The Battle over Taxes

The shake-up of the President's economic team has stoked an already fierce debate over tax cuts vs. deficits

If George W. Bush thought he'd be basking in universal applause for shaking up his underperforming economic team, he guessed wrong. While business execs heaved a sigh of relief on Dec. 6, when the President fired Treasury Secretary Paul H. O'Neill and White House economist Lawrence B. Lindsey, Bush's plans for a seamless succession haven't panned out.

Just days after the purge, the White House tapped CSX Corp. CEO John W. Snow for the Treasury job (page 32), named retired Wall Street exec William H. Donaldson to head the Securities & Exchange Commission (page 33), and was expected as early as Dec. 12 to sign up Stephen Friedman, ex-COO of Goldman, Sachs & Co., to run the National Economic Council. The result: furious criticism from the Right over Friedman's deficit-phobia and a renewed debate--likely to intensify next year--over whether Bush's tax cuts will bust the budget.

While conservatives swallowed their misgivings about Snow, whom many privately deride as a traditional corpocrat, White House political aides had to spend several days phoning right-wing activists to quell rebellion over Friedman. Conservatives' beef with the 63-year-old financier, who ran Goldman with Robert E. Rubin prior to his friend's departure to serve as Bill Clinton's Treasury Secretary, is that he is a Rubin clone. Because Friedman, like Rubin, believes deficits are harmful, they fear he won't effectively sell a tax-centric economic policy. Says David A. Keene, president of the American Conservative Union: "Why don't we just bring Rubin back instead of a pale imitation?"

In a sense, Friedman has become the symbol of a much larger fight, one with roots in the Ronald Reagan era: Should the government spur economic growth with cuts in marginal tax rates and generous business-tax incentives, or should the focus be on eliminating a deficit that puts upward pressure on interest rates?

Each side can cite anecdotal evidence, but nothing conclusive, to support its views. In 1993, when Rubin helped steer Clinton away from a big social-spending program into tax hikes and deficit-cutting, supply-siders predicted an economic collapse. Instead, the economy boomed. Now, the debate has flipped. Deficit hawks, led by Rubin and traditional Republicans, such as Peter G. Peterson, president of the Concord Coalition and chairman of investment firm Blackstone Group LP, warn that Bush's big tax cuts will swell the deficit, push up interest rates, and eat billions of dollars needed for baby boomers' retirement. So far, the prophets of interest-rate Armageddon have been just as wrong as supply-siders were back in '93. Why? The economy is weak, tech is pushing many prices lower, and global overcapacity is adding to the disinflationary pressure.

This debate will come to a boil in January, when the President's new team rolls out a jobs-and-growth package that is heavily dependent on big tax cuts. Bush will ask Congress to speed up some of the cuts enacted in 2001, make his tax-rate changes permanent, add new incentives for individual savings and investment, and grant a tax break for business purchases of capital equipment. The price tag: perhaps $40 billion to $50 billion in 2003 and up to $300 billion over 10 years.

Despite questions over whether Bush's recruits will be enthusiastic advocates for more tax-cutting, the White House wouldn't sign up a new team without demanding loyalty to Bush's philosophy. That means Treasury honcho Snow, who sounded ultratraditional during the 2000 campaign, will have to change his tune. That year, he told BusinessWeek that Job No.1 for Bush was to "secure the surplus... and use a significant part of it to pay down the debt."

That won't happen now. Instead, economists say, the short-term deficit will rise as high as $250 billion. That means Bush has to hope that the stimulative kick of aggressive tax cuts will rocket growth up to 3.5% to 4%. That would render the deficit a fairly small share of gross domestic product.

The Bush crew's insistence that tax cuts will cause output to spurt isn't rooted solely in GOP evangelism. It also reflects the backstage policy power of White House über-strategist Karl Rove. He is willing to roll the fiscal dice in the short term in hopes of restoring market confidence, providing a bigger fiscal jolt for the slumbering economy--and providing "election insurance" for his boss by saving significant stimulus for 2004. "There's no doubt what Karl is focused on," says an Administration official.

Indeed, Rove & Co. may opt to delay moving up the '06 cut until the election year, a step that would give families an income boost just as Bush is campaigning for a second term.

Another bit of '04 juice could come from a plan to give investors relief from the "double tax" on corporate dividends. The Administration wouldn't eliminate the levy entirely but could opt to permit individual investors to exempt, say, 20% of their dividends from taxation. A policy that gradually eliminates double taxation is considered sound by many economists because it would end the revenue code's penalty on companies that pay dividends. But full elimination could cost a staggering $250 billion over 10 years.

If partial relief from double taxation is enacted next year, it won't be felt by most taxpayers until April, 2004--just as they are preparing their 2003 returns. Says William C. Dudley, chief economist at Goldman Sachs: "As far as Karl Rove is concerned, the fact that [tax relief] is coming through in the spring of '04 is not at all bad."

But the deferred-gratification strategy is risky. The Administration is gambling that the feel-good effects of the package will boost the stock market and ease corporate and consumer anxieties about the future right away. But there is reason to doubt that a small tax cut will have an electric effect on a $10 trillion economy. According to a study by University of Michigan economists, only 22% of the families who got rebates of up to $600 in 2001 actually spent them. And with unemployment hitting an eight-year high of 6% in November, some worry that skittish consumers will finally trim spending, knocking Christmas sales down and setting the stage for a weak start to 2003.

That's why many Democrats--and even some business groups--favor a big payroll-tax cut next year. One plan would give workers a six-month break from payroll taxes on Social Security and Medicare applied to the first $10,000 of wages. That would quickly pump $125 billion into the pockets of workers and might give the economy a rapid kick. The downside, aside from the high price tag: It could further undermine the Social Security Trust Fund. Democrats also want to move up scheduled rate cuts, but only for the middle class. And they'd freeze rate reductions for the wealthy and limit tax breaks for very large estates. They claim this approach would stimulate the short-term economy without busting the long-term budget.

Many of the Dems' plans focus on middle-class consumers. But the White House doesn't believe they're the economy's main problem. Instead, it argues that a lack of capital investment is the culprit. That's why the President wants to expand first-year write-offs for purchases of plant and equipment by hiking them from 30% to around 50%. The hope is that cutting the aftertax costs of such investments will get companies to order new gear. Two beneficiaries: the hard-hit telecom and tech sectors.

But it's not clear that even these added breaks will stimulate investment by industries that are still saddled with massive overcapacity. Similar tax sweeteners enacted last March have done little so far. Martin Regalia, chief economist at the U.S. Chamber of Commerce, says they're good for the long haul. But "you're not going to get an economic-stimulus-type kick out of expensing."

Other elements of the Bush package are included less for their stimulative punch than as precursors to future reform of the tax code. A proposal to make it easier to contribute to tax-deferred 401(k) plans and individual retirement accounts would spur long-term savings. And in a political nod to the plight of the working poor, the White House may embrace a Capitol Hill-backed proposal to make the child tax credit a bit more generous. What's more, to grease passage of any final package, the Administration may accept Democrats' pleas to extend unemployment benefits for jobless workers.

With Republicans in control of Congress, Bush and his team will have little trouble muscling their program past an outgunned band of Democratic liberals and a few lonely GOP deficit hawks. Then comes the ultimate test: Will this tax-driven fiscal fix help the weak economy and save Commander-in-Chief Bush from the family curse? Rove & Co. plan to leave very little to chance.

By Rich Miller, Howard Gleckman, and Lee Walczak, with Richard S. Dunham and Lorraine Woellert, in Washington

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