The Secret Behind Our Unsung Economic Boom

Speech by Donald L. Luskin

My job is to help my institutional investor clients understand the political environment here in Washington, and make winning bets on how that environment will impact the economy and the markets.

It's been a very profitable approach, for one simple reason. People are irrational when it comes to politics. And when people are irrational, there are profits to be had. Political passions keep investors from grasping how changes in tax policy, regulatory policy, monetary policy, and trade policy are going to move stocks and bonds.

The dominant passion right now -- well, it's more than a passion: it's also a fashion, practically our national pastime -- is to despise George W. Bush. Nothing he can do is right. Nothing is good enough.

There was a story in the New York Times last week that says it all. When Bush was hosting Chinese president Hu Jintao in Washington, he took him for a cruise on the Potomac on the presidential yacht. Hu's hat blew off into the river -- and before the Secret Service could do anything about it, Bush jumped overboard to get it. But he didn't get wet! He landed on the surface of the Potomac, and actually walked on the water to get President Hu's hat.

The headline in the New York Times was: President Bush Can't Swim.

In this kind of political environment, it seems that everyone is blind to the amazing success story that is our economy. According to the latest polls, 30% of Americans believe we are in an economic recession right now. And among my clients, I can tell you that there aren't any of them who think we're in a real bull market.

Yet over the last six months the S&P 500 has returned about 12%. That's just six months, and it's a bigger return than stocks have had historically in the average full year.

Since the official end of the last recession, in November 2001, the S&P 500 is up 24%. Why isn't that a bull market?

Over the same period, real GDP has grown 15%. At the rate of economic growth we logged in the first quarter of this year, our country grows the equivalent of an entire Australia every year. Worried about high oil prices? At this rate our GDP growth in a single year is three times the value of the entire economy of Iran, oil, nukes and all.

4 million payroll jobs have been created since the recession bottom. The unemployment rate has fallen from 5.5% to 4.7%. Federal income tax receipts are at an all time high. Home ownership is at an all time high. Household net worth is at an all time high. Per capita disposable income is at an all time high.

And 30% of Americans think this is a recession. This economy can walk on water, but it can't swim. As President Bush himself might say, this economy is misunderestimated.

It's all the more remarkable when you think about just how many things are conspiring to hold back the growth of the economy.

The Sarbanes-Oxley Act is a grotesque tax on American business. The ever-present threat of strike suits from the plaintiff's bar -- or from the Inquisitor General of the State of New York -- is a sword of Damocles hanging over every corporation. The Patriot Act makes it harder to move money and assets across national borders. Our post-911 obsession with security makes it harder to move ourselves to do business in airplanes, or even move from office building to office building. The threat of protectionism is mounting -- everything from steel tariffs, and the suicidal idea of slapping a 27.5% tariff on all goods that enter this country from China, to a new law that would require congressional review of every acquisition of US assets by foreigners.

So what's the secret of this amazing economy? I'll be happy to tell you, because it's a secret that's laying out there in plain sight. But there is none so blind as he who cannot see. And politics can blind the best of us. The secret is the 2003 tax cuts on dividends and capital gains.

Let me walk you again through some of the statistics about this current economic expansion -- but instead of looking at what's happened from the official recession bottom in November 2001 to now, let's also look at what happened from April 2003, which is the last month-end before the tax cuts were enacted into law.

Let's start with the stock market. From the recession bottom to April 2003, the S&P 500 actually lost 18%. Since April 2003, the S&P 500 has gained 51%. Now that's a bull market -- but you just have to start at the right place.

From the recession bottom to April 2003, 1.03 million payroll jobs were lost, and the unemployment rate actually went up from 5.5% to 6.0%. Talk about a jobless recovery! But since April 2003, payroll jobs have increased by 5.11 million, and the unemployment rate has fallen to 4.7%.

From the recession bottom to April 2003, real GDP grew 3.2%. Since April 2003, it has grown 11.3%.

From the recession bottom to April 2003, S&P 500 earnings increased only 7%. Since April 2003, earnings have grown 59%.

From the recession bottom to April 2003, manufacturers' new orders fell 5%. Since April 2003, they have increased by 38%.

From the recession bottom to April 2003, non-residential fixed investment fell 1%. Since April 2003, it has increased by 35%.

And here's the most remarkable of all. From the recession bottom to April 2003, federal income tax receipts fell by 11%. Since April 2003, they have increased by 26%, and now stand at all time record highs. Think about that one for a second. We cut taxes on personal incomes, capital gains, and dividends -- and tax receipts went up.

Let's hear it for voodoo economics. It works.

Why does it work? It's really so simple. Tell people they will get to keep more of the fruits of their labors and the fruits of their investments, and they will labor more and invest more. The economy will grow -- and so will tax receipts.

But there's something else at work when you cut the taxes on dividends and capital gains in particular. By doing that, you've directly removed a disincentive to risk-taking and capital formation. There has never in history been any kind of economic growth that came from anything else. Risk-taking and capital formation are what it's all about -- and when you lower the taxes on them, you get more of them. So you get more growth.

Lower taxes on capital are a windfall for the rich, I suppose. That's the demagogic message we always hear opposing this policy that has wrought such miracles. It's true that the rich get to keep more of their dividends and capital gains after taxes. But ordinary Americans benefit, too.

Even if you are not rich, but only a member of the huge "investor class" that invests through IRAs and 401ks -- which means you already weren't paying taxes at all on dividends and capital gains -- you still benefit. Why? Because lower taxes on capital make stock prices go up.

Do the math. If a taxable investor pays a lower tax on his dividends or capital gains, effectively his expected return is going to be higher. And when expected returns are higher, you're willing to pay more for a share of stock today -- because you'll get more from it over time. So stock prices go up.

For rich investors, then, lower taxes on dividends and capital gains are actually offset by the higher stock prices that must be paid to get that income in the first place. But with stock prices higher, that means the cost of capital is lower across the entire economy. That means more money can be raised to fund the innovation that leads to productivity growth, which, in the end, is the wellspring of wage growth.

I know, I know. What about the deficits? Can we afford these tax cuts? As our after-dinner speaker last night, Dallas Fed President Richard Fisher, pointed out: aren't deficits and the associated federal debt at staggering all time highs? Yes -- but as is often the way with after-dinner speakers, that wasn't the whole story. Our GDP is at all-time highs, too. As a fraction of GDP, our deficits and our debt are nothing special. They're about average for the last 30 years. We've seen higher in this country in the past, and in fact many nations today have far worse.

Besides -- after the 2003 tax cuts, as I mentioned before, tax receipts went up -- and are at all time highs. Of course the gurus at the Congressional Budget Office predicted, before the tax cuts, that just the opposite would happen. For instance, right after the tax cuts were passed, CBO lowered its estimates for 2004 capital gains tax revenues from $125 billion to $91 billion. How much did we actually get in 2004? $151 billion. Hey -- the gurus were only off by 60% (and in the wrong direction).

And remember the tax increases rammed through by President Clinton in 1993? You know how the Democrats are always saying that we can afford higher taxes today, because wasn't the economy great in the 1990s when taxes were higher?

Well, let's look at what really happened after the 1993 tax increases were enacted. In 1996 federal tax receipts were only 3% higher than the CBO had forecasted before they were enacted. Tax receipts didn't start surprising on the upside in the 1990s until 1997.

And what happened that year? A Republican congress slashed the capital gains tax.

So the well kept secret to this economy is just a single piece of excellent economic policy -- which has done yeoman's duty fighting all the ill effects of so much bad policy.

The tragedy of it, though, is that those 2003 tax cuts are set to automatically expire. The low dividends and capital gains tax rates revert to higher levels after 2008, and the low personal income tax rates revert after 2010.

In a world of Sarbanes Oxley and Eliot Spitzer, this economy really can't take that. We won't be walking on water if that happens. And we won’t be swimming.

Under the arcane rules of congressional budgeting, the 2003 tax cuts can be extended under a process called "reconciliation," which is filibuster-proof in the Senate. Only takes 50 votes, with Dick Cheney casting the tie-breaker if necessary. So not a single Democrat is required.

Yet the Republican majority still can't do it. Legislation to extend the tax cuts has been mired in committee debate since last November. Senate Finance Committee chairman Chuck Grassley and House Ways and Means chairman Bill Thomas are deadlocked over some trivial legislative details -- and time is running out.

Already we're starting to see the leading edge of the adverse economic effects that will ensue if the tax cuts are not extended. In the first quarter of this year, there were fewer dividend increases among S&P 500 companies than in the first quarter a year ago. That's the first time in four years that that's happened -- and it's clearly not because of bad earnings.

No, some smart CFO's have figured that they don't want to commit to paying higher dividends -- that will be very hard to lower later on -- if there's a significant risk that in 2009 to top tax rate on those dividends will jump from 15% to 35%. Suddenly share repurchases look like the way to go, because if the tax cuts aren't extended, at least the capital gains tax rate will only jump from 15% to 20%.

Or maybe they're figuring that, with those higher tax rates, they don't need to return profits to shareholders at all. This might be a good time to buy another corporate jet. 

I've been a super bull on this economy all along. I turned bullish in March 2003, when it was clear to me that the invasion of Iraq was going to make George Bush popular enough -- if just for a month or two -- to get the tax cuts enacted. He did it. The tax cuts were enacted, and all the good things I told my clients would happen actually did happen.

And now we're on the verge of throwing it all away -- mostly because that same war in Iraq has made our president so unpopular. Instead of extending these tax cuts, we're debating over how high a fence to build on the Mexican border, and what color to make the $100 check we're going to send to every American so that they can spend the money on gasoline taxes.

All Americans will be impacted if these low tax rates on capital are allowed to expire. But there's no industry that will be more directly affected than your industry -- the capital industry. Mr. Fisher last night said: don't give a dime to any politician who is going to increase our debt. Fair enough. So here's something better you can do with that dime. Drop it in a pay phone in the lobby and call your senator or congressman -- and urge them to extend the 2003 tax cuts on dividends and capital gains.

Thank you.

About the Author

Mr. Luskin is chief investment officer of Trend Macrolytics LLC, and former vice chairman of Barclays Global Investors.