -- cutting marginal tax rates now rather than later and ending or at least easing the double tax on dividends. Accelerating the tax rate reductions has only a small and temporary negative effect on tax revenues, well below $100 billion even on a foolishly static basis. Taxing dividends the same as capital gains could also be accomplished with little or no long-term revenue loss, particularly if dynamic benefits to the economy are considered.

There are numerous other tax changes that would be extremely helpful with no visible loss in revenue. One such free lunch would be killing the inexcusable corporate alternative minimum tax, which aggravates recessions by taxing unreal profits but subsequently returns the loot with tax credits during boom times. Another cheap fix would be eliminating the tax penalty on short-term capital gains, which is easily avoided with clever timing but which nonetheless hurts savings and the market by making stocks less liquid and more risky.

Chronic ignorance about such complex microeconomic incentives is the flip side of the simplistic macroeconomic alchemy of pretending to smooth-out the inevitable ups and downs of business through expert manipulation of budget deficits. Liberal Keynesians claimed budget deficits were a "fiscal stimulus" and surpluses a "fiscal drag." Conservative Keynesians made the opposite argument with equal ardor, claiming budget deficits raised interest rates while surpluses added to savings and investment.

Ironically, today's liberals sound like yesterday's conservatives. In a 1992 Wall Street Journal op-ed, I called President Clinton's economic advisers "Eisenhower Democrats." That label made Clinton scream at his staff, according to Bob Woodward. But it was just intended to highlight the contradictory irrelevance of both liberal and conservative versions of Keynesian demand-management.

When Chicago economist Robert E. Lucas Jr. was awarded the Nobel Prize in 1995, they called him "the economist who has had the greatest influence on macroeconomic research since 1970." When the most influential macroeconomist of the past three decades talks it is smart to listen.

In January, Lucas presented a typically decisive paper on "Macroeconomic Priorities." He found that "there remain important gains in welfare from ... providing people with better incentives to work and save, not from better fine tuning of spending flows." He added that "the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management."

By contrast, President Bush's Keynesian critics, such as Paul Krugman of The New York Times, pretend that what we need is more short-run demand management, better fine-tuning of spending, rather than long-run supply-side policies to improve incentives to work and save. Keynesian diehards eschew policies that are known to work and promote policies that are sure to fail.

Veteran Washington Post columnist David Broder observed two year ago that "this year, as in 1981, you can see congressional Democrats recalculating how far they have to bend their principles and suppress their doubts in order to avoid being caught on the losing side of the tax debate." If your party keeps losing such debates, year after year, and also keeps losing elections, perhaps it is time to consider the possibility that you just might be wrong.

Broder, whose musings are often enlightening on other topics, will keep his job no matter how frequently he offers terrible economic advice. Senators using budgetary excuses to obstruct lower tax rates and lower dividend taxes, despite nearly three years of economic and investor disappointment, may need to be gently reminded before it's too late that they cannot be equally confident about their own job security.