Tax policy: Again, the economy is responding to lower taxes

Saturday, July 15, 2006

Here are a couple of insightful excerpts regarding recent trends in the U.S. financial situation that will help you understand the impact of government tax policy.

The Big Bang story of U.S. private business: Did you know that just over the past 11 quarters, dating back to the June 2003 Bush tax cuts, America has increased the size of its entire economy by 20 percent? In less than three years, the U.S. economic pie has expanded by $2.2 trillion, an output add-on that is roughly the same size as the total Chinese economy and much larger than the total economic size of nations like India, Mexico, Ireland and Belgium.

Most in the mainstream media would rather tout the faults of American capitalism than sing its praises. And, of course, the media will almost always discuss supply-side tax cuts in negative terms, such as big budget deficits and static revenue losses. But here's another suppressed fact: Since the 2003 tax cuts, tax-revenue collections from the expanding economy have been surging at double-digit rates, while the deficit is constantly being revised downward.

For those who bother to look, the economic power of lower-tax-rate incentives is once again working its magic. While most reporters obsess about a mild slowdown in housing, the Big Bang story is a high-sizzle pick-up in private business investment, which is directly traceable to Bush's tax reform. It was private investment that was hardest hit in the early-decade stock market plunge and the aftermath of the 9-11 terrorist bombings. So team Bush's wise men correctly targeted investment in order to slash the after-tax cost of capital and rejuvenate investment incentives.

The move paid off. Investors now keep nearly 50 percent more of their after-tax capital returns -- an enormous increase that has resulted in a remarkably profitable and highly productive business sector. While the overall economy has grown by one-fifth since mid-2003, private business investment has expanded by 37 percent.

The dirty little secret here is that record low tax rates on capital are leading to continued job and income gains as businesses continue to expand. "But," you might respond, "I thought job gains were soft." Well, the marquis employment report for June may have showed "only" 121,000 new non-farm payroll jobs, below Wall Street expectations. But this leads to another factoid that the mainstream media largely ignores: The household survey of job creation has been booming at a much faster clip than headline corporate payrolls. This month's household survey shows 387,000 new jobs in June, following 288,000 in May.

According to the U.S. Small Business Administration, firms with fewer than 500 employees created 88 percent of the net new jobs in the U.S. between 1990 and 2003 (the last year for Census Bureau data). During this 14-year period, the share of total jobs created by small businesses was never less than 50 percent and was sometimes double the employment total.

Large corporations are reluctant to hire because it is so expensive to do so. Think health-care and pension costs as well as payroll add-ons for unemployment compensation and worker disability. The modern cost-cutting pressures of globalization also force large firms to take a highly cautious hiring approach.

-- Excerpts from a column by Lawrence Kudlow

Principles of prosperity: Now let me turn to five basic principles of economic growth. First and foremost is the rule of law: Without individual equality before the law, entrepreneurs cannot challenge already existing businesses. Alliances between the latter and government regulators who place barriers before entrepreneurs must be guarded against.

The second essential principle is property rights. We take it for granted in this country that if you buy a piece of property, everyone acknowledges that you own it. Most countries don't have that kind of uniform property system.

A few years ago, Hernando DeSoto, a great economist from Peru, saw that in countries like his, although there is entrepreneurial activity, there isn't the corresponding prosperity found in the U.S. And he wondered why. In his recent book, "The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else," one of the key factors he cites is the absence in so many other countries of a legal foundation for property rights. In Brazil's shanty towns, an individual may know that he owns the house in which he lives, and his neighbors may know it, but the fact is not recognized elsewhere.

Mr. DeSoto was asked by the Egyptian government a few years ago to determine who owns the businesses and residences in Egypt. His finding was that 88 percent of the businesses in Egypt are illegal. Why is that? Here in the U.S., it is possible to set up a business legally in a matter of days. In Egypt, it takes a couple of years. It requires going through numerous bureaucracies, doling out numerous bribes, etc. So it makes sense to proceed "informally."

On the other hand, running a business outside the law limits its growth. Most "informal" enterprises never grow beyond the level of family enterprises, because if they get too big they might attract the attention of the tax collector. DeSoto's group also reported that 92 percent of Egyptian housing is illegal. People living in residences may have deeds; but only a few miles away, those deeds are not recognized. In Egypt, as in so many other places, there is no uniform system of establishing and protecting property rights. As a result, four billion people around the world own $9 trillion of assets that amount to dead capital.

What do I mean by "dead capital"? Remember that here in the U.S., the most important source of capital for new ventures is not Wall Street, the local banker or the venture capitalist. It is the mortgage market. People either increase their mortgage or take out a second mortgage in order to start businesses. This is not possible in countries like Egypt. Understanding this was the key to Japan's post-World War II economic boom. General MacArthur reformed a feudalistic property system, in which the peasants had only an informal system of property exchange, into a system with formalized property exchange, into a system with formalized property rights. Immediately, the Japanese economy took off. The importance of property rights is not sufficiently recognized by those of us who take them for granted.

The third principle of economic prosperity is lower taxes. Taxes are not just a means of raising revenue for the government. They are also a price. Income taxes are a price paid for working; taxes on profits are the price paid for being successful in business; taxes on capital gains are the price paid for taking risks. In light of this, the importance of low taxes is easy to see: When you lower the price of good things -- things like work, success and risk-taking -- you tend to get more of them. Raise the price of these good things and you get less. In 2003, we lowered tax rates in the U.S. and the economy started to grow again.

As we've seen time and again, tax cut do not mean a loss of tax revenue. By increasing incentives, the government comes out ahead. Washington's revenue in the last fiscal year was up 15 percent -- $100 billion above expectations. Washington's problem is not revenue, but spending.

The fourth principle I would mention is making it simpler to launch legal businesses. Getting bureaucracy out of the way will inject a new vibrancy into the economy.

The fifth and final principle is free trade. Expanding markets and creating greater opportunity for trade benefits us all.

In closing, I will remind you of a point I made earlier. The reason that the great economic debate continues into the 21st century, despite the proven superiority of free markets in terms of delivering prosperity, is because of the misperceptions that keep democratic capitalism from capturing the moral high ground. Dispelling these misperceptions should be our priority as we carry on that debate in the years ahead.

-- Steve Forbes, excerpt from a speech at Hillsdale College

Gary Rust is chairman of Rust Communications.

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