April 11, 2003
URL:http://www.washingtontimes.com/commentary/20030411-4579560.htm
Beneficial Rx for the economy
John Ryding
The U.S. economy is like a .350 hitter, who last season struggled through adversity to hit .290 and has now seen his batting average drop to .250.
Now .250 is not a terrible batting average, and neither is .290. But this hitter's potential is so much greater. The economy grew at 2.9 percent in 2002, though its potential growth is probably around 3.5 percent, and, in the early stages of the recovery, the economy would normally be growing at around twice the pace of last year.
Moreover, in February and March, amidst the swirling sandstorms of geopolitical uncertainty, the growth of the economy slowed significantly from last year. Speculation is increasing that the Federal Reserve will cut the Fed funds rate again in the coming weeks even though short-term interest rates the lowest in 44 years. There also are increasing discussions about what the Fed will do if the Fed funds rate gets close to zero. All this speculation, however, misses the point. Clearly, it is not monetary policy that is holding the economy back at present.
There is an economic policy proposal on the table, however, that I believe is the right prescription for lifting the economy out of the doldrums, and that is the president's plan for jobs and growth. The plan proposes to accelerate the income-tax rate reductions that Congress passed in 2001. This is just sound economic policy. If the tax cuts were a good idea at the time they were enacted, they are an even better idea now as the economy struggles to reach its potential growth. Further, by delaying the tax cuts to 2004 and 2006, current policy gives incentives to households and small businesses to postpone economic activity until it is taxed less.
Just as individuals accelerated income into 1992 to beat President Clinton's 1993 retroactive tax increase, so current tax law encourages individuals to delay receiving income and, with interest rates at 44-year lows, the cost of waiting is low.
However, the centerpiece of the president's plan is the elimination of the double-taxation of dividends, and it is this proposal I believe will bolster U.S. economic growth, create jobs and capital and improve the environment for corporate governance by encouraging dividends and discouraging leverage. It is also this element of the president's plan that is at risk, at least in part, by the Senate budget resolution to limit the tax package in 2003 to only $350 billion over 10 years vs. the House resolution of $726 billion.
Dividends in the U.S. are taxed at the highest rate of any major economy, which is poor economic policy for an economy with such a large savings deficit. In 2002, the U.S. ran up a current account deficit of $503 trillion, or 4.8 percent of gross domestic product, which represents the shortage of domestic savings vs. investment. U.S. economic policy should encourage domestic savings by reducing taxes on capital and boosting returns to saving. An economy with a high demand on capital should not be disadvantaged vs. the rest of the world by maintaining such high taxes on dividends, which ultimately could threaten the ability of U.S. corporations to raise capital to finance capital spending.
The U.S. tax system not only is biased against savings, but it is also biased in favor of raising debt rather than equity. For example, $100 of profit that is paid out as interest to a top-rate taxpayer results in an after-tax interest payment of $61.4 (because interest payments are deductible for tax purposes at the corporate level), whereas $100 of profits paid out as dividends are taxed at the 35 percent corporate tax rate and then the 38.6 percent top individual marginal tax rate, resulting in an after-tax dividend payment of $39.91. This represents a 53.8 percent advantage of debt over equity financing and encourages corporations to leverage their balance sheet, which in turn increases the financial vulnerability of corporations. Industries such as telecommunications and airlines continue to struggle under the weight of debt accumulated during the last expansion and eliminating the double-taxation of dividends would encourage sounder and more transparent corporate balance sheets.
There are those who criticize the proposal to eliminate the double-taxation of dividends on the grounds it would not provide any immediate stimulus to the U.S. economy. However, this argument ignores the discounting power of the equity market, which is able to anticipate changes in future after-tax cash flows. Consider $100 of profits paid out as dividends to a top-rate taxpayer under the president's proposal. Exempt from tax at the individual level, this would result in a $65 of after-tax dividends compared to $39.91 under current tax law, which represents a 62.8 percent increase in the amount of after-tax dividends that can be paid. The stock market would anticipate the increase in after-tax cash flows to investors and immediately capitalize this into the value of equities.
While discounted future dividends are far from the only determinant of stock prices, we believe a 20 percent boost to the equity market is a reasonable estimate of the increase in equity prices given the size of the boost to after-tax dividends. A 20 percent increase in equity values would raise household wealth by about $1 trillion, bolstering household balances.
Finally, there are those who criticize the proposal on the grounds of income redistribution. This misses the point that the major beneficiaries of the change would be workers rather than shareholders. The major determinant of real wage gains is productivity growth and the major determinant of productivity growth is capital spending. For example, over the last five years, real wage rates have risen 11.1 percent as productivity increased by 14.5 percnet, whereas real wage rates only rose this much over the prior 17 years. A policy that encourages capital formation and productivity growth thus benefits all working Americans, not merely those Americans who own stocks.
The Senate would be well advised for the good of all Americans to reconsider the president's proposal.
John Ryding is chief market economist for Bear Stearns & Co. Inc. |
