Taxes and Tax Politics Jude Wanniski May 31, 2002

To: Students of SSU
From: Jude Wanniski
Re: Taxes and Tax Politics

This lesson was first posted here January 19, 2001, just as the Bush administration got underway. I wrote it in response to a question from an economist who was going on the White House staff at a mid-level position, a young man who wanted to know how the Reagan tax cuts were sold. [I'll have some added comments at the close related to today's tax politics.]

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The key was Kemp’s motivation for “selling tax cuts” to the Republican Party. In his first contact with the supply-side ideas of the economist Robert Mundell on The Wall Street Journal editorial page, Kemp saw a way to reduce the unemployment rate of his congressional district in western New York, the blue-collar Buffalo area. When he read a piece I’d written about Mundell in the fall of 1974, “It’s Time to Cut Taxes,” the Buffalo unemployment rate was roughly 18%, the highest of any urban area in the country. If Buffalo had a low unemployment rate, we might never have heard about Kemp, or as a new congressman representing Buffalo, he might have decided to make health care or education or outer space his cause. But he was at the margin of the spreading national problem of “stagflation,” the combination of unemployment and inflation that was not supposed to happen in a Keynesian demand model. In his first election to Congress in 1972, he won very narrowly. In his subsequent elections, the blue collar Democrats and Republicans of his district sent him back with landslide victories exceeding 80%.

From the very beginning, then, the Kemp argument for tax cuts was never a goal unto itself. He never talked about giving money back to the people who were overtaxed. He never talked about shrinking government because he liked smaller government. He never spoke of denying the central government tax revenues in order to starve Congress of revenues it would like to spend for wasteful social programs. Like the tax cuts espoused by John Fitzgerald Kennedy, Jack French Kemp’s goal was to get the country moving again. Both JFKs argued the dynamics of lower tax rates -- that over time they would produce a broader revenue stream. This is the most critical element in selling tax cuts, because it elevates the debate out of the zero-sum partisan swamps. Of course, if you are going to argue that tax rates of one kind or another are higher than they need to be to produce a given revenue stream, then you had better be right, or the electorate will punish you and your political party for wrecking the public finances. In 1962, JFK proposed cutting the top tax rate on personal income to 70% from 90% to get the country moving again. Kemp sold the idea to Ronald Reagan and the GOP, when the top rate was 70%, but swollen by several years of inflationary bracket creep. The goal of economic expansion was matched by an obvious instrument to bring it about, something that would benefit everyone, especially those at the bottom of the economic pyramid.

Most people at the bottom of the economic pyramid really do not pay taxes, at least not directly. So the politics of tax cutting must take that into account. In 1994, House Speaker Newt Gingrich rallied the Republican Party behind his 10-point “Contract With America,” and the Republicans won control of the Congress for the first time since the 1952 elections. One of the 10 points was a cut in the capital gains tax, to 15% from 28%. The grave political mistake Gingrich made was in deciding to cash in on the tax cuts without the use of “dynamic” scoring. In other words, there was no attempt made to argue immediately after the election that the lower capital gains tax would inspire an expansion of the economy and bring in a broader revenue stream than the higher rate. Gingrich and the other GOP leaders decided to use “static analysis,” which would mean there would be a dollar-for-dollar revenue loss for their overall tax plan. It would have been easy to get the capgains tax reduced, because even static analysis would show it would produce more revenue in the early years as individuals sold assets earlier than they otherwise would have done. What messed up Gingrich was his commitment to the Christian Coalition to have a “tax cut” for children, a $500 kiddie credit. This enormously expensive idea would have no supply-side effects and would show red ink under a “dynamic” or a “static” basis. So the decision was made to do it all static.

When Democrats have a static proposal to cut tax rates, they immediately swing into motion with their constituents. Oh? A tax cut for people who pay taxes? The rich pay most of the taxes, don’t they? And where is the money going to come from to put more money into the pockets of the rich? Why of course, out of Social Security, out of Medicare, out of the school-lunch program! Widows and orphans will have to go without so that the top 1% of the privileged class will have even more money for their pleasures. It does not take much political intelligence to see how much sense this makes in a political campaign, especially if it happens to be true. You cannot please either the financial markets or the political markets with a “tax cut” that is really not a tax cut at all, but a conservative attempt at social engineering. Newt Gingrich is gone because at the moment he came to the Speakership, he abandoned supply-side economics and dynamic scoring.

The 1996 presidential race showed how not to sell a tax cut, with Kemp again figuring in the action. The GOP nominee, Bob Dole, invited Kemp on the ticket after the Dole campaign had picked a tax program that Kemp already had publicly criticized as being ineffective. Kemp’s supply-side friends tried to point out to the Dole team that the idea of cutting the income-tax rates by 15% just for the sake of cutting rates was not terrible, but the design contained flaws involving the alternative minimum tax that would actually increase taxes on millions of middle-income Americans. The advice was ignored. Kemp was asked to put on an old Buffalo Bill jersey with his old No. 15 on it and to be a team player in selling it. Cutting the 39% top rate by 15% would not even get it back to where it was before President Clinton was elected and it certainly could not be sold as a growth measure. In his debate with Vice President Gore, Kemp was helpless against the Gore charge that it was a “risky scheme” that contained the flaws which Kemp had publicly criticized.

George W. Bush easily could have won the presidency this year, but he barely made it, and without a majority of the popular vote. His $1.6 trillion tax plan was not designed for any purpose but to return surplus taxes to the people. At the time the plan was designed by the demand-side economists in the Bush entourage, the economy was expanding. Indeed, several of the same economists who were involved in the design of the Dole 15% plan had come up with the tax package for the Texas Governor. So it was “sold” without regard to economic growth at all. The Bush economists decided that since the economy was booming under Clinton/Gore, they could not sell it as a growth measure, but as a “fairness” measure. It specifically excluded a cut in the capital gains tax. Its centerpiece was, and remains, a “fixing” of the marriage-tax penalty, another favorite of social conservatives and the Christian Coalition. Like the $500 kiddie credit, it is very expensive when reckoned both on static and dynamic analysis and comprises a significant fraction of the proposed $1.6 trillion total cut. Once again, the Democrats during the presidential campaign warned that the money to pay for all this would come out of the fixed pool. No matter how George W. Bush struggled to sell his tax plan as being fair to the people who had produced the surplus, Gore and the Democrats were able to rally their political base with the argument that the funds would come out of the Social Security/Medicare pool -- which then would be empty in the future when current workers became old and/or ill. With all his appeals of compassionate conservatism, Bush lost the black vote by a larger margin than any Republican since Barry Goldwater in 1964. Conservatives find it convenient to forget that Goldwater campaigned against the Kennedy tax cuts of that year as being fiscally irresponsible.

If tax cuts are to be politically “saleable” they have to have a purpose that makes sense to the broad electorate -- the national family. If the basic problem is that the black family has been destroyed over 40 years of inflation, destructive welfare rules, and declining real wages, the solution involves the creation of capital that will reach every corner of the country. Ask black and Hispanic leaders what they want most for their people and they will answer “Access to capital and credit!” The Keynesian argument on how to do this is to pass a law or a regulation that requires banks to lend to blacks and Hispanics, an affirmative-action, zero-sum measure, which is the favored solution of President-elect Bush’s Keynesian economists. This approach requires banks to lend to sub-optimal minority borrowers and withhold capital from optimal white borrowers. It further drives a wedge between the races, while reducing the overall efficiency of the economy. The most direct positive-sum solution would be an elimination of the capital-gains tax, which would dramatically expand capital formation and make it so plentiful that sub-optimal borrowers would become optimal. By increasing the capital/labor ratio, productivity would expand with the economy and so would real wages. The black family would be able to finance the household budget with the after-tax earnings of one breadwinner.

By “positive sum” we go back to John Kennedy’s metaphor of “a rising tide lifts all boats.” When it becomes possible to argue that reducing certain tax rates that now are damming up a wider or deeper revenue stream, the Democrats can no longer make the case that the scheme is risky or that it threatens to dry up the future sources of revenue for Social Security or Medicare.

This is essentially the answer I gave to the economist who called me last week with the question of how to sell the Bush tax program. Of course, I also advised that in order to sell the program, it had to be altered in order fit the appropriate sales argument. Paul O’Neill, who has been nominated to be Treasury Secretary in the Bush administration, was unable to make a positive-sum case for the $1.6 trillion plan he has to sell to the Congress. He had to fall back on the “fairness” argument, that the surplus should be returned to those who had sent it, not to those who hadn’t paid any taxes. The argument was as polished as it could be, but still ineffective. Senator Trent Lott, who will be majority leader after the Inaugural, has proposed a capital-gains tax cut to 15% as an amendment to the Bush plan, but the Bush economic team has plainly indicated that is not its preference.

Trying to sell a $1.6 trillion tax plan that is fundamentally flawed, I suggested, is similar to a manufacturer of dog food who hires the best advertising firm on Madison Avenue to sell fundamentally flawed dog food. If the dogs won’t eat it, their owners will not buy it, no matter how many nifty commercials they see.

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As you may recall, none of this good advice was taken by the Bush administration. The President's closest economic counselor in the West Wing, Larry Lindsay, is a conservative Keynesian who helped design the $1.6 trillion tax-cut bill mentioned in the above lesson. He pushed hardest for a "tax rebate" that would "put money in the pockets of the American people" so they could spend the economy out of the doldrums. The economy yawned and sank further into the doldrums, as all the supply-siders in town warned would happen. There were some tiny tax cuts that would eventually have supply-side effects, but they were pushed into the future. If I'd been asked how to NOT conduct fiscal policy, I would have advised Dr. Lindsey to do exactly what he did. The only reason Gross Domestic Product rose to pull the economy out of a technical recession was the jump in federal spending, mostly in response to the needs of the Pentagon in conducting its war on terrorism. The problem is that the surplus in the federal budget quickly disappeared. You can always "buy" your way out of a recession, but someday the bonds issued to finance the spending have to be repaid with tax revenues.

Sadly, there were no complaints from Republicans in Congress about the Bush tax package, although there were murmurs about future tax reforms. Even Jack Kemp praised the Bush plan during the campaign, even knowing it was worse than the plan he had to defend in 1996 -- because he is a partisan team player. This is a large part of selling economic programs in a political environment. One has to choose between applauding the party leader's flawed initiatives and standing to the side and pointing out the flaws. Kemp was effective in his early years in Congress, where he could represent novel ideas that worked as advertised. The effectiveness was gone when he felt he had to go with the flow as a party elder. At the moment, there are no "young Turks" I can see in either party willing to play the role Kemp did in the 1970s in promoting the supply-side ideas that are necessary both in monetary and fiscal policy to solve the budget problems coming down the pike. My hope is that SSU students will consider running for public office and take up this challenge.

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This is the final lesson of the spring semester, unless there are sufficient interesting questions posed in TalkShop on this topic of tax politics.