Franklin Delano Hoover
upi.com
Analysis: Franklin Delano Hoover?- III
By Martin Hutchinson
UPI Business and Economics Editor
From the Business & Economics Desk
Published 11/8/2002 11:48 AM
View printer-friendly version
WASHINGTON, Nov. 8 (UPI) -- To deal with the current difficult economic situation, in which recession is sliding into "double dip" depression, the Bush administration needs to mitigate possible policy dangers and to avoid delusion, either in itself or among investors. However it must also take positive policy steps if George W. Bush wants the economy in November 2004 to be in a state that permits his re-election.
I have divided this analysis into three parts. The first part, published Wednesday, examined closely the historical analogies and the problem facing the administration. The second part Thursday looked at the available remedies in the areas of danger mitigation and delusion avoidance. This third part examines the few positive steps that can and must be taken to ensure speedy recovery.
The current combination of exceptionally loose monetary policy, fairly loose fiscal policy, a stumbling economy, a large payments deficit, excessive consumer credit, high debts in the banking system and a stock market that is still overvalued is a very dangerous one.
In particular, there is a danger that the stock market drop and accompanying dollar weakness that is more or less inevitable in the next 18-24 months will damage investor confidence and consumers' financial positions to such an extent that we will return to an even more depressed version of the "malaise" economy of 1978-79, with no growth and reawakening inflation, only without either fiscal or monetary tools available to rescue us.
The current monetary looseness, as has been amply demonstrated during 2002, does very little for the productive sectors of the economy, but is producing a housing bubble, accompanied by record levels of mortgage refinancing, much of the proceeds of which goes into consumption. Meanwhile the weak stock market and credit overhang in the banking system together prevent productive industry from getting the finance it requires and mean that the U.S. capital stock becomes frozen in its distorted state of 2000, with excess telecom bandwidth and very little genuine innovation.
The solution is to rebalance the economy, by providing a tax policy that benefits sound stock market investment while penalizing excessive consumer borrowing, mortgage and otherwise.
The current U.S. tax system works in precisely the opposite direction. Home mortgage interest is tax deductible, without limitation, providing a huge subsidy to housing as distinct from other forms of consumption. On the investment side, while capital gains are taxed at moderately favorable rates, dividends are taxed twice, at the corporate and personal level.
Thus $1 of pretax corporate income paid out as a dividend becomes 65 cents after corporate tax, then is subjected to personal tax at (say) 31-percent federal income tax plus 5-percent state income tax, so that only 41.6 cents are left for the dividend recipient, even in this case, where federal and state income taxes are by no means at the highest possible levels.
The solution is to adopt a tax reform that is balanced, without significant income re-distribution effect and yet eliminates the subsidy of housing finance and double taxation of dividends.
Allow dividends to be deductible against corporate income for tax purposes, taxing them only at the recipient level.
Simultaneously, remove the tax deductibility of home mortgage interest above a fixed level, chosen so as to balance the cost of the dividend tax change.
The back of my envelope says capping the deductibility of mortgage interest at $10,000 per annum should do it -- thus a taxpayer paying $12,000 in mortgage interest would be able to deduct only $10,000, and not the extra $2,000. However, my envelope is not the Congressional Budget Office econometric model, which would determine the precise deductibility limit that would equalize tax cost and revenue when both changes were taken together.
The great majority of the cost and benefit of this dual change would go to the relatively wealthy, those with mortgages more than $160,000 (at present interest rates) or with substantial share portfolios. Of course, there would be a few less wealthy people affected -- young middle-class families in major urban centers with large mortgages would suffer, while elderly pensioners living off savings would benefit.
This dual tax change would have two economic effects.
It would reduce the huge benefits that the recent reduction in interest rates has brought to home ownership, thus cooling off the housing bubble.
More important, it would stabilize the stock market.
If stock valuations are primarily driven, as theory states, by the expected future stream of dividends, then a tax change that reduced dividend tax by 35 percent (and thus, ceteris paribus, increased net dividends by 35/65) would also increase the equilibrium level of the stock market by 35/65 -- from around 5,000 on the Dow, as today, to 7,692. Only a modest decline from current values would then bring the stock market into equilibrium and end the spiral of asset deflation.
As well as bringing the stock market closer to equilibrium, removing the double tax on dividends would increase the proportion of equity returns that came from dividends and thereby stabilize the stock markets going forward, making a repeat of 1996-2002's asset bubble and vicious backlash less likely.
Dividends, being cash, are much more difficult to manipulate than earnings, so a move toward higher dividends would tend to thwart two cancers of the capitalist system: thieving management and dishonest brokers. The more transparent are the returns from stocks, the better able are investors to make informed decisions and the better the system works.
There would be additional second-order benefits from this tax change. It would reduce the rate of house price appreciation and divert savings into productive uses, thus benefiting the economy as a whole. It would also reduce the attraction of foreign source corporate income (which, being taxed abroad, would not if paid out as dividends benefit from the U.S. tax exemption) and of tax shelters -- shareholders would have every reason to grumble if management put their money in tax shelters instead of getting an equal tax shelter by paying it out to them in cash.
All three of these second-order effects would benefit U.S. economic activity and tax revenue, making the change highly economically simulative, as well as tax revenue positive rather than revenue neutral as the static model would suggest.
Overall tax cuts (beyond making permanent the 2001 cut, which has no short-term effect but is desirable for long-term planning) are dangerous in revenue terms now that the United States is running a budget deficit, and approaching an actuarial problem when the baby boomers start retiring around 2008. "Tax reform" along the lines of the 1986 measure, simplifying the tax structure and lowering rates, is certainly desirable, and probably increases growth incrementally, but has little short-term effect in getting the United States out of recession.
The tax change outlined herein, by redistributing the benefit of lax monetary policy from housing, where it is at best neutral, to the productive sectors of the economy and by removing the chasm that still yawns under current stock market valuations, would stabilize the economy within 12-18 months and allow it to resume growth.
Politically, Bush appears today to be truly gifted, like Franklin Delano Roosevelt. Without exceptionally skilled economic policies, the current asset-deflation recession will deepen into a depression, making him almost certainly a Franklin Delano Hoover, a clever politician who nevertheless fails to be re-elected because of a poor economy.
The tax changes outlined herein, together with the defensive and cosmetic measures outlined in part 2 Thursday, would allow him to become a Franklin Delano Coolidge, a president skilled both politically and economically, who achieves triumphant re-election. |
