What's Better Than Bush's Tax Plan?

Chances are his original proposal won't get passed. The compromise taking shape, however, will likely be an even stronger economic booster

By Amey Stone

The federal budget process has been particularly painful for investors this year. From beyond the Beltway, congressional battles tend to look confusing, and they're influenced by an incomprehensible set of arcane rules. But this time around investors have an especially large stake in how the budget shakes out. The economy sorely needs a near-term stimulus, and the Bush Administration's plan strikes many investors as the best way to get some.

However, the President's proposals now face so much opposition that the overall tax cut could be reduced from his original bid of $726 billion over 10 years to as little as $350 billion. And that has sparked concern among some investors. They fear that the economic stimulus they were counting on to get the economy over the hump this year is being whittled away.

Yet in many ways, this year's budget battle is typical of how the White House and Congress negotiate a deal everyone can live with. While the compromise package that's likely to emerge in the next few months will probably be quite different than what the President proposed, chances are it will provide stimulus to the sluggish economy more quickly than the original plan. Better yet, it also should have fewer long-term consequences in terms of increasing the federal budget deficit.


  The best example of how a blow to the Bush tax cuts doesn't mean the economy will losing out on short-term stimulus is the plan's original centerpiece: the increasingly embattled proposal to eliminate the taxation of stock dividends as ordinary income to individuals. President Bush has said he needs a tax cut of at least $550 billion over 10 years to revive the economy. That would allow for a reduction of dividend taxation to perhaps an 18% rate at best, say Washington insiders. "Bush will be lucky to get half a loaf," says Greg Valliere, chief strategist of Schwab Washington Research Group. "And he may not even get that."

For various reasons, many investors and economists like the full dividend tax cut. Some because they say it streamlines the tax code, others because they think it will lead to cleaner corporate reporting, and others just because it will give the downtrodden market a lift and themselves a tax break.

Yet many private economists say the costly plan would actually provide very little direct stimulus to the economy. The biggest beneficiaries would be wealthy investors who are unlikely to spend the tax savings. And the tax cut's other positive economic impacts, particularly a Bush claim that it would lead to more capital spending by businesses, are indirect at best.


  What Bush is likely to get instead of the full dividend tax break is the other key piece of his plan -- an acceleration of cuts to marginal income tax rates that were approved two years ago. This is by far the most important part of his strategy for boosting gross domestic product, say economists. "In terms of providing stimulus to the economy in the short run, moving up the marginal-rate reduction is much more effective than the dividend exclusion," says Gus Faucher, senior economist at research firm Economy.com.

The Administration may even need to compromise a bit here and give a break to people in the lower tax brackets first. Many economists -- though far from all -- believe that would provide nearly as much stimulus to the economy at lower cost to the government. That's because middle- and lower-income taxpayers are more likely to spend the tax savings, putting those dollars to work immediately. Hinted at by Treasury Secretary John Snow in a recent newspaper interview, a compromise position delaying tax cuts for the wealthy was later repudiated by the Administration, but Valliere believes it may still be on the table.

Extra near-term stimulus from the rate cut could come if it's implemented in 2003 as a tax rebate -- a real possibility, says Valliere. A rebate is the quickest way to get the cash in consumers' hands. Just two years ago, a tax rebate helped give the economy and the consumer some extra juice. "It proved to be a valuable offset to the adverse impact of September 11 on consumer spending and economic activity," says John Lonski, chief economist at Moody's Investors Service.


  More good news for investors: As part of the negotiation process, some aid may be tossed to cash-strapped states, many of which are planning steep cuts in services and hikes in fees and taxes to cover deficits. State-level spending cuts and fee hikes would create a major drag on local economies, so spending now to prevent that would offer a clear boost to the economy. "That's the most effective short-term spending solution we can come up with," says Michael Davis, a professor in economics and finance at Cox School of Business at Southern Methodist University.

This wasn't part of the Bush plan, but many economists and tax-policy experts believe it's the strongest short-term stimulus the federal government could provide. Some powerful voices in Congress, including Senator George Voinovich (R-Ohio), are fighting for it. It may be the kind of compromise position the Bush Administration endorses in exchange for a higher total tax cut.

Valliere also believes plenty of near-term economic stimulus is likely to make it into the final budget act to raise the child tax credit (from $600 to $1,000) and reduce the so-called marriage penalty. "This will all be bargained out," he says. "Right now they're still fighting over the price tag." His firm's research estimates that the final tax package could add a half-percentage point to GDP in the second half of the year, allowing for a 3% annual growth rate. "It's not enormous, but it will give the economy a little extra boost," says Valliere.


  For investors, the promise of that stimulus remaining in the budget bill -- and the potential for more to be added during the coming months of negotiations -- should relieve some anxiety. So should recognition that the embattled dividend tax break, while potentially a nice bit of tax reform, was too costly for these lean times and really wouldn't have been much of a near-term booster anyway.

A lot of budget wrangling is still ahead, but it's looking increasingly like the final package of tax cuts will give the economy just the boost it needs at just the right time.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Beth Belton

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