If you hoped that Alan Greenspan’s congressional testimony last month would help cut through the thick fog of competing opinion on President Bush’s tax-cut plan, you were probably bitterly disappointed. Greenspan proved once again, in my opinion, that he’s the world’s greatest two-handed economist: “On the one hand…but on the other hand….” And the conflicting media coverage of his conflicting statements probably didn’t help matters.
So let me try to cut through the fog for you, so you can clearly evaluate the controversies about Bush’s plan for yourself. If you’ve been reading my columns you know that I support the plan. But long-time readers also know that I’m not a “Bushie” or even a Republican. Rather, I support Bush’s tax-cut plan because I’m an investor, and I happen to think that the plan will help the economy grow, politics entirely aside. So let’s do a simple question-and-answer session, and see if you end up agreeing with me.
Will eliminating the double-tax on corporate income help the economy grow? Yes, because of a very simple chain of reasoning. The most powerful source of economic growth is productivity growth — in fact, they are very nearly the same thing. Productivity growth comes from capital invested in new equipment, new technologies and new businesses that allow people to work more effectively. Eliminating taxes on dividends and retained earnings would increase the expected return on that invested capital — so people with capital will invest more of it. The result will be more productivity and more economic growth.
Is the double-taxation of dividends unfair? Yes, because when a company whose stock you own makes money, that’s your money. When the company pays corporate income taxes on it, that’s your money being taxed. When the company sends you a dividend, they’re simply returning your money to you, with taxes already paid. Why should you pay taxes again just because your money was transferred from the company to you?
Won’t cutting taxes on dividends just benefit the rich people who receive dividends in the first place? It will indeed benefit them directly, but it will also indirectly benefit many more people who don’t receive any dividend income at all. A worker’s wage is primarily a function of one thing: how productive he is. Eliminating dividend taxes will trigger more business investment that will in turn make workers more productive — and as a result, wages will rise.
Will tax-free dividends make the stock market go up? Yes. I wrote about this extensively two weeks ago, and my forecast is that the S&P 500 index would rise by about 15% if dividend taxes were eliminated. A crude example shows why. Today a $10 stock that pays a $1 dividend that’s taxed at a 50% rate has a 5% after-tax yield. If the dividend tax were eliminated, the after-tax yield would jump to 10% — or would it? In a reasonably efficient market, the stock’s price would surely double to $20, restoring it to the 5% after-tax yield that the market judged appropriate all along.
Will tax-free dividends hurt other tax-free investments such as municipal bonds? No, stocks won’t offer any better competition to munis than they do today. Based on my argument above, the after-tax yields of stocks will be no different after a tax cut than they are now. So there’s no reason to think that investors would prefer them to munis any more than they do today.
Is the Bush plan all about dividends? No, there are many other features. One of my favorites is the creation of new types of savings and investments accounts that will make it possible for investors large and small to put away more money tax-free. Another is the acceleration of the reduction in personal income-tax rates that were first put in place in 2001, creating incentives not just for people to invest more but to work harder too.
Will Bush’s plan “stimulate” the economy? Well, this is a tough question because I’m never sure what people mean when they say “stimulate.” It’s always seemed to me that economic policy wasn’t like a pep-pill you could swallow to make a tired economy perky again. All I know is that when you increase the rewards for economic activity by lowering the taxes on that activity, you create incentives for more of that activity — and that’s what Bush’s plan does. If those incentives constitute stimulus, then yes, the plan will stimulate the economy.
Will the proposed tax cuts increase the deficit? Hard to say for sure, but it only makes sense that any tax cut will tend to increase deficits at least in the short term, all else equal. But in the long term, if tax cuts end up increasing the rate of economic growth, then two wonderful things will happen. First, the larger deficit will soon become a smaller fraction of the overall economy, because the economy has grown. And second, when the economy grows, tax revenues will grow right along with it — perhaps entirely overcoming any deficits. In the late 1990s, for example, it was neither a cut-back in government spending nor an increase in tax rates that brought deficits under control — it was the roaring economic boom that increased tax revenues all by itself.
Do deficits matter anyway? For most of my life it’s been the GOP that hated deficits. When I was younger, its efforts to crush deficits were always called “root-canal Republicanism.” Now it’s the Democrats who hate deficits, and the Republicans don’t seem quite so concerned anymore. Politics aside, budget deficits certainly do matter, but not necessarily in the way the most of the commentators think. Deficits only matter because they finance government spending, and government spending matters a lot. Government spending can either be good or it can be bad — how it is financed is secondary at best. You can’t make bad spending good by paying for it right away, and there’s nothing wrong with borrowing to finance good spending. So while the political parties kick up smoke about deficits, try to peer through the fog and see what it conceals. Spending is what matters.
So what do you think? If you’re like me, you probably see that a lot of the typical objections to Bush’s plan don’t hold a lot of water. At the end of the day, I like Bush’s plan a lot. Is it perfect? No. I can think of plenty of things I’d do differently. But I think it’s solid, it will work, and heaven knows the economy needs something. And if anybody else is proposing anything better, I sure haven’t heard about it. I say let’s put politics aside and just go for it.
– First published in SmartMoney.com
