The Forrest Gump Economy

Billmon

How stupid is the Bush economic "stimulus" plan? Let me count the ways . . . 968, 969, 970 . . . forget it. Who’s got the time?

So instead I’m going to focus on just one part, one fat and obscenely swollen appendage of the whole monstrous package: abolishing the federal income tax on stock dividends.

I could argue that this particular proposal is Exhibit A for the prosecution in the case of DiIulio v Rove -- a prime example of the Bush Administration’s tendency to make domestic policy based on which conservative or corporate clique screams the loudest.

That would be too charitable. I think they've just planted a "stupid" tree behind the Oval Office, and every once in a while Bush and Rove step outside and shake the thing until something falls off. And this particular policy lemon is one of the results.

But as Forrest Gump likes to say, stupid is as stupid does. So let’s examine some of the arguments we are hearing for why giving the obscenely wealthy another $300 billion in tax breaks is such a supremely brilliant idea.

I should apologize right up front for the absurd length of this post. But I really wanted to dig into this one, so I could give you a clearer picture of what a farce economic policymaking has become under George II.

Stupid Argument #1: It’s Only Fair

I’ll start by disposing of the bleeding-heart conservative notion that there is something intrinsically unfair, even Satanic, about the so-called "double taxation" of dividends.

Of course, the same people will also tell you that taxing wages twice – income tax and payroll tax – is eminently fair, because Social Security and Medicare are benefits, whereas the many boons that corporations receive from the federal government – export subsidies, crop subsidies, insurance subsidies, etc. etc. – are . . . well, not benefits.

Now strictly speaking, dividends aren’t taxed twice -- or at least, not twice to the same taxpayer. Corporations have to pay income tax on their profits, whether they distribute them to shareholders or not. And shareholders have to pay tax on their dividends, because they’re income.

Is this fair? Or, to put it another way, is it fair to require a fictional legal entity that has been given many of the rights and privileges of an American citizen – although not (yet) the right to vote – to pay federal taxes on its income?

A more progressive age believed it was. It also held that since shareholders were legally separate from the corporations whose stocks they owned (with only limited liability for their debts or misdeeds) it wasn’t unfair to make them pay tax on the dividends they received from those corporations. Just as I have to declare the interest on that personal loan I made to my brother-in-law, even though we’re really all just one big happy family.

Now to a conservative, this may seem an injustice on par with the Dredd Scott decision (worse, probably) but to me, it’s just the price corporations pay for the privilege of flying the American flag. If they don’t like it, they can (and often do) go find a nice filing cabinet in Bermuda to live in.

Stupid Argument #2: It’s More Efficient

Fairness is in the eye of the beholder, but efficiency is what really puts the gleam in an economist’s eye. There is a plausible argument that the current tax treatment of dividends encourages corporate managers to take on too much debt, in much the same way as the presence of a pipe can lead a house full of crackheads to smoke a little too much rock.

Under some conditions, this could reduce market efficiency – capital is harder to raise, costs more than it needs to, and doesn’t flow around the various nooks and crannies of the economy as easily as it should. Everybody loses.

To raise capital, corporations usually have a choice: They can issue equity or debt – sell stocks or sell bonds. Interest payments on bonds can be deducted from corporate income; dividends can’t. Ergo, there is a tax incentive to peddle bonds.

This can be dangerous. Dividends can be suspended if a company runs into trouble, but it’s a lot tougher to convince bondholders to "look at the bigger picture." Many an otherwise viable company has failed because it couldn’t make its quarterly interest payments.

All this may be plausible, but that doesn’t make it correct. We’ve been through several cycles of corporate debt binging since the end of World War II – the most recent being in the late 1980s – and it's not clear tax incentives had anything to do with them.

But even if there is a problem, eliminating the personal income tax on dividends is a curious way of dealing with it. It doesn’t change the incentive structure for corporate managers: Favoring debt over equity would still tend to raise the after-tax bottom line, and thus, their own bonuses.

Theoretically, this preference would be offset by stockholders, who would have their own incentive to favor dividends. But it’s a Rube Goldberg apparatus:

1.) investors would rather have dividends than interest, so they would prefer stocks over bonds.

2.) Preferring stocks, they would drive equity prices up and bond prices down.

3.) Corporate managers would realize they can get more buck for the bang by selling stocks.

4.) Corporations would shift from issuing debt to issuing equity.

This requires some fairly heroic assumptions about market rationality, and about the responsiveness of corporate financing decisions to external signals. It’s also complicated by the fact that many institutional investors – pension funds, college endowments – are tax exempt, and thus don’t care about differences in after-tax returns. So the little ball might not push the right lever or drop through the right hole.

What’s worse: the Bush plan would induce some market distortions of its own. From a taxable investor’s point of view, dividends would go from worst to first – better than interest income, even better than capital gains.

Of course, that will probably become the wedge for the next Republican attempt to chop the capital gains tax to zero. But in meantime, it should give a nice big shot in the arm to the tax shelter industry, which has been in the doldrums since the 1986 tax ‘reform" act. Well, that might create some jobs, anyway.

If the Bushies were really serious about making the capital markets more efficient – as opposed to just greasing the wealthy – they could ask Congress to make dividends deductible on corporate income tax returns, just as interest payments are now. Corporate tax rates could be adjusted upward to make the whole thing revenue neutral. Problem solved. But of course, that wouldn’t help the GOP reward its best and most loyal customers: the ultra-wealthy.

Stupid Argument #3: It Will Boost Demand

To boost economic growth, a tax cut has to do one of two things: increase aggregate demand, or increase aggregate supply. This one would probably do neither.

I’ll address the supply-side issue in a minute. But the demand-side equation is the most relevant one, since our current economic problems are not, by any stretch of the imagination, caused by a shortage of productive capacity.

To boost consumer demand, it’s not enough to put money back in the hands of taxpayers. They have to spend it. If they decide to sock it away for a rainy day instead, it can actually make things worse, by further suppressing demand. This was the great insight of Keynesian economics, as valid today as it was in the 1930s.

The problem: Rich people save a much larger share of their incomes than poor people, and the ultrawealthy save most of all. It’s why they own everything. So a tax cut that goes primarily to the tiny minority in the highest income bracket is probably going to be saved, not spent.

Now we come to the "class warfare" issue. Note that I have not framed this as a matter of "fairness." I’m being pragmatic here. If the goal is to stimulate the economy and create jobs, then presumably we want a plan that will work. A tax cut that is skewed too heavily towards the rich won’t.

And it would be hard to exaggerate the degree to which this particular tax cut is skewed towards the rich. The Wall Street Journal – that house organ of wild-eyed liberalism – reported in yesterday's issue that 63% of all dividends are received by households with pre-tax incomes of $100,000 or more.

But that doesn’t really do it justice. The IRS actually breaks income distribution down a little more precisely than that. Based on the latest data, nearly 30% of all dividends are received by households with annual pre-tax incomes over $500,000, and more than 20% by households with incomes of over $1 million a year – the top 0.7% of taxpayers who reported dividend income.

In terms of stimulating consumer demand, the federal government could probably get a bigger bang by burying the money in the ground and paying people to dig it back up again.

Stupid Argument #4: It Will Stimulate Supply

Just as there’s more than one way to steal a Florida election, there’s more than one way to stimulate the economy. If businesses can be coaxed into investing more, it not only increases demand for goods and services, it increases our ability to produce those goods and services. A virtuous circle.

Now Mae West once said too much of a good thing is simply wonderful. But that’s not necessarily true of capital spending. We had way too much of it – or more precisely way too much in a few narrow areas (telecom, Internet) – during the late 1990s. But a more balanced investment boom would be helpful now, since tax cuts or no tax cuts, consumers aren’t going to carry this expansion forever.

So would this dividend tax cut do the trick? In theory, maybe; in reality, almost certainly not. The key would be whether higher after-tax returns induced investors to accept lower pre-tax returns. This would reduce the cost of capital, lowering the "hurdle rate" at which a proposed capital project would become a paying proposition.

But it’s also an iffy proposition. As economist Allen Sinai and former Fed Governor Andrew Brimmer pointed out in yesterday’s Washington Post, the package, while large relative to the federal budget, doesn’t amount to much of a hill of beans relative to the U.S economy – much less the global one.

Investment responses to changes in after-tax returns also tend to be one-off – capital spending accelerates until a new equilibrium is reached, then tapers off. So unless the jump start triggers more sustainable underlying forces – as in the early 1960s – the boom tends to fizzle out – as it did in the mid-1980s.

There is also the question of whether encouraging companies to pay dividends would itself be a demand-side and a supply-side drag, since it would divert retained earnings that might otherwise be used to finance investment.

My answer is: Who knows? If it caused profitable projects to be cancelled it might be harmful, but if it induced companies like Microsoft to stop sitting on piles of cash and return them to investors who could profitably reinvest them elsewhere, it might be helpful.

But anything that shifted purchasing power from those who intend to use it to those who intend to save it would likely be counter-productive, at least in the short run.

Stupid Argument #5: It Will Help the Stock Market

This is actually a variation on Stupid Argument #4. If after-tax returns are increased, investors will bid up stock prices. This will reduce the cost of capital, and have the happy effect of refloating some of the submerged asset values left behind by the collapse of the tech bubble. A major pension financing crisis might thereby be averted.

If there is any coherent policy behind the dividend proposal, this is probably it. I think the Fed is very nervous about the risk the stock market will become a Japanese-like sink hole, pulling the "real" economy down into a deflationary morass. This view has probably been communicated through whatever passes as a policymaking process at the White House.

According to yesterday’s Wall Street Journal, the administration is projecting a 10% increase in stock prices if the plan is passed. They wanted to forecast a 20% gain, but apparently the computer started laughing so hard they had to reboot and start over.

Now this is funny: When the Japanese tried to rig their own stock market with various tax gimmicks and other interventions in the 1990s, we told them they were a bunch of economic illiterates. But wait, I forgot: We're Americans, so of course this is entirely different, which makes it OK.

The problem for the Bushies is that they may run into the law of unintended consequences. Since the early 1980s, companies have been steadily increasing share buy backs, as a substitute for paying dividends. This kept shareowners happy because it's transformed taxable ordinary income into tax-deferred (and taxed at a lower rate) capital appreciation.

One recent study, "Dividends, Share Repurchases and the Substitution Hypothesis, Journal of Finance, August 2002 (yeah, I really read shit like that, it's part of my job), has confirmed there has been virtually a one-to-one negative correlation between paying dividends and buying back shares. In other words, firms that spent more of their free cash flow on repurchasing shares tended to spend less of it paying dividends -- evidence that buybacks have indeed been a substitute for dividends

If dividends are no longer treated as taxable income, shareholders will want that money in cash. If corporations oblige them (and they would have no reason not to do so, since it would allow them to pay lower returns on capital) then corporate share buyback programs will probably start to dry up, removing what has been a fairly significant prop under U.S. share prices.

Over the past few days, the market has been rallying, and this has been interpreted by some as "proof" that the Bush plan is, in fact, good for stocks. A lot of things are going on right now – we've had some marginally better economic news; it’s the first week of the year and lots of money managers are betting on a "January effect" to boost prices; investors may simply be discounting the notion there will be some kind of tax package, and that it will be good for them.

I don’t know. But if anyone really believes the market always gets these things right – right away -- then I’ve got a suitcase full of Internet stocks I’d love to sell you, cheap.

Conclusions

There’s one issue I haven’t touched: the budget deficit. I’m not a particularly big deficit hawk – at least not right now -- so it’s not very high up on my list of stupid Bush tricks

But it is true that if tax cuts lead to higher deficits, and higher deficits lead to sharply higher long-term interest rates, any stimulative effect of the Bush plan could end up being crowded out. That’s Keynesian economics in an era of globalized financial markets.

Of course if the administration’s real goal is simply to redistribute income massively upwards, then none of the above matters. The plan will be a smashing success the minute it is passed.

Life, as Forrest Gump reminds us, is like a box of chocolates: You never know what you’re going to get. But that’s not true about the Bush White House. We always know what we’re going to get -- and what part of the anatomy we’re going to get it in.

Posted January 06, 2003 10:09 PM | Comments (18)