Midway on the Stockman Strategy
Jude Wanniski
July 6, 1981

 

Executive Summary: The surprising Reagan administration victory over House Democrats on budget reconciliation consummated the first half of David Stockman's strategy for the economic recovery plan. To those who believed the bond market would be impressed, including Stockman, the drift in the financial markets must have disappointed. Time has been lost and Reagan's political capital spent, but as the tax debate opens the incentive idea has made considerable headway in both parties. The Southern Democrats, with the President on the budget, have less excuse to stay with him on taxes, and have a fighting chance to prevail on the House floor. Once again, the across-the-board individual tax-rate reduction is threatened with dilution, as narrower interests crowd the Congress. The idea of a second tax bill fades, but should be revived by the President, along with another attempt at compromise, as a way of holding his coalition together. The outlook remains positive, but vague anxiety creeps into the picture.

Midway on the Stockman Strategy

A few days before the House of Representatives voted to adopt the Reagan administration's budget reconciliation measure, by a squeaky 217-to-211 tally, Rowland Evans (of the Evans & Novak team) described it to an audience of consumer credit executives as "the most important vote in Congress in 48 years." The audience was clearly astonished at this pronouncement. The national news media had not prepared the public for this significant impending vote, let alone a vote to bring the New Deal to a screeching halt, which is more or less how Evans described it.

The public learned of the vote after the fact. The network news was still unable to explain what the vote was about, except that it had to do with the budget and spending. Its importance was conveyed by describing the personal lobbying effort the President had made on its behalf. There were pictures of Tip O'Neill, looking grim and defeated, and by the weekend of June 27, there were news reports that certain unnamed Democratic leaders were thinking of expelling from the party the 29 House Democrats who had defected on the vote. This must have been a big vote, right?

Yes and no. Obviously the vote was a momentous one to the Washington crowd, even though the House members and their congressional aides freely admitted that they didn't know what exactly they were voting on. It will be years, one staff person was quoted as saying, before the full effects of the vote would be felt. We might think of the classic barroom brawls of the John Wayne genre, where there is no explicit reason for the mass fistfight, sides are chosen and blows struck at random, and no issues are resolved.

Clearly, the central aim of David Stockman, who had masterminded the budget strategy, was a rally in bonds. On June 15, Morgan Stanley's Erich Heinemann had observed impishly that late last year "David Stockman came to Morgan Stanley and basically asked, 'What do we do to get bond prices up?' (We gave him some advice, and he's followed the advice, and of course bond prices have gone down.. . .)".

The advice from Morgan Stanley, reinforced by Henry Kaufman and Alan Greenspan, was essentially the old idea of belt tightening; gimlet-eyed bankers and bond buyers would be especially impressed if Stockman would pitch a few widows and orphans into the street. Yet the financial markets yawned through Stockman's triumphant budget votes. Stocks and bonds actually weakened after the key June 24 vote, which practically everyone in Washington, including Stockman, thought the administration would lose. And even as the OMB Director celebrated, Henry Kaufman was on the wires predicting another rise in interest rates. There should be, Stockman told the financial press on June 27th, "a major favorable effect on attitudes and expectations around the country, particularly on financial markets." There didn't seem to be.

The supply-siders were greatly relieved with Stockman's victory. But not because it was some kind of turning point in history. Rather, he had committed the administration to a strategy of budget squeeze first, tax cuts second, and while supply-siders disagreed with the order, everyone was riding on Stockman's gamble. A defeat would have crippled him and the political momentum would have gone to the Democrats, threatening the tax bill. So far, only time has been lost.

Stockman had essentially decided that he could move a big boulder without a lever, and with much grunting and groaning and a last minute shove by the President the boulder did move. The tax cut was the lever that would have gotten the boulder rolling, buoying the economy before assaulting outlays. As it is, the effect of the reconciliation vote on the economy is negligible. The size of the budget cuts, after all, are small relative to the size of the economy and the public debt. But they are prospective, which means as nice as they are to contemplate, they would easily be overwhelmed by a weakening economy.

Supply-siders are forever being chastised by conservative Keynesians for being "indifferent" to deficits and government spending. But this is a misperception. Supply-siders do not share the Keynesian fascination with aggregate demand, the amount of ready cash jingling in the consumer's pocket, and thus do not directly aim at cutting spending in order to trim demand and thereby reduce consumer pressure on prices. It may work economically, in the textbooks, but it never works politically, which is reality.

Deficits, instead, are seen as red ink that flows from high tax rates and the other government impediments to commerce. Spending can be momentarily reduced through heroic feats of budgetary strength, but unless the barriers that are the core of the problem are brought down, the economy will not measurably improve. For one thing, spending is felt as an aggregate burden on the economy; tax rates are borne as marginal burdens by individuals. A spending cut leaves individuals in the same tax brackets, with no change in their willingness to supply labor and capital to the market. Yet, individuals who had been recipients of the spending are now forced to seek resources elsewhere, but they are as likely to go into the non-taxed barter economy as into the official economy or, off subsidized employment onto the welfare rolls. The clearest examples are the postwar experiences of World War I and II, both of which were evidenced by sharp declines in government spending. A recession followed the first war as tax rates remained high; vigorous expansion followed the second as tax rates were simultaneously reduced.

The great difficulty in getting spending levels down and keeping them down in the current environment is that the social and political forces that generated the spending impulse have not been extinguished or resolved (as the onset of peace resolves war budgets). The clamor for public resources via the federal spending process is generated at the margins of a shrinking economy and they can not simply be put off. Cutting outlays (for food, housing, and essentials in order to economize soon) translate into rising public and private outlays of resources to combat crime, health problems, etc., just as surely as slashing the defense budget for economy's sake invites public and private expenses associated with weakness.

Happily, there is a second part to the Stockman strategy, which is the tax cut, which aims at neutralizing the social forces that invite spending by encouraging a bigger private economy. But has the exercise in budget reconciliation been so politically expensive that the tax bill has been endangered? After all, an enormous amount of the President's capital has been consumed in trying to generate a bond rally through a budget squeeze. His standing with the public has sagged again, understandably. The economy's remarkable buoyancy during January and February faded precisely as Stockman's strategy was unfurled and the tax cut's effective date twice postponed. Interest rates remain destructively high. Relief seems to be in sight, but the public's patient optimism has given way to vague anxiety. How appropriate it was for the President to be scheduled during the Independence Day recess to address the N.A.A.C.P. in Denver, after the spending cuts and before the tax cuts. Reagan tried to get the convention of black leaders to celebrate their "emancipation" from government spending programs and White House aides were said to be "taken aback" by the chilliness of the response. It is testimony to Reagan's winning personality, though, that he was not booed. Instead, they will wait and see what happens next.

The chief difficulty now for the White House is that the Southern Democrats who gave him the budget victory are now in an extremely uncomfortable position with their colleagues in the House of Representatives. Twice the 29 "boll weevils" abandoned and infuriated their colleagues by going with the administration. Most of them represent districts that went overwhelmingly for Reagan in 1980 and the pressure on them was strong, on almost any excuse, to stay with him instead of their Democratic leaders. On the tax bill, though, it is hard to find that excuse.

The President has his tax bill and the Democrats have theirs, at least emerging from House Ways and Means. If the bills were widely different, the boll weevils could rationalize another crossover vote for the Reagan program. But by now the Democrats have learned a lot about how to maneuver in this new supply-side world, and the measure they are arranging does not look different enough to constitute an excuse. Then why worry? If the alternatives are all that similar, a respectable tax package is in the bag, right?

A 25 percent across-the-board personal income-tax cut over three years, say the Republicans. A delayed 25 percent cut over two years, say the Democrats, but with cuts skewed to the lower income-tax brackets.

A cut to 50 percent from 70 percent in the maximum income-tax on unearned income. Effective January 1, 1982, say the Republicans. Phased in over two years from that date, say the Democrats.

A business tax cut that focuses on accelerated depreciation, say the Republicans. A business tax cut that lowers the corporate rate, beginning in 1984, say the Democrats.

There seems bipartisan support for a $600,000 exclusion on the gift and estate tax, up from $175,000, with the maximum exclusion on annual gifts to an individual going to $10,000 from $3,000. In addition, there are a host of Christmas-tree ornaments that seem designed to give employment to lawyers and accountants, including the infamous "All-Savers Certificates" designed for the tottering S&L's. There's relief on the "marriage-tax penalty." There's a bone to royalty owners of oil and gas leases on the "windfall profits tax." I.R.A. and Keogh plans are liberalized.

As always, the supply-siders see the threat to the across-the-board tax-rate cut. Indeed, the "Kemp-Roth" feature of the bill has been so diluted already that some supply-siders are suggesting a formal disassociation. Bruce Bartlett, top GOP economist of the Congressional Joint Economic Committee, last month observed in a memo circulated on the supply-side grapevine that the original Kemp-Roth bill, introduced in 1976, called for an immediate 30 percent tax cut. Five years later, with consumer prices almost doubled, we are still debating a 25 percent cut that would not be fully effective until calendar 1984, with prospective inflation even offsetting the bracket creep during that period. Paul Craig Roberts, Assistant Secretary of Treasury for Economic Policy and usually the most pessimistic of the supply-side economists, is now much more optimistic, however. Roberts argues that while Bartlett is correct, the tax bill that is now emerging does not reflect the intellectual conversion to supply-side economics that will produce much more ambitious legislation soon after Mark I is buttoned up.

The original Reagan Plan, remember, was to first get a "clean bill" passed, including only the 10-10-10 version of Kemp-Roth and the 10-5-3 depreciation schedule for business. A second tax bill that would address the other tax adjustments promised in the Reagan campaign would follow. The rationale was that the general public would benefit from the first bill, which would bring early economic growth. The second bill would address the interests of narrower "publics." Treasury Secretary Donald Regan, in describing the approach, put such items in this second category as the gift and estate tax, the windfall profits tax, marriage-tax penalty, indexation, tuition tax credits, and the IRA, Keogh adjustments.

From our view, the original plan has been tattered by the exigencies of White House consensus-seeking, first with Ways & Means Chairman Rostenkowski and the Democrats in general, then with the boll weevils. In one way or another, all the special publics are being accommodated in the "first" tax bill, and by now the idea of a second bill lacks credibility. This nonbelief in a second tax bill increases the problems the President has with his original proposal.

The Independent Petroleum Association of America, representing the nation's 12,000 "wildcatters," provide a case in point. Dating back to 1975, when President Ford signed the energy bill that extended price controls on crude oil, the wildcatters have been a relentless political force on behalf of free-market Reaganomics. Texas gave all its delegate votes to Reagan over Ford in 1976. The oil patch went for Jimmy Carter over Ford, when Carter promised deregulation, and that was sufficient to give Carter the White House. Carter, though, betrayed the wildcatters and instead of relief, saddled them with the wellhead tax on domestic crude production that became known as the "windfall profits" tax. They not only went after Carter with a vengeance, but raised more than a third of all the political action money spent on the congressional races, which was decisive in the GOP capture of the Senate as well as the gains in the House.

In February, the IPAA executive board met to draw up its "wish list" to present to the incoming administration. Instead, it noted the President's plea for a clean bill and Secretary Regan's promise of a second bill, and decided to stand back and heed the Reagan request, holding fire on both the windfall tax and on natural-gas price decontrol. They also held their tongues when David Stockman, who had chaired the energy subcommittee of the Republican Platform Committee, as budget director announced implicit support of the windfall tax, "a prodigious producer of revenue," and also recommended an end to the oil-depletion allowance, to raise revenues (an idea quickly squelched by the President himself).

By early June, though, the picture had changed. The wildcatters played good guys, and proved Leo Durocher's dictum. While they sat on the sidelines waiting for the second tax bill, everyone and his brother made a deal with the administration on the first bill, in exchange for support of Stockman's reconciliation measure. Royalty owners got a $2,500 exemption. Synfuels were revived. The sugar industry gets new price supports. The S&L's get their saver certificates. Which is not to say that Stockman should not have made these "adjustments," as he called them. Once he decided to lift the boulder, he was forced into that expediency. And the wildcatters, no longer believing there will be a second tax bill, finally went to the hill and won from the Senate Finance Committee a 50 percent reduction in the windfall tax on new, undiscovered oil, literally the last special bone written in by the committee before it voted out its tax package.

The House Democrats on Ways & Means have not been oblivious to the goings-on. Their proposal to cut the corporate tax rate in stages to 34 percent, instead of offering accelerated depreciation, aims squarely at busting the coalition of Reagan support in the business community. In fact, it hit at the populist-elitist schism in the GOP, the Western and Eastern wings of the party, in the sense that the populists last year swallowed 10-5-3, which allocates capital toward physical assets away from human assets, in exchange for the Business Round-table's faint support of personal tax-rate cuts instead of reindustrialization schemes. The supply model, of course, favors corporate rate cuts over over-accelerated depreciation because they leave the producer unbiased in choosing factors of production. (The supply model generally favors personal tax cuts over corporate tax cuts because the latter put the bias in favor of individuals who work for corporations, while the personal income tax is free of such bias.) If implementation of the Democratic proposal were not delayed for three years, it would be hard to keep more than half the Republicans from favoring that alternative.

Similarly, there is talk of a Democratic proposal to exempt the first 1,000 barrels of oil from the windfall tax, with the revenue losses to be recouped by taxing the major oil companies on overseas earnings.

In short, there really is no Reagan "coalition" as evidenced by the reconciliation votes. The Democrats, after stumbling around, are playing shrewdly, and at the moment have a fighting chance to win on the House floor. They may even make their package attractive enough to draw away a block of Republicans, at the expense of Kemp-Roth. The Senate will stick to the 25 percent cut, but there will be a different story in the conference committee. Reconciliation with the House could easily mean knocking off the first 5 percent, and if the next 10 percent doesn't take effect until July 1 next year, the President will have been snookered into a 5 percent effective cut for the first two years of his term instead of the 20 percent he began with. In the 1982 elections, the Democrats will be asking the electorate, "Are you better off now than you were in 1980?"

Treasury Secretary Regan on June 25 gave me his "personal assurances" that there will be a second tax bill, when I raised the subject in this context during a 40-minute meeting in his office. He was so emphatic that he left no doubt that he believes there will be a second bill on the heels of the first. But Washington really doesn't believe this anymore and is acting as if it doesn't.

At least one possible strategy suggests itself: The White House should immediately elevate the idea of the second tax bill and commit the President to it as fervently as is Secretary Regan. The special interest clamor that is now crowding in for tax breaks, threatening a delay or dilution of the economic recovery program to the vanishing point, will either get their drink at the well in the first round and sit out the second, or forego the drink now for the chance of a more satisfying draught down the road.

It could be that as a result the order will have reversed itself, and the legislation that will pass this year will be the Christmas tree, with next year's election-year package a robust supply-side package. Craig Roberts may be exactly right, that the supply-side incentive ideas have advanced well beyond the shape of the current tax proposal, which has its roots in last year's thinking. While Stockman has slid backward under the pressure of his budget job, important converts have been made. Donald Regan has become a powerful advocate, White House Chief of Staff James Baker and Communications Director David Gergen turned from adversaries to allies, as did Rep. Barber Conable, ranking Republican on Ways and Means. Rep. William Brodhead of Michigan, chairman of the liberal Democratic Study Group, may be the most important new convert to the supply-side concept. It was Brodhead who proposed cutting the unearned income-tax rate to 50 percent from 70 percent when the White House shied. He tells me he now sees no reason why personal tax rates should be higher than 35 percent, In a 2-1/2-hour conversation I had with him June 23, he clearly had come to the revelation that all successful liberal leaders experience, that wealth must be created before it can be redistributed. It will take a Broadhead to lead the young liberals into the supply-side framework.

At the moment, though, halfway through the scenario dictated by Stockman's strategy, Washington is waiting for Congress to return with instructions from the grass roots and the President to come home with reflections on the strategy thus far. We can expect the House Democrats especially to come back in a fighting mood, led by a Tip O'Neill who already vows to renew the battle, more dangerous now that he has been wounded. Perhaps this is why the President's victory over spending is clouded by a vague anxiety over taxes, the prospect of two sides settling down to a long period of trench warfare.

The obvious move for the President would be one of conciliation. O'Neill signaled in the New York Times of July 1 that had the President originally agreed to the one Democratic request of a two-year tax cut instead of three, it all could have been worked out, taxes and spending. Ed Meese, he said, scotched the idea. There is, of course, absolutely no idea why the tax cut should be three instead of two, as long as the two-year bill has punch in it. Reagan can always come back again for the rest. Thus, if he revives the idea of a second tax bill in 1982, the President may also be able to reopen the potential for a decent compromise on the first, and avoid a long, bloody political siege. There is really not much left to fight about on taxes or spending, and the delay on the tax bill only postpones the critical debate on monetary policy. There's no reason why Tip O'Neill shouldn't have a bill for the President by October 1, as promised, but the President has to move that boulder himself.