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The Assault on Growth

Break out the John Travolta videos; if you liked the 1970s you will love the next four years.

We are at an inflection point in contemporary history where depending on the angle of how it is thrown a stone either skips elegantly across the surface of the water or it sinks immediately to the bottom. The much discussed “stimulus” bill that President Obama will sign, has been presented as an emergency measure that must be passed immediately never mind that most members of Congress couldn’t possibly have read all one thousand pages of the bill in its entirety. Obama has asked citizens to judge him by the number of jobs his plan will create – three million– yet even by its proponents own measure; the plan is short of immediate spending and will be hard pressed to make that target. Most of the infrastructure spending doesn’t take place until late 2010 or 2011, about the time the economy should be well out of the current recession.

But there is a larger question that is more critical than whether this or another version of a stimulus package will pull the economy out of the ditch. Step away from the current debate to consider where the U.S. is heading irrespective of what gets signed:

  • Tax rates are going up, not down
  • The U.S. has the second highest corporate tax rate in the world.
  • The Alternative Minimum Tax (AMT) will hit 25 million annually.
  • The country is turning its back on an open trading system.
  • Relative to other currencies and relative to most commodities the dollar is falling.
  • A massively masochistic global warming “cap and trade” scheme threatens to punish domestic industries and send jobs to China, the rest of Asia and to developing nations generally.
  • Health care, which is already one-sixth of the American economy may soon be nationalized.
  • Trade unions will gain power if not more broad based membership.
  • Access to new domestic oil will be inconsequential with national policy driving the cost of energy ever upward.

Nothing in the stimulus bill will change any of the above. So perhaps this is a good time to consider what it takes to grow an economy especially one griped by recession. Speaking at a Manhattan Institute forum recently Stephen Moore, senior economics writer for The Wall Street Journal, identified four necessary cornerstones for economic growth: 

  • A tax policy with low rates and a broad base.
  • Commitment to an open trading system.
  • Sound money.
  • Keeping government regulation under control.

Compare this to the developments cited previously. That we’re not exactly headed in the right direction suggests confusion among the experts. The policy dials that were once tuned toward growth are being turned to something quite different. The political class as well as the chattering class are consumed with policies that promote “fairness,” income redistribution to “help the poor,” the environment, to help the unemployed, or “obscene” CEO pay. In short, it’s about good intentions. The trouble is the connective tissue between the means and the ends seem to be at odds.

One is reminded of the interview ABC News anchor Charlie Gibson had with Barack Obama during the Presidential campaign before the Democratic primary debate in Philadelphia. The interchange between Gibson and Obama on the then Senator’s plans to raise the capital gains tax went as follows:

Gibson: Senator, you have said you would favor an increase in the capital gains tax. You said On CNBC, and I quote, “I certainly would not go above what existed under Bill Clinton,” which was 28 percent. It’s now 15 percent. That’s almost a doubling, if you went to 28 percent. But actually, Bill Clinton, in 1997, signed legislation that dropped the capital gains tax to 20 percent.

Obama: Right.

Gibson: And George Bush has taken it down to 15 percent. And in each instance, when the rate dropped, revenues from the tax increased; the government took in more money. And in the 1980s, when the tax was increased to 28 percent, the revenues went down. So why raise it at all, especially given the fact that 100 million people in this country own stock and would be affected?

Obama: Well, Charlie, what I’ve said is that I would look at raising the capital gains tax for purposes of fairness. We saw an article today which showed that the top fifty hedge fund managers made $29 billion last year–$29 billion for fifty individuals. And part of what has happened is that those who have been able to work the stock market and amass huge fortunes on capital gains are paying a lower tax rate than their secretaries. That’s not fair.

Gibson: But history shows that when you drop the capital gains tax, the revenues go up.

Obama: Well, that might happen, or it might not.

When I first heard this exchange on television my jaw dropped. Does this person have the slightest clue about how economies work in the real world?  Does he understand how jobs are created – and destroyed? Why do liberals profess to love creating jobs but hate the people who actually create jobs? Mr. Obama admitted before millions of people on national television that he would raise the capital gains tax–even if it meant a fall in revenues collected by the federal government – all in the name of “fairness.” And he insists that anyone who disagrees with him is – wait for it– an “ideologue.”

Milton Friedman once wrote that the problem is “not that we don’t know what works, or that we don’t know what the answers are. The problem is that there are so many self-proclaimed experts who know what is not so.” In their recently published book, “The End of Prosperity,” authors Stephen Moore, the aforementioned editorial page writer for The Wall Street Journal, Arthur Laffer, the Stanford economist and inventor of the eponymous Laffer Curve and Peter Tanous, president and CEO of Lynx Investment Advisory LLC, set forth a cogent economic history of the last 50 years in terms of what policies promote growth and which ones destroy it. It is perhaps the best and most accurate summary of where we have been and, sadly, what may be in store in our future.

Liberals like to disparage any supply-side argument with the notion that “tax cuts are the solution to every problem in the world.” Not true. Tax policy is important but the underlying truth is that people respond to incentives. And that growth is achieved by expanding the supply of goods and services through incentives – and by knocking down disincentives to work and the formation of capital.

The facts are plain. The authors exhaustively document that there were two Presidents who understood this well, one a Democrat, John F. Kennedy, and another a Republican, Ronald Reagan.  President Kennedy sponsored legislation to cut income tax rates by 30 percent. These cuts spurred economic growth and job creation at rates the country had not seen since Coolidge. Total national employment grew by more than one million jobs in the four years after the enactment of the Kennedy tax cuts. The economic growth rate grew from 4.3 percent to 6.6 percent. The tax cuts generated an increase in revenues which helped balance the budget. Total tax receipts grew from $48.7 billion in 1964 to $68.7 billion by 1968. This was a faster rate of growth in collected federal revenues than was achieved in the previous five years before the tax cuts were enacted.

And while we are on the subject of economic stimuli, the authors helpfully quote Arthur Okun, President Lyndon Johnson’s chief economic advisor, who calculated a massive stimulus from the plan: “The tax cuts of 1964 are credited with a $25 billion contribution to our GNP by mid-1965, a $30 billion effect by the end of 1965, and an ultimate $36 billion increment.” Remember this was 1966 when the U.S. economy was one-fifth as large as today.  Even Walter Heller, President Kennedy’s chairman of the Council of Economic Advisors concurred when he later testified before Congress in 1977.

“What happened to the tax cut in 1965 is difficult to pin down, but insofar as we are able to isolate it, it did seem to have a tremendously stimulative effect, a multiplied effect on the economy,” Heller told Congress.

Unfortunately the destructive legacy of Lyndon Johnson, Richard Nixon, Gerald Ford and Jimmy Carter, what Moore & Co. call “the four stooges of the American Presidency,” undid everything Kennedy’s policies set out to achieve. LBJ’s income tax surcharge, Nixon’s wage and price controls, Ford’s  staggering ineptness (remember  the “Whip Inflation Now” buttons he handed out), and  Carter’s windfall profits tax among numerous other blunders triggered one of the worst bear markets in our history since the Great Depression. The Dow Jones average fell 20 percent in nominal terms and 70 percent in inflation adjusted terms. The authors quote Florida State University economist James Gwartney: “By 1980, the average tax rate of a typical working couple with two children had risen to 20.9 percent with only 13.7 percent in 1965. More importantly for incentives, the couple’s marginal tax rate jumped from 23.6 percent in 1965 to 35.1 percent in 1980.” During this period inflation went from bad to worse. It shot from 7 percent in 1978 to 14.5 percent by 1980. Mortgage rates in that year hit an astronomical 21.5 percent. Unemployment hit 7.2 percent. By 1980 the misery index the combination of unemployment and inflation rates reached 21 percent!

Keep this mind the next time Obama announces that our current distress is “the worst since the Great Depression.” He’s only off by fifty years.

What turned things around was a new President who understood that incentives matter. In 1981, President Reagan worked with Democrats to enact a tax bill that would lower rates. Unfortunately the delayed phase-in put the recovery off by two years. By 1983 the economy expanded by 3.5 percent and by 1984 by 6.8 percent. Congress took back some of the scheduled cuts in subsequent legislation but the Tax Reform Act of 1986 broadened the tax base and flattened rates down to just two: 15 percent and 28 percent. In 1999, The National Bureau of Economic Research declared the period from 1982 to 1999, “the longest sustained period of prosperity in the twentieth century.” The Federal Reserve calculated the net wealth – assets minus liabilities–of all U.S. households and businesses during this period at $25 trillion in today’s dollars. Moore told a group at the Manhattan Institute that, adjusting for inflation, more wealth was created in America during this 25 year period than in the previous 200 years.

Obama likes to say that he’s a pragmatist but doesn’t want to return to the “failed ideas of the past.” “We tried tax cuts and they didn’t work,” he often says. Really? (Whatever they teach at Harvard Law School it isn’t economic literacy.) The favorite narrative of liberals is that tax cuts only favor the rich. But the record for both the Kennedy and Reagan years is that the rich paid more in taxes than they had previously and that incomes for middle income groups advanced appreciably. For example, the poorest 20 percent of Americans experienced a 6 percent gain in real income in the 1980s after suffering a five percent decline in the 1970s. Blacks saw incomes rise 11 percent compared to 9.8 percent for whites during the Reagan years.  While it’s true that many unionized factory jobs in industries like steel, autos, and textiles were lost due to overseas competition, for every job lost between two to three jobs were gained in services, technology, healthcare and knowledge-based industries.

Moore  & Co. worry that Obama is the “anti-Reagan” in that he is determined to brush aside the evidence of the past in order to create a new New Deal one that will rinse and repeat the policies of the 1970s. The spending conjured by the stimulus bill, Moore argues will result in more borrowing in inflation adjusted terms than was borrowed by the U.S. from 1776 to 1980. (The fact that a Republican-led Congress under Bush 43 went on a huge spending spree, basically destroyed its brand, as the party of fiscal soundness.)

Over the last forty years, the markets have not been bullish about a Democratic monopoly on power. The last three times Democrats controlled all the levers of power in Washington, 1965-68, 1977-80, 1993-95, “They were pushed by unions, environmental groups, the poverty lobby, and trial lawyers to pass sweeping anti-growth changes in tax, regulatory and spending policies that torpedoed the economy,” according to the authors. Interestingly the authors conclude that the second worst predictor of anti-growth than Democrats controlling every branch of government is when Republicans control everything. Divided government, at least in postwar America, seems to favor bullish economic outcomes. Bill Clinton’s economic policies improved after 1994 when a new Congress saved him from his worst excesses. After flirting with the left wing of his party he moved to the center supporting NAFTA and free trade. His reform of welfare, for example, “ending welfare as we know it” in no small measure also restored incentives to work and was as significant in its own way as Nixon recognizing China.

Moore thinks Obama should learn from Bill Clinton’s experience, but fears that he is taking on Jimmy Carter’s thinking.  If low tax rates really failed why is it that virtually every country around the world are adopting policies which the U.S. once championed but has now turned its back on? Sweden, of all places has lowered its capital gains rate so that it is ten points below that of the U.S.!  Moore remarks that “while the new Left in America continue to argue on talking-head TV shows and on the floor of the U.S. Congress that tax rates don’t matter, the rest of the world has stopped listening to them.” He met with the lead tax counsels from many Fortune 500 companies: Intel, Dell, IBM, and Caterpillar. He reports the consensus was that “in most countries today large companies can virtually cut their corporate income tax liability to zero. What was disturbing was that several of the executives, who are in site selection for new plants and factories, said, ‘The tax rates are way too high in the U.S. We don’t even consider the U.S. for expansion anymore.’ “Moore adds,We’ve forfeited our lead.”

Now if only Obama can find his inner Clinton.

About J.P. Donlon

J.P. Donlon
J.P. Donlon is Editor Emeritus of Chief Executive magazine.