Late Friday afternoon, as the U. S. Senate inched toward its Memorial Day recess, Senate Majority Leader Bill Frist (R-Tenn.) placed an exclamation mark on the hypocrisy of the week. Addressing his colleagues, he thanked them for the bipartisan spirit that had animated the Senate's deliberations on the tax-cut proposals. That morning, Vice President Dick Cheney had cast the tie-breaking vote in the Senate to reduce taxes on investment income to the lowest level since the Great Depression. Unbeknownst to the outside world -- and contra Frist's invocation of bipartisanship -- Democratic senators and representatives were denied the privilege of actually seeing the legislation on which they were voting.
After the tax vote, the Senate enacted a $1 trillion increase in the national debt ceiling -- the largest such increase in the country's history. Some observers thought deferring the debt-ceiling vote until hours before a weeklong recess was a hazardous bit of brinkmanship, as the government faced default in several days. But the logic behind the down-to-the-wire strategy was impeccable. The House of Representatives had recessed for its Memorial Day break in the wee hours of Friday morning because it was deemed politically unbecoming to compel fiscally conservative House Republicans to vote for a higher debt ceiling immediately after enacting massive tax cuts. The House having bolted town, the Republican Senate leadership correctly calculated that to avert default, the Senate would be forced to accept the increased debt ceiling precisely as written in House legislation weeks earlier.
The farcical procedural charade acted out on Friday pales before the substantive long-term harm done to the economy and financial markets. The skewed distributional effects of the tax cut have been well advertised: The majority of taxpayers receive 5 percent of the benefits while the top 5 percent of taxpayers reap the lion's share. Tax burdens shift from investors to future wage earners. Proponents argue that because wealthy taxpayers pay more in total tax dollars, they should reasonably expect a larger piece of any equitable tax cut. Sensible rhetoric, bad math. A proportionate tax cut would mean that a family earning $2 million a year would receive 40 times the tax-cut benefit of a family earning $50,000 annually. The rich family wouldn't spend much of that extra money, so the plan would constitute a lousy stimulus program, though a case could be made that it would be fair. But can the new law -- under which the $2 million earner receives 200 times the benefit of the $50,000 family -- really be called fair?
A subset of the social-equity argument is that the dividend tax cut benefits the elderly. It's true that the majority of the dividend break goes to the elderly. What's missing from the analysis is that the more affluent happen to be disproportionately concentrated among the elderly. As Jonathan Chait points out in The New Republic, the bulk of the dividend benefit goes to the one elderly person out of nine who earns more than $100,000 a year. From the perspective of an economic stimulus, the tax package has our policy goals precisely backward.
The United States faces two fundamental problems: the risk of continued subpar growth over the near term and the prospect of daunting deficits while we fund the baby boomers' retirement over the long term. The logical response would be to maximize short-term stimulus and constrain out-year deficits; this package has it in reverse. Indeed, a pervasive misconception in the wake of the federal tax cut is that government fiscal policy is now expansionary. Actually, state and local government combined are twice as large as the federal government, and the spending cuts and tax increases at the state and local level -- a necessary response to the worst budget crisis since World War II -- will largely offset the federal stimulus.
In fact, despite a $20 billion increase in federal aid to the states -- the only element of the program genuinely expected to expire after two years -- the package has three negatives for state and local finance. First, borrowing costs may edge higher as the marginal investor shifts from municipal bonds to tax-advantaged dividends. Second, many states have income-tax systems that piggyback off federal income taxes and capital gains; lower federal tax rates automatically reduce state revenues in those jurisdictions. Finally, the big kicker in the federal bill -- lower rates on dividends and capital gains -- obviously provides no direct benefit to state and local pension funds, which are already tax-exempt. If the legislation had been drafted to permit corporations to deduct dividend expenses, a sensible idea that would actually reduce the cost of corporate capital, pension funds and other tax-exempt investors would have benefited.
Intellectually honest proponents of the tax package downplay its short-term stimulative effects. The central problem facing the economy today is the excess supply of goods and services relative to demand, the residue of the investment bubble. Higher after-tax returns for investors will not induce businesses to increase hiring or make capital expenditures; only increased demand will do that. To increase demand you send dollars to taxpayers with the greatest propensity to spend, not the wealthiest taxpayers with the strongest propensity to save.
The case for the tax package as short-term stimulus simply cannot withstand scrutiny. The stated cost of the legislation is moderate because its various tax benefits expire after a few years (the so-called sunset provisions), yet the package will induce behavioral change because everyone knows the sunsets are fraudulent. Companies will divert cash flow to raise dividends in response to investor pressure, but they will also deploy the same cash flow to increase hiring and capital expenditures. The lowest interest-rate environment in 45 years proves that deficits don't matter, but the disconnect between today's rate environment and the impending economic boom is some inexplicable and meaningless anomaly.
The single feature of the tax package that demands respect is its political brazenness. There are reasons no president in a quarter-century has proposed a serious dividend tax cut. (The Carter White House briefly supported a version but dropped it.) Public-opinion polls show an overwhelming preference for increased federal aid to state and local governments, health-care spending, and buttressing Social Security and Medicare -- all instead of tax cuts. There is even less support for cutting capital gains and dividends taxes, because the benefits of those cuts are concentrated among the wealthy. So if the arguments about fairness and short-term stimulus are disingenuous, why is this package now law?
The mind-set that produced dramatically reduced taxes on investment profits is based on an economic faith that is theological in its intensity and imperviousness to rational analysis. It has long been an article of faith in some circles that eliminating taxes on capital would unleash productive investment and a new age of economic growth. Increased incentives for investors are good for financial markets, and stronger market returns will ripple across the economy.
This legislation is the most powerful expression of that theological belief in our modern economic history. The immediate response of most Wall Street commentators is that whatever you think about fairness or deficits or accounting hocus-pocus, this bill is good for the stock market. On a near-term basis, the reinforcing effects of lower taxes, a strategy of dollar devaluation and global monetary easing could certainly feed ebullience. As a fiduciary of a public pension fund with a long-term horizon, and as an equity investment manager with a similar perspective, I would certainly find it reassuring to believe that the long-run outlook is positive. And if the package had directly reduced corporate capital costs by permitting corporate deductions for dividend payments, it would have increased corporate return on equity. But the irony is that a package constructed to juice investment markets will ultimately have the reverse effect.
Assuming no collateral impacts, lower taxes on any asset class will increase valuations of that asset class. Thus tax subsidies for equity investments should increase equity values. However, there are caveats and collateral effects. The largest caveat is that most of the stock-market investor pool is tax-insensitive. The majority of equity ownership is in the hands of foreigners and tax-exempt investors. A further significant share is held on behalf of taxpaying investors in equity mutual funds, whose relevant benchmark is pre-tax performance. Institutional funds know that most investors chase performance without checking those pesky after-tax returns.
The larger problem with the new tax law can best be understood in terms of the recent problems in corporate governance. It may be OK for a closely held private company to cook the books to manufacture phony earnings; no harm, no foul if an owner wants to bamboozle himself. But with a public company, especially one heavily dependent on continued financing from the capital markets, make-believe accounting to cover up a deteriorating balance sheet is ultimately counterproductive. When investors figure it out, the terms and conditions under which they will provide capital become harsher. Capital markets will require higher interest rates on your debt, pay less for your stock or devalue your currency.
The company at issue here -- U.S.A. Inc. -- is dependent on external capital flows of nearly $2 billion a day, which works out to a record 5 percent of our gross domestic product.
At the same time, we face a long-term structural budget deficit beyond anything any superpower has ever faced. You can't find the numbers in any official forecasts, because those forecasts are based on twilight-zone accounting constructs. Serious Republican senators, such as Foreign Relations Chairman Richard Lugar (R-Ind.) and Chuck Hagel (R-Neb.), candidly warn that the alternative to a failed Iraqi state is a multiyear and expensive U.S. commitment there, but it's not in the budget. Everybody in Washington knows that the alternative minimum tax as written will hit 40 million families by the end of this decade. Unless every incumbent member of Congress is prepared to face the holy wrath of middle-class voters, which would be an uncharacteristic inclination, the alternative minimum tax will be rewritten.
Then there's the new tax law, where the dry discipline of public accounting mutates into high satire. The bill is a pileup of accounting fictions, a fun house of tax benefits that jump out at you only to expire when you enter the next room.
The addictive appeal of sunsetting tax cuts -- here's your money, now it's gone -- has made it the drug of choice for public accounting, the public-sector analogue to stock options. Once corporate management understood that options weren't treated as compensation (and thus not an expense), it was theoretically possible to assemble an entire management team without incurring any compensation expense.
The standardization of sunset provisions as a tax-accounting tool opens infinite new possibilities. Enact a tax benefit designed to be of indeterminate duration into law. The dollar cost of the benefit for two years is $100 billion, which means that it's only $10 billion annually when measured against a 10-year budget plan. And because nobody seriously cares about tax-code provisions taking effect years in the future, the next iteration will be to offset the cost of short-lived tax benefits with tax increases effective in 2012. That modest step, hardly a leap for those who brought us this far, yields political nirvana: a perpetual stream of tax cuts with zero budgetary impact.
Strictly speaking, what we call tax debts are debt obligations that will be borne by our children. The morality of such an intentional debt transfer aside, that debt is a tax on long-term economic growth. And the contempt we have shown for our long-term fiscal health and any semblance of honest public accounting will entail a price in terms of global capital flows.
The unvarnished truth is that this legislation is regressive, out of sync with national priorities, inefficient as short-term stimulus and unaffordable to boot. It is driven in part by motives that cannot be publicly articulated: rewarding a contributor base and forcing an eventual fiscal crisis, which will compel the government to defund public programs and privatize the major entitlement systems. The one stated argument that proponents actually believe is that lower taxes on capital will catalyze a long-term investment boom, the modern incarnation of trickle-down economics.
After the House of Representatives had approved the president's tax plan, Majority Leader Tom DeLay (R-Texas) defiantly announced, "This ain't the end of it. We're going to have some more." He was giving voice to the widely held view that later this year and in each subsequent year, the president will advance new agendas of tax cuts. Taking care of your base isn't exactly revolutionary behavior in politics, and magical thinking about financial markets that masquerades as economic theory is red meat to the base. But in a world of globalized capital flows, a cascade of budgetary fabrications will eventually have horrific consequences. Even in economic policy, contempt for world opinion will ultimately be noticed -- and answered.
Orin Kramer is chairman of the New Jersey State Investment Council, former associate director of the White House Domestic Policy Staff under President Jimmy Carter and an investment manager. The opinions expressed here are Mr. Kramer's and do not reflect the views of the State Investment Council.
