Mr. Bush Lights a Fire

His tax cut will surely stoke the economy in the short run. But will it suffocate long-term growth?

Cutting taxes is nothing novel for George W. Bush, a politician who has made the quest for ever-lower rates a reflex action. Still, the $350 billion growth package he just muscled through Congress could be the most important of his Presidency. With one eye on the economy and another on reelection, he's betting faster rate cuts and juicy investment incentives will boost the stock market, prompt businesses to start spending, and shake off the nation's economic malaise by November, 2004. "This legislation is adding fuel to an economic recovery," Bush declared as he signed the tax bill on May 28.

Thanks to congressional pleas, the tax cut delivers a bigger jolt of up-front stimulus than Bush sought. The infusion of $210 billion this year and next should give a lift to an economy that definitely needs help. The same day Bush signed the tax bill, the Commerce Dept. announced that orders for durable goods fell an unexpectedly sharp 2.4% in April.

Debate is raging over the long-term benefits of the tax package, and many see political motives behind its passage. Because many of the tax law's provisions are aimed squarely at investors, Bush's strategists hope to score points with a burgeoning group of stockholders. The package is the first true "Investor Class tax cut," contends Jonathan Collegio of Americans for Tax Reform.

Whatever the tax package does for the President's reelection chances, many believe it will help lift the black mood that has been weighing on growth. "The economy is such a product of optimism or pessimism," says Michael J. Birck, CEO of Tellabs (TLAB ) Inc., a telecom-gear maker in Naperville, Ill. "If [people] read into this that they have more disposable income, they are likely to spend more." Already, there are signs that Americans' spirits are rising. The Conference Board reported that its consumer confidence index climbed in May, to 83.8, up from 81 in April. Stocks are also showing signs of life. With optimism about the outlook for corporate profits growing, the Standard & Poor's 500-stock index is up 19% since early March.

Most economists believe the tax package will provide a significant short-term lift. By itself, the tax cut will boost gross domestic product by roughly 0.5% this year and another 0.5% next year, economists say. Add to that big spending on defense and domestic security, aggressive rate-cutting by the Fed, and a weak dollar that should help U.S. exporters. Says William D. Zollars, CEO of Kansas-based trucker Yellow (YELL ) Corp.: "All this -- tax cuts, a rising stock market, improved earnings and consumer sentiment -- creates [an] atmosphere that will get business spending moving."

The key questions are when -- and by how much. Over 18 months, the Bush tax cut should add billions to the economy. Almost $120 billion will come from lower rates, relief for two-earner couples, and breaks for families that get the child credit. Cutting rates to 15% for dividends and capital gains injects $23 billion more. And businesses will get nearly $50 billion in investment incentives.

The measure also sends $20 billion in aid to governors over two years, which will offset some fiscal drag from higher state and local taxes. Of the individual cuts, roughly 60% will go to people making $100,000 or more, many of them investors. Families will get checks from the Treasury Dept. for the sweetened kid credit by summer, and workers' take-home pay will rise by July thanks to lower withholding.

If this multipronged offensive boosts the economy, look for a smart increase in corporate profits next year and a related kick in stock prices. Says GOP economist Kevin A. Hassett: "When you lower costs, you stimulate business fixed investment. And it sure could use some stimulation."

Here's how key sectors could benefit:

-- MANUFACTURING Durable-goods producers are positioned to gain from both low interest rates and more generous equipment write-offs. Companies that have been holding back on purchases may want to pull the trigger before the Bush breaks expire at the end of 2004.

-- TECH Signs hint that demand for computer gear is rising a bit. Orders jumped 15% in April, after months of decline. Liberalized depreciation may accelerate the trend. Overall, the cost of capital for tech outfits will drop because of the new 15% rate on capital gains. But will all this offset continued overcapacity in tech and telecom?

-- FINANCIAL SERVICES Tax cuts on dividends and capital gains should help rev up the market, and brokers and mutual funds may gain. But the new law giveth and taketh away. The advantages of tax-deferred investment accounts, such as variable annuities, have shrunk. Likewise, real estate investment trusts and bonds could be less attractive because their returns will still be taxed at rates up to 35%.

-- RETAILING More money in consumers' pockets -- $31 billion this year and $88 billion next -- means busier cash registers. Says Leonard H. Roberts, CEO of Fort Worth-based RadioShack (RSH ) Corp.: "You're putting [money] into people's pockets [right away]. That will increase consumer spending."

A crucial part of the White House strategy is lifting the stock market. But it's not clear the plan's investor-friendly cuts are big enough to keep up the momentum if corporate earnings don't improve considerably. Most economists felt the original $390 billion plan to eliminate double taxation of dividends and capital gains would have pushed up share prices by 5% to 7%. This version, costing $148 billion for both cuts, is only 40% the original's size -- and so it's likely to provide a smaller kick.

Sure, lower rates on capital gains should spur many investors to sell some long-held shares. Families can take advantage of rates as low as 5% by transferring appreciated stock to children. But the overall impact on the stock market may be muted. Many gains and dividends go untaxed, because equities are owned by tax-exempt investors such as pension funds. And much of the benefit of lower capital gains rates could flow away from Wall Street, into real estate investments or art collections.

Beyond that, the Tax-Cutter-in-Chief's course isn't without risks. With his tax-cut tally up to $2 trillion over 10 years, the President has fired his last fiscal bullet, given a deficit likely to exceed $400 billion this year. Critics fret that a tax-starved government won't have the long-term resources to aid the poor, build schools, or provide health care. Economists wonder whether the tax cuts -- most of which are due to expire between 2005 and 2010 -- can be sustained when Washington faces big IOUs for health and retirement benefits for the elderly. "These costs," says Urban Institute economist Leonard E. Burman, "are waiting for our children."

For his part, Bush says the country can bear these burdens if the economy returns to a robust growth rate of 3.5% to 4% per year, and that's what his program will deliver. Economists agree with the goal but disagree over whether these tax cuts will boost growth over, say, 5 or 10 years. This argument is especially tough to sort out since different elements are scheduled to phase out over the next decade. Incentives for capital investment, for instance, are due to lapse on Dec. 31, 2004. Dividend and capital-gains rates could revert to their old levels by 2009. Bush allies insist they'll make the cuts permanent and predict powerful economic benefits. Hassett, for example, sees an overall 1% boost in GDP. Proponents argue that tax-cut-propelled growth will shrink the deficit to manageable levels.

Critics counter that, like Ronald Reagan, who saw his 1981 tax cut whittled down, Bush may have to let some cuts expire. Yet if the measures are temporary, that will undermine their effectiveness. "To the degree [the tax cut] is perceived as a one-time shot, it will have less impact," says James W. Paulsen, chief investment strategist at Wells Capital Management.

If the cuts are permanent and growth doesn't spurt as planned, the deficit could explode. Indeed, the tab for keeping all of the cuts on the books could exceed $800 billion over the next decade. If Washington must borrow trillions to pay the bill, productivity and investment could suffer. An analysis by economic consultants Global Insight posits that the plan will boost GDP more than 1% over 18 months but will have scant impact after five years.

Bush's political aides are focusing on the next 17 months. And they believe their boss is already reaping political gains for fighting malaise via lower taxes. According to a May 6-22 poll by Ipsos-Public Affairs, Bush has made inroads among the investor class. While noninvestors prefer an unnamed Democrat to Bush in 2004 by 36% to 35%, investors strongly favor the President, 50% to 27%. Most striking is the pickup among investors earning $25,000 to $50,000: Although usually Democratic, they pick Bush by 2 to 1.

Continuous tax cuts also put Democrats in a box by shrinking the money available for new social spending. The result: They must either reduce the generous safety-net proposals that appeal to their base or finance their plans with unpopular tax hikes.

That dilemma won't end anytime soon. The President wants to keep cutting taxes far into the horizon. And there's no doubt the Texan has staked his electoral future -- and America's economic fate -- on the notion that tax cuts will have an electric effect on growth. If a nation mired in a post-boom funk doesn't respond to this Reaganesque magic, Bush and his party could pay a stiff price. Still, Bush is a believer. And as his tireless stumping for his tax package proved, optimism can sway some doubters -- for a time.

By Howard Gleckman and Richard S. Dunham in Washington, with Stephanie Anderson Forest in Dallas and Roger O. Crockett in Chicago, and bureau reports

    Before it's here, it's on the Bloomberg Terminal.