The Tax Cuts Worked!

Smart Money.com ^ | 10/31/2003 | Donald Luskin

[Grampa Dave]

The Tax Cuts Worked!

By Donald Luskin - October 31, 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 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 April 26, 2002, column1, 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, as I pointed out in my Sept. 23 column2, 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.

As I wrote here last week3, 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, which I've also written about in this column4. And 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 straighten up and fly right, and if the trend toward protectionism continues to strengthen. Please…let's not snatch defeat from the jaws of victory.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com5.

[Grampa Dave]

At look at the economy, the job markets and our stock markets by Donald Luskin.

[Grampa Dave]

The latest Luskin report fyi!

[Grampa Dave]

Something for your weekend reading.

[gitmo]

I thought the tax cuts hadn't kicked in yet.

[Grampa Dave]

They kicked in August/September in the real world.

In the twisted world of the lunatic left, they are still waiting.

[lchoro]

They worked in 2001 also, if not for the unexpected occurrence of 911 in the same quarter.

[Grampa Dave]

You posted, "They worked in 2001 also, if not for the unexpected occurrence of 911 in the same quarter."

Makes one wonder if al Qaeda saw what was happening to our economy in 2001 and made sure that 9/11 would have a negative impact on the tax cust.

[NormsRevenge]

Morning Gramps! Looks like a good place to drop this one. :-)

Mike Shelton - OC Register

[Grampa Dave]

Thanks Norm, as usual the Rats end up sucking hot air and vapors when they try to lie about what is happening to make GW look bad.

Sierra Wasp loves this cartoon!

[Grampa Dave]

[iBillDavis]

so the tax cuts and more government spending worked this reporting period but where will it go from here...i predict it will be much lower next time...

[meenie]

I have a plan based on present economic policies to give us perpetual prosperity. First, if tax cuts are good, then no taxes would be excellent for future growth. Secondly, collecting no taxes would allow Alan Greenspan to expand the monetary base to cover the lack of taxes as he is now giving credit for the ending of our recession. The public should use the services of these two geniuses (Alan & George) to liberate themselves from the responsibilities of supporting government. The growth of our economy would astronomical if my plan was followed.

[Grampa Dave]

So which financial genius did you vote for in 2000 and do you plan to vote for in 2004?

[Arrowhead1952]

Don't know if you saw the post by Cathryn Crawford, but I really liked this one.

[Grampa Dave]

Well, I will listen to Dr Paul Erdman as to where the economy is going.

Tell us who you voted for in 2000 and plan to vote for in 2004.

Paul Erdman's latest on the economic news

http://cbs.marketwatch.com/news/print_story.asp?print=1&guid={5FF45869-05F2-42B6-8B6D-748B09E6BBD2}&siteid=bigcharts

ERDMAN'S WORLD

The other shoe has finally dropped
Commentary: Investors get second helping of good news

By Paul Erdman, CBS.MarketWatch.com
Last Update: 12:49 PM ET Oct. 30, 2003


HEALDSBURG, Calif. (CBS.MW) -- The U.S. economy's startling 7.2 percent growth in the third quarter was just half of the good news that greeted us this week. The other half was that the burgeoning economic recovery is no longer being fueled solely by consumer spending, especially on housing and vehicles, but now has spread to capital spending and exports.






The trend in capital spending is unmistakable. In the first quarter, it was down 4.4 percent. In the second quarter, it was up 7.3 percent. In the most recent quarter, it rose by more than 11 percent. Exports, which had fallen 1 percent in the second quarter, increased by 9 percent in the third.

This tells us two things. First, the huge overhang of excess capacity that was the legacy of the vast and ill-planned overinvestment in plant and equipment during the bubble years is now increasingly being worked off. And, second, where exports are concerned, the gradual devaluation of the dollar is finally beginning to take effect on foreign sales.

All this bodes well for future job creation, which should begin to phase in in earnest during the first quarter of next year, and add yet another boost to the recovery.

All this excellent economic news is, however, not necessarily going to translate into good new for the financial markets in the immediate future.

Equity valuations, especial where high-tech stocks are concerned, have probably overshot economic reality -- even the reality reflected in this week's numbers -- by so much that there is very little immediate upside potential left.

Where bonds are concerned, such rapid economic growth now will only hasten the day when demand for capital will begin to exert upward pressure on long-term interest rates, thus deteriorating bond prices. But the growth effect here will continue to be muted by the fact that, despite this surge in growth, the rate of inflation will remain extremely low even next year.

That said, there seems to be very little risk of any imminent downward movement in either stock or bond prices. So the average investor can safely sit tight for the time being.

Economist and author Paul Erdman is a CBS.MarketWatch.com columnist.

[Moonman62]

They worked in 2001 also, if not for the unexpected occurrence of 911 in the same quarter.

The economy did quite well for a short period after 911, because that caused Greenspan to end his war on wealth. The first round of tax cuts focused on consumer spending. As Luskin points out, that only works for one year, or less.

[Grampa Dave]

I hadn't seen this gem, thanks for posting it.

[Moonman62]

A must read article for all conservatives and Republicans. I would include liberals, but their heads would probably explode when confronted with the truth.

[xrp]

iBillDavis

Since Oct 28, 2003

He's a DU troll. A combination of Bill Clinton and Gray Davis, thus the name iBillDavis.

[Grampa Dave]

Wouldn't you like to be part of a group to read this over and over in a 2 day session to Herr Krugman of the NY Slimes as part of a reality intervention process to wake him up.