Celebrating Our Forecast Jude Wanniski April 6, 2004

Memo: To Website Fans, Browsers, Investors
From Jude Wanniski
Re Spring is here, so are the jobs

When the news reached the financial markets on Friday that 308,000 new jobs were created in March, there were celebrations in the Polyconomics' offices in Parsippany, N.J. For almost a year, since May 23, we had been advising our institutional clients and newsletter subscribers not to expect the tax cuts then enacted to produce new jobs until this spring. When asked, we also warned Democrats not to count on the "jobs issue" for the November elections because there would be jobs aplenty and a rise in real wages as the labor market tightened. Here is the first client letter explaining the mechanics of how the economy would develop:

Polyconomics
May 23 2003
Domestic Reports

TAX BILL A BIG WINNER
By Jude Wanniski

The lead story in The Wall Street Journal today is about “Bush’s Tax Cut: Victory – at a Cost,” with the reporters noting that “it will provide a significant short-term boost to the economy, but at a potentially significant long-term cost.” Nonsense. The legislation is far better than any of us could have imagined could come out of this Congress just a few months back. As it is, the dramatic cuts in the cost of capital embodied in this first truly supply-side package will feed economic growth far into the future, with its rosiest impact on the employment numbers showing up in time for the 2004 presidential elections. The equity market has already advanced by about 5% since the legislation began coming out of the shadows in mid-March. At first, it appeared all the economy would get would be an acceleration of the cuts in marginal income-tax rates, with no room at all for a cut in the double-tax of dividends and not even a mention of a cut in the capital gains tax to 15% from 20%.

It was the President’s father who campaigned in 1988 for a cut in capgains to 15%, but who gave up on the legislation after he was elected when outmaneuvered by the Senate Democrats. In the space of several weeks, George W. Bush has brought home his father’s foreign policy objective of regime change in Iraq and his domestic policy promise of a 15% capgains rate. And he has added the first of his own objectives in cutting into the double-taxing of corporate dividends, which he surely aims to complete in a second term. By expanding bonus depreciation to 50% from 30%, the legislation instantly increases cash flow to corporate America by roughly $53 billion. What the Journal reporters and their editors do not see is that the lower costs of capital in the dividend and capgains provisions will soon begin showing up in orders for capital goods, as the after-tax returns on those goods will rise accordingly.

As we have been pointing out repeatedly, the biggest gains will be to labor, which was being unemployed as the business community found it could supply all the demand for goods and services with a reduced work force, given the high after-tax cost of marginal capital. Gary Robbins of Fiscal Policy Associates points out that before there is a renewed expansion in the work force, the business sector will have to see that the surplus of capital at the new lower cost is being accompanied by a scarcity of labor. He thinks the third quarter numbers will begin reflecting the first phase and it will be clear by the second quarter of next year there is increased demand for labor. And this will occur at higher real wages again reflecting the increase in the capital/labor ratio.

Most of the credit has to go to the President, as he made the hard decision to ignore all the Robin Hood rhetoric of the Democrats in pursuit of his objectives. The editors of the WSJ editorial page Thursday blasted House Ways & Means Chairman Bill Thomas for his “failure” to get all he could have gotten out of the divided Congress, but if it were not for Thomas it would have done President Bush no good at all to be resolute in his determination. It was Thomas who first delivered everything the President wanted in a $726 billion package to eliminate the dividend tax, but then saw it would be impossible to get anything close to that number from the Senate. Instead of whittling away at the $726 billion to get it into Senate range, Thomas went back to the drawing board with his 5-15 plan to tax dividends and capgains at the same rates. Where the sunsetting of these rates back to the original, higher rates after five years would have had a very modest effect on corporate behavior if applied only to dividends, the new combination will pack enough punch to insure that it will be practically impossible to let them expire.

Without an effective class warfare argument to prevent supply-side downward adjustments in marginal tax rates on capital and labor, the Democrats can only stand aside and complain that the package will fail, and hope that it does. The only opening they have left to offer the electorate in terms of economic growth is a commitment to fundamental tax reform. A total overhaul of the tax codes would permit Democrats to finesse the class-warfare arguments, something they seem not yet to have noticed.

The most important development here, I believe, is that President Bush has established a baseline for tax policy. In his first two years, he tried a front-loaded neo-Keynesian plan to boost consumer demand, and that was a sure loser. By replacing Treasury Secretary Paul O’Neill with John Snow early this year, Mr. Bush made it possible for Bill Thomas to change course in mid-stream, as Snow clearly supported the House package over the Senate version that the White House political people were still pushing. This is why there was so much confusion earlier this week, as The New York Times reported the Senate version had been picked, when in fact it was Thomas and the House version that won the President’s favor -- with Snow’s endorsement being decisive.

I’ve told the story before, but it bears re-telling on this account, of the time in March 1989 when I was invited to Washington by George W. Bush. His father had a few days earlier cinched the GOP presidential nomination, with Jack Kemp a distant loser. I was asked to lunch to advise on what the supply-siders really wanted to be happy with his father. At the top of my short list was a cut to 15% in the capital gains tax. His face lit up as he said he thought that was doable. That’s because of his father’s experience in the Texas oil business. He knew that when you hit a productive well, you would want to sell it so you could look for more, but the high capgains rate would discourage you from selling. Your capital would be frozen, he said. As a result, it always struck me as odd that he would understand that so clearly in 1989, but leave the concept out of his 1999 plan. He’s finally on track and that bodes well for the future.