Anxieties on Wall Street
Jude Wanniski
June 17, 1985


Executive Summary: The financial markets are more skittish than usual, with stock indices like the Dow at lofty levels while corporate profits sink. Something has to give. Our relative optimism is based on a sense that policy is at least pointed in the right direction. The Fed still hasn't eased, but at least it's boxed in, unable to tighten. We see the discount rate going to 6 ½ % later in the year, the long bond at 9%. The President's tax reform is making nice headway, with supply-siders surprised at the lackluster opposition mounted by New York's Cuomo, the leader of anti-tax reform. The $2000 personal exemption, enormously popular, almost guarantees legislation. Reagan, though, often sounds like Jimmy Carter on the fairness issue, bad advice from his pollster. The legislation will invite a wave of tax cutting in states like New York, which don't seem to realize they will get a windfall on a federal "piggyback." So as long as Volcker comes through, there's nothing much to worry about. 

Anxieties on Wall Street

"What is the mood on Wall Street? an article in the June 10 Wall Street Journal asked. 'To put it charitably, nervous. To be frank, scared." Why the fear? With the stock market so strong and the economy sluggish, the Dow making record highs while corporate profits sank, it was no wonder Wall Street brooded.

Obviously, something has to give. Either the economy has to strengthen and corporate profits climb or the stock market tumbles. The only other explanation would be some fundamental change in the price-earnings multiple, Wall Street suddenly happier with lower corporate profits. Forget it.

No, the reason for the general state of anxiety on Wall Street undoubtedly has to do with the uncertainties surrounding economic policies. The market is well aware the economy is flat and profits are sinking — although IBM revealed it may be flatter and sinkier than was the general awareness. But this has to do with past policy, the Fed's determination a year ago to flatten and sink the economy from a high growth level. But that's been done, and there is hope and expectation in the air that monetary and fiscal policies are going to be more or less okay. At least the direction seems to be right. Still, there are an unusual number of ominous clouds around that could bring sudden storms — as we saw in the market skid in the week of June 10. A general survey of the situation might help.

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MONETARY POLICY. Beryl Sprinkel, chairman of the President's Council of Economic Advisers, insists that money is gushing out of the Federal Reserve and we will soon see a resurgence of inflation. But he is the only administration figure who has this view, including his immediate boss, White House chief of staff Donald Regan. The reason we're not hearing from Sprinkel is that he's been told to clam up, the White House and Treasury wanting to encourage further monetary ease by the Fed. The fact that last month's cut in the discount rate to 7 1/2 from 8% was not followed by a rise in the price of gold and commodities, or a sinking of the dollar, left the Fed plenty of room to ease further. The market saw this, expecting another cut in the discount rate that didn't happen. Why didn't the Fed see it?

In reality, the Fed hasn't been easing at all. It's "permitted" the decline in interest rates, to prevent the dollar from climbing even higher in the foreign-exchange markets and to avoid even more of the drastic consequences of deflation. The helpful pressures on the Fed are still there. We imagine the austerity-minded Fed governors would love to keep squeezing, driving commodity prices down, but bad things happen. They've hit bottom.

The next question is, will the Fed actually have to ease, to get interest rates down in order to push gold back toward $350 and the Deutschemark back to 2.80? There's no way of knowing if the Fed can avoid a new debt crisis at the level of deflation implied by $315 gold. The price of oil has to fall at that level and other commodity prices will drift even lower. This puts added pressure on the banking system, especially in the oil patch and farm states. And Argentina and Mexico, among others, seem to be back on thin ice. The decline in interest rates the Fed has permitted helps some, but will it be enough? Probably not. There has to be some real easing.

To a considerable degree, the stock market has this kind of surmise built into expectations. Lower interest rates will foster greater economic activity and higher profits. But what happens when the Fed sees some signs of growth? Do they hike rates back up to stamp out the growth? No. More likely they act to prevent rates from falling further, and then only if they are worried about whatever may be developing in the commodity and foreign-exchange markets.

There are plenty of economists around who see resumed economic growth pushing up the demand for credit and boosting long-term rates later in the year. Michael Evans see CNP growing at 4 to 5% and the Treasury long bond up near 12% at year's end. Henry Kaufman, who last month pronounced an end to the bond-market rally just before its snazziest gains, also clings to his illogical flow-of-funds model: Economic growth will push up interest rates which will push down economic growth which will push down interest rates! Michael Evans is no better, with the same circular reasoning, although he probably has more of the monetarist model in his thinking. Lacy Hunt, like Sprinkel, expects interest rates to surge on the money supply inflation he thinks is built into the economy. Typically, the monetarists, who supposedly have such profound respect for "markets," now insist the commodity and bond markets are wrong in not seeing the inflation they see.

Interest rates are not headed back up, although the bond market will be spooked from time to time when a bit of better-than-expected economic news is reported. In the fall of 1983, when gold was over $400, we thought interest rates would fall as long as Volcker kept gold from sinking below $400. Volcker chose deflation over economic growth, and we've paid for his choice in lost production, climbing budget deficits, and farm bankruptcies galore. But there's nothing anyone can do about the past. We will have considerably less price inflation at $315 gold than we would have had at $415, and Volcker can cite this as an achievement. What's important to bear in mind is that there is no room for repetition of this process. In 1983 the economy was booming and now it is not. The cost of further deflation rules it out as an option, which is probably why we're finally hearing such stalwart austerians at the Fed as Henry Wallich and Chuck Partee sounding more reasonable. We're thinking of a gold trading range of $300 to $350 and expect the Fed will move to the high side of that range in avoiding banking anxieties. We see the discount rate at 6 1/2% later in the year and the Treasury long bond at 9%.

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TAX REFORM. If the President's tax reform simply disappeared, would the stock market be stronger or weaker? Weaker. We think reform has been helping the market to a significant degree since the beginning of the year — when it first became clear the Reagan Administration was serious about it. There's good reason to be nervous about the stock market if we consider how difficult it will be to get solid legislation through Congress this year. Failure would be a blow to the financial markets. By the same token, success would be rewarded with a major run-up in stocks. We're still confident of successful legislation.

This doesn't mean any old reform legislation will do. Treasury II, though, would do just fine, with some minor adjustments. And even if it were enacted as is, Wall Street would almost surely applaud. The top marginal tax rate of 35 percent on personal income combined with a 50 percent exclusion on capital gains would in itself be a stunning contribution to the economy's potential. The doubling of the personal exemption to $2,000 will also have marvelous productivity effects across the lower-income classes.

The problem is that the opponents of tax reform — the special interest groups that do zero-sum analysis — could be successful in weakening the bill to the point where it isn't worth the effort. So far it has been encouraging to the reformers that the opponents, who are lining up behind New York Cov. Mario Cuomo on the issue of state-and-local tax deductibility, aren't showing much smoke.

There had been concern among the supply-side reformers that the top income-tax rate of 35 percent was not low enough to offset the loss of state-and-local tax deductibility in the 16 high-tax states. The fact that these 16 states have a majority of seats in the House suggested that Cuomo could put together an anti-reform coalition that would restore deductibility. The revenue loss could not be made up without inciting other groups, and the reform effort would unravel.

Cuomo, though, found himself in the extraordinary position of defending the interests of the high-income itemizers of New York and getting little support from liberal Democrats in the other high tax states. Rep. Fortney (Pete) Stark, one such California Democrat, took to the House floor with ridicule at the idea that when it came down to a vote, New York's Democratic congressman would vote against a major tax cut for the majority of their constituents just because a few high-income itemizers would be nicked for more.

Rep. Jack Kemp, who may very well find himself running against Cuomo in 1988 for the presidency, suddenly found himself in the awkward position of agreeing with Cuomo on this point. Except that where Cuomo wants to use the deductibility issue to destroy tax reform, Kemp worries that the deductibility issue might destroy tax reform. With a 30% federal tax rate, Kemp had argued inside the Administration, Cuomo would not be able to rouse opposition on the issue. Even in New York City, with an 18% combined state-city income tax, people would be better off and would ignore Cuomo's warnings.

Jim Baker actually presented three options to the President, one of which the President chose, the other two reflecting Kemp's concerns. One was a "maximum average tax" of 30%, suggested to Kemp by Robert Mundell and Alan Reynolds, patterned after Hong Kong's 25% top marginal rate and 17% maximum average. That is, the top federal rate would be 35%, but when the average rate hit 30%, that would become the new marginal rate. High-income taxpayers would have the option of simply paying 30% of gross income and filing by postcard. The second option was a 32% maximum rate, with the 3-point differential paid for by eliminating the 10% exclusion on corporate dividends.

The tradeoff of a 32% top rate for the 10% dividend exclusion was fought by Donald Regan, who wants the dividend exclusion for Wall Street. The maximum average tax idea was probably rejected because of the "distribution" arguments that worry Jim Baker, those that complain of the biggest percentage benefits going to the rich.

This has been one of Baker's weaknesses, going back to 1981 when he blocked an administration proposal to cut the top rate on "unearned" income to 50 from 70% — arguing that the Democrats would attack the proposal as being "unfair" in favoring the rich. That left it up to Rep. William Brodhead, a liberal Democrat from Michigan now retired, to offer his amendment that cut the rate to 50%.

This is a critical point rarely understood. Republicans, especially but not only those born into families with means, forever worry that the masses want to keep tax rates high on the rich out of sheer envy. This is an age-old political myth, exploited by egalitarians everywhere and liberal Democrats in the U.S. It simply isn't true. The vast majority of people in the U.S. (and in the world) have no idea what the top marginal income-tax is until they approach it. When President Kennedy in 1962 proposed cutting the top rate to 70 from 91% there wasn't a peep of disapproval from the masses, although John Kenneth Galbraith and his friends were appalled. The electorate was similarly unconcerned in 1981 and Brodhead did his thing.

President Reagan has put a lot of energy into his reform plan, running around the country making speeches. But he's only done a fair job of selling it. Unfortunately, he was persuaded to adopt a negative argument in defending state-and-local nondeductibility, asserting that low-tax states should not "subsidize" high-tax states like New York. This zero-sum argument is unbecoming to Reagan and inflamed New York's political leaders of both parties. Happily, Reagan dropped this confrontational approach after receiving private criticism.

But he still sounds like Jimmy Carter denouncing the Three Martini lunch: "It just doesn't seem right for a wage-earner carrying his tuna fish sandwich to work to subsidize exorbitant business lunches at luxury restaurants." He asked corporate executives, "Why not brown bag it once in a while?"

Leonard Silk of The New York Times was quick to spot this new wrinkle in Reaganomics, wondering if the President had picked this up from Harvard's ultraliberal social philosopher John Rawls — that inequalities can be justified only if they contribute to the good of all. Silk also noticed the "fairness" idea creeping into a White House briefing paper in an unusual way:

At bottom, fairness is growth. "Reducing rates and increasing the perception of fairness," said the White House paper, "should increase incentives for work, saving, investment, risk-taking and innovation." Thus, fairness had joined tax cuts as a key element in supply-side economics.

The idea that an assembly-line worker will work harder because his boss is also brown-bagging, is a version of supply-side economics heretofore tried without success in Moscow and Mao's Beijing. The idea has been rattling around inside the U.S. Treasury recently, picked up by Deputy Secretary Richard Darman and endorsed by White House pollster Richard Wirthlin. Wirthlin's polls find the American people want "fairness" in the tax code, which gets translated into "equality," when all that the people are saying to the pollsters is that they want everyone to play by the same rules. They object to the rich and the powerful, the people with connections, the elite, stacking the game for themselves by manipulating the tax laws.

The President was better when a reporter asked him what he thought about people with incomes over $200,000 getting "a tremendous tax cut." Reagan shot back that "they pay a tremendous amount of taxes." And when The New York Times reported that he and Nancy would have big tax savings under his plan, he cheerfully allowed that he hoped so, because so much of his income goes to taxes.

But even these defenses are not on the mark. People with incomes over $200,000 won't be getting the tremendous tax cuts the newspapers indicate because so much of their income is sheltered. In the years immediately before he became a presidential candidate in 1976, Governor Reagan himself paid no federal taxes at all, the result of tax shelters arranged for him by his lawyer, William French Smith. The President should be putting more stress on the idea, as Calvin Coolidge did in the 1920s, that the object of lowering the high marginal rates was to get more revenue from the wealthy:

I agree perfectly with those who wish to relieve the small taxpayer by getting the largest possible contribution from people with large incomes. But if the rates on large incomes are so high that they disappear, the small taxpayer will be left to bear the entire burden. If, on the other hand, the rates are placed where they get the most revenue from large incomes, then the small taxpayer will be relieved. The experience of the Treasury Department and the opinion of the best experts place the rate which will collect most from the people of great wealth, thus giving the largest relief to people of moderate wealth, at not over 25 percent.

The absence of any groundswell of opposition to the President's proposal indicates general satisfaction with it, no matter what arguments are being made for or against it by the politicians. Certainly the $2,000 personal exemption is immensely popular, so much so that despite all other difficulties, it practically guarantees there will be tax reform this year. And chances are it will remain pretty much intact, with the President howling at attempts to alter provisions in a major way and thus threatening reform and the $2,000 exemption.

Although the Democrats are pushing for a 40% top rate on personal income, that play seems designed to prevent the House Republicans from pushing the 35% rate down. There are menacing noises coming from Ways and Means Chairman Dan Rostenkowski about the "tax breaks" for independent oilmen in Treasury II relative to Treasury I, but that also seems pro forma. Puerto Rico is still in some trouble over the section 936 provision, Treasury II scrapping 936 and substituting a wage credit. But the Treasury II wage credit is so much more generous than Treasury I that the static revenue gain disappears. The Puerto Ricans should be able to win back 936 in Congress, since it won't cost anything. Baker and Darman wouldn't object, we can be sure.

There will be an attempt to get the top rate on personal income down to 30%, but chances are remote. If a straight vote could be arranged to substitute a 32% top rate for the 10% exclusion on corporate dividends, that could win. But everyone in town is eyeing the $6 billion that the dividend exclusion costs, hoping it will pay for their restored preference.
The impact of tax reform on the economy would be dramatic, not only because of its direct effects, but because of the change it would force on the rest of the world. Governor Cuomo, for one, would be pushed into state tax reform to get personal rates down, to avoid the kinds of problems he now warns about. Because state and local business taxes will remain deductible against federal taxes, there will no doubt be a drift toward lower state and local income taxes and higher business taxes — the net effect also being beneficial to the economy. Governors and legislators in most states will also be delighted to find that the federal reform will provide an automatic revenue windfall for them. This is because almost all states "piggyback" their state income taxes to the federal adjusted gross incomes, which of course will rise substantially with the elimination of curtailment of many deductions. This wave of windfall revenues will invite state tax cutting. Governor Cuomo and New York Mayor Ed Koch should have more than $1 billion to play with in getting rates down.

It's also not hard to imagine the pressures a 32 or 35% rate on personal incomes and a 33% corporate rate will have around the world. A tax-cutting breakthrough almost anywhere in Europe would have a domino effect.

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