It’s The Tax Cuts Stupid!

by | Nov 4, 2003

Stock market punditry is a tough game, and victories are few and far between even for the best of us. So when a victory comes along, you do a victory lap. The third quarter’s gross-domestic product growth rate of 7.2% was a big victory. Representing the biggest quarter for the American economy in almost 20 […]

Stock market punditry is a tough game, and victories are few and far between even for the best of us. So when a victory comes along, you do a victory lap.

The third quarter’s gross-domestic product growth rate of 7.2% was a big victory. Representing the biggest quarter for the American economy in almost 20 years, it’s a powerful vindication for those of us who have argued all year that the economy has turned the corner.

So let’s do a big victory lap.

But when we’ve gotten that out of our systems, let’s take a hard look at what it really means — and what it doesn’t. And then let’s talk about how to invest in it.

First, was it for real? That question has be asked, once you understand that the Commerce Department’s methodology for computing GDP is so arcane and bizarre that it would make Enron blush. For example seemingly red-hot 5.8% GDP growth in the first quarter of 2002 was subsequently revised down to a merely orange-hot 5% — which was largely caused by accounting legerdemain that treated the quarter-over-quarter reduction in inventory liquidations as though it were actual growth. I exposed that chicanery in my past column, and correctly predicted that there was little evidence for anything more than a tepid recovery from recession — and little reason to own stocks.

But this time it’s different. This time the growth is real. Personal consumption grew at a 6.6% rate. Capital investment by business grew at an 11.1% rate. And the growth wasn’t just the effect of higher government spending — that grew at a rate of only 1.3%.

Second, what caused it? There’s never a single answer to a question like that, but anyone who has followed this column this year knows what I think is primarily responsible: the tax cuts that were passed into law this May, reducing tax rates on wage and dividend income and on capital gains.

Even the worst tax-cut critics are having to rethink things here. No one on Wall Street argued against the tax cuts harder than Goldman Sachs’s economists, and now even Goldman’s Edward McKelvey has told the New York Times that the tax cuts “definitely had a stronger impact on spending than we anticipated.”

That’s a welcome capitulation, but it’s also damning the tax cuts with faint praise. Tax-cut opponents can still argue the big pop in consumer spending stimulated by tax rebates received in the last quarter was just a one-shot deal.

And that leads me to the third question. Will it last? Well, 7.2% is a tough act to follow. But the answer is yes, it will last (although I’ll give you plenty of caveats in a moment).

The reason it will last is that a little stimulus to spending through tax rebates is about the least important thing about this year’s tax cuts. As I’ve argued here so many times this year, the real magic of the 2003 cuts is in the new incentives they create for investing. By lowering taxes on dividends and capital gains, the after-tax returns of all forms of investing are increased. That will make more people and more companies want to make more investments of all kinds. This quarter’s 11.1% growth in fixed business investment follows on last quarter’s 7.3% growth — two very vigorous numbers, back to back, in response to the tax cuts.

Investments are the key, because it’s only through investment that productivity and competitiveness can be sustained and renewed. Without them, no mere consumer-spending spree can ever really lead to important economic growth. Long after the rebate checks are spent, the fruits of increased investment in productivity and competitiveness will continue to grow and ripen. The tax cut on dividends and capital gains is going to be the growth gift that just keeps on giving.

And speaking of productivity, here’s the fourth question: Should we be worried about jobs? Absolutely not. Depending on which government statistics you look at, job growth is either just now getting started or may even have been well underway all year.

Remember, jobs are the result of growth, not the cause of growth. We’ve got growth now. Soon we’ll have all the jobs anyone could ever want. Just you wait and see.

OK, now for those caveats. What could go wrong now? Unfortunately, plenty.

The Federal Reserve’s interest-rate policy has come off the rails, and we’re at risk of seeing a new episode of inflation. Wednesday’s Fed meeting only confirmed my worst fears. The Fed has once again said that it will keep interest rates at historic lows for a “considerable period.” And with the economy growing like topsy, that’s a sure-fire recipe for inflation.

And there’s another risk on the horizon–that risk is the ugly specter of protectionism. Our Treasury Secretary John Snow has been jetting around the world trying to strong-arm China and Japan into strengthening their currencies against the dollar — the theory being that this will make our goods more competitive in world markets, but at the cost of disrupting all the manifest advantages of global trade.

White House insiders tell me that Snow knows better, and that he’s only doing it to prevent Congress from passing punitive tariffs. But either way, it’s bad for economic growth here and around the world.

So let’s put it all together and consider optimal investment strategy. First, there’s just no way this can turn out that’s good for Treasury bonds. If Greenspan straightens up and flies right — and raises interest rates — Treasurys will drop. But if he doesn’t — and a new round of inflation starts up — then Treasurys will still drop. It’s a no-win deal.

Stocks, on the other hand, have a couple of ways to win here. If Greenspan and Snow do their jobs right for a change and growth keeps booming, it doesn’t take a genius to figure out that stocks still have a lot of catching up to do. The riskiest stocks should continue to turn in the best performance.

So, short term, we can do our victory lap. And for the future, this game remains ours to lose. And we still really could lose, if the Fed doesn’t start getting vigilant about inflation, and if the trend toward protectionism continues to strengthen. Please

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at He is also a contributing writer to

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