The war bucks economy

Larry Kudlow
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Posted: Dec 14, 2001 12:00 AM
As the global war on terrorism escalates, the role of military spending in the budget and the economy will inevitably become larger. Already, government strategists are discussing post-Afghanistan options that include Iraq, Yemen, Somalia, Sudan and Libya. As the conflict between Israel and PLO terrorists heats up, Lebanon comes into play, which means Syria and Iran may become theaters of war. This is a new type of war that will mandate a focus on costly high-tech equipment, even more so than the Gulf War, where large military formations engaged in combat. Rather than spending on personnel, bases, battleships or tanks, the focus will be on equipment like precision-guided missiles, battlefield communications systems and surveillance gear. U.S. military power, especially its technologically advanced precision weapons, have completely dominated in Afghanistan. Russian generals and other skeptics were proven wrong. This predominance will permit Washington to use the military as an instrument of diplomacy by other means in future terrorist conflicts. Nonetheless, we must not rest on our laurels. A high-priority build-up in defense spending is on the way -- although federal budget-makers have not yet wrapped their arms around this fact. There can be little question that early estimates of $2 billion per month to finance the war effort will fall way short of the mark before long. In fact, supplemental appropriations have already raised the original fiscal year 2002 spending level by $47 billion to $363 billion. It is necessary, then, to thoroughly examine our nation's defense needs, since defense spending as a share of gross domestic product during the 1990s dropped from 5.5 percent around the time of the Persian Gulf War to the woefully inadequate 3 percent of recent days. During the Cold War 1960s, the military budget absorbed about 9 percent of GDP. In the aftermath of Vietnam, defense slipped to less than 5 percent of the economy. President Reagan's final assault on Soviet communism temporarily increased the defense allotment to nearly 6.5 percent of national income, but it has been in decline ever since. For an even larger historical context, consider that national defense spending as a share of total federal budget outlays has plunged from 50 percent in the early 1960s to 15 percent more recently. Undoubtedly, Sept. 11 will make defense a far more important spending category. In ballpark terms, the defense budget could rise to the vicinity of 6 percent of GDP over time. That means annual spending increases of $75 billion in the years ahead, nearly three times the yearly increase originally budgeted for fiscal 2002. Like the rest of the economy, the military sector is being transformed into a high-tech machine. So stepped-up defense purchases and production will have a more salutary impact on the economy than has been the case in prior wars. Indeed, the coming economic recovery cycle will likely (SET ITAL) exceed (END ITAL) what nearly all economists anticipate will be the benefit of greater defense demands. There are already signs of this in the new factory-orders data for the month of October. Defense capital-goods orders soared by 206 percent, translating into 6 percent of all manufacturing orders during the month and 10 percent of all durable-goods orders. And the big October jump will not be a one-time event. While private sector equipment and software spending has slumped from a 15 percent growth rate over a year ago to nearly a 10 percent decline rate recently, defense spending in this area has accelerated from a 5 percent decline rate to a 15 percent rate of increase. While industrial production in the private manufacturing sector has been falling for 13 consecutive months, production of defense and space equipment has been on the rise. Of course, as the Pentagon will shop private-sector producers for equipment vital to the war effort, policy-makers need to help guarantee that defense goods remain affordable. Congress can do this by bringing corporate tax rates down and accelerating the depreciation rates used in capital cost-recovery calculations. This will go a long way toward reducing the burdensome tax cost of high-tech production. In addition, lower capital-gains tax rates would provide new investment incentives for the defense industry. So would dropping the top marginal income-tax rate from 40 percent back to the 1986 upper limit of 28 percent, as recently recommended by the mainstream Organization of Economic Cooperation and Development. This move would particularly benefit smaller, entrepreneurial defense suppliers who pay the personal income tax. It would also make available new investment flows from successful upper-end earners. Economic growth policies will be absolutely vital to financing and winning the war against terrorism. Over the next decade, pro-growth tax-reform measures can significantly expand national income and substantially elevate the tax revenue baseline to fund increased military spending and other national priorities. Expanding the economic pie is the best way to finance domestic and international needs. Supply-side tax policies will not only raise our potential to grow, they'll show the world just how strong the economic power of freedom and democracy really is.