Higher Taxes: Just How Much Will They Hurt?by
The "sacrifice" that President Clinton is asking of the American people is taking the hard turn from on-the-stump rhetoric to in-your-face reality. Most important, the costs are going to hit the paychecks and profits of a lot more people and companies than the Administration had originally proposed.
For now, there is nothing in Clinton's economic plan that dramatically alters the outlook for the rest of 1993. The economy is chugging ahead on its own momentum, and it will get a small kick from the Administration's plan for $31 billion or so in fiscal stimulus.
But by 1994, the negative impact of one of the largest tax increases in American history will begin to inhibit economic growth. The question is, by how much? Up until Clinton's talk to the nation on Feb. 15 and his State of the Union address on Feb. 17, consumers and businesses seemed convinced that the long-term gain from his plan would outweigh the pain, especially amid evidence of an already healthier economy.
Indeed, January surveys showed that optimism among consumers and businesses generally was on the rise. And unlike the two previous upturns in expectations since early 1991, this one is rooted in genuine improvement. The latest data show that retail sales are holding up and that low mortgage rates should keep housing on firm ground (chart), despite the January setback in homebuilding. Also, lean inventories suggest further output gains, and inflation keeps snoozing.
HIRING IS RISING ON A TIDE OF OPTIMISM
However, after seeing the five-year, $245 billion tax pill that the White House wants people to swallow in an effort to invest more while cutting the deficit, both Household and Corporate America might be having second thoughts. All this could cause optimism to head south again in coming months, but as long as jobs and profits continue to rise, the bitter medicine will go down easier.
The financial markets gave divergent initial assessments of Clinton's plan after his address on Feb. 15. The bond market liked the commitment to deficit reduction, but the stock market bristled at the way the Administration wants to achieve it. On Feb. 17, the rate on 30-year Treasury bonds closed at 7.10%, the lowest yield in the 30-year bond's 15-year history. However, the day before, the Dow Jones industrial average plunged 82 points.
Clinton's heavier reliance on new taxes compared with spending cuts, as well as a growing perception of an anti-business tone in his proposals, triggered the sell-off. Although stocks were generally thought to be overvalued and ready to blow off some steam anyway, the drop in share prices still could be foreshadowing a downswing in the recently cheerier mood of Corporate America.
A survey by Dun & Bradstreet Corp. says that January readings of manufacturers' optimism about first-quarter business conditions were the highest since the survey began three years ago. D&B also reported that builders were more upbeat. And the National Federation of Independent Business said that increased optimism about sales and earnings among small companies in January was fueling an increase in hiring.
Recent signs of firmer labor markets partly reflect some production growth this quarter that is a result of companies' need to rebuild inventories. Stock levels of manufacturers, wholesalers, and retailers rose 0.4% in December, but sales jumped 1.9%, pushing the ratio of inventories to sales to an 1112-year low (chart).
However, February's tax talk could cause businesses to rethink their prospects for growth and profits. That is especially true if Clinton's program runs into trouble in Congress. Already, Republicans are griping at the greater emphasis on new taxes, and Democrats facing reelection in two years may balk at the spending cuts.
If so, the bond market will push long-term interest rates back up and depress stock prices. And even if the plan sails through Capitol Hill relatively unscathed, the larger-than-expected tax burden threatens to place a greater drag on corporate earnings. So, Clinton's plan could well be a lose-lose proposition for stocks.
SHOPPERS SHOW NO SIGNS OF FATIGUE
For Household America, the talk of sacrifice sends an ominous message: Just when you thought it was safe to feel good about the economy, along comes the tax shark. The latest data clearly show that consumers are more bullish on the economy. But maintaining that optimism in the face of higher taxes could be tough.
The University of Michigan's index of consumer sentiment in early February shows that consumers feel a bit better about current economic conditions, but their expectations for the future are unchanged. That may mean that households are already wary about higher taxes down the road. If so, consumer confidence in late February and into March could post sizable declines.
One reason for a more sour mood: President Clinton has lowered the threshold of where to inflict the pain. Jacking up taxes on the 300,000 or so people who make more than $200,000 annually is one thing. But now, the White House admits that even households earning $30,000 will not escape Uncle Sam's tightened grasp.
Keep in mind, however, that a bigger tax bite will not begin to grab households until much later this year and into 1994. For now, the talk should have little impact on actual consumer spending. Indeed, shoppers were still doing their thing in January, even as the Clinton Administration floated some trial balloons on higher taxes.
Retail sales increased 0.3% in January, on top of a 0.8% rise in December (chart). Sales would have been stronger, but receipts at restaurants and drugstores fell sharply. More cyclical categories--furniture, department stores, and car dealers--posted impressive gains last month.
Moreover, shoppers show no signs of retreat. The Johnson Redbook Service, published by Lynch, Jones & Ryan Inc., reports that department- and chain-store sales in the first two weeks of February were running 5% above January's pace. And sales of U.S.-made cars and light trucks stood at an annual rate of 11.3 million in early February, up from the 11.2 million in January.
The recent flurry of demand for housing is another sign that consumers feel more positive about jobs and the economy in general. True, that was not apparent in the 7.2% drop in housing starts in January, to an annual rate of 1.19 million. But weather played a big role in last month's drop.
Other data are presaging advances in home buying--the biggest financial decision for most consumers. The Mortgage Bankers Assn.'s index of mortgage applications to buy a home rose a further 1%, to a new high in the week ended Feb. 5.
Low interest rates are a big reason for the record pace of mortgage applications. HSH Associates reports that the rate on a 30-year fixed mortgage slipped to 7.86% in the week ended Feb. 12 (chart).
INFLATION IS STILL UNDER WRAPS
If the Clinton plan flies, a sustained rally in the bond market will push mortgage costs even lower heading into the important spring and summer home-buying season. In addition, relentless good news on inflation will keep upward pressure off long-term interest rates.
Producer prices of finished goods rose only 0.2% in January. Although the core price index, which excludes food and energy, rose a larger 0.4%, the gain reflected one-time jumps in tobacco and car prices. The annual pace of core inflation for finished goods continues to decline, and except for one brief period in 1986, it is currently the lowest in the data's 19-year history (chart).
The bright inflation outlook heightens the chances of an accommodative monetary policy from the Federal Reserve Board. That would help ease the pain on the economy from the sacrifices in Clinton's program. For now though, the President's immediate challenge is to try to sell castor oil to households and businesses at the very time when they are finally beginning to feel better.