Twilight of the Tax-Cutters

No one has told the Wall Street Journal editorial writers, to be sure, but pushing for tax cuts has become the political equivalent of flogging that proverbial dead horse. Congressional Republicans watched their proposed $793 billion tax cut disappear from sight without much of a fight. Steve Forbes is the only presidential candidate still banging the flat-tax drum, and even he has reinvented himself as a social conservative. Earlier this summer, Alan Greenspan notoriously–at least for those on the right–said he’d rather see a budget surplus go toward paying down the debt than toward a major tax cut. And most polls show that the American public ranks lower taxes low on the totem pole of priorities for the government.

It’s true that if you frame poll questions about taxes differently, you get different responses. Greenspan did say he would prefer a tax cut to more government spending, and it’s safe to assume that the Republican Party platform in 2000 will call for a significant tax cut. But that call sounds increasingly hollow, at least from an intellectual perspective, and the reason is not just that bringing the budget into balance (via, in no small part, the 1993 tax increase) has proved to have pleasant side effects for the economy. Even more important is the fact that much of the Reaganite case for tax cutting depended on the harsh reality of life in an inflationary economy.

Supply-siders have now become among the most ardent advocates of the idea that inflation is dead, and that therefore the economy can safely grow much faster than it has in the past. But they don’t appear to have considered what the death of inflation might mean for their tax-cutting fervor.

In Wealth and Poverty, for instance, George Gilder made the impact of inflation central to his emphasis on tax-cutting. Effectively calling for an end to the capital-gains tax, he wrote, “With a rate of inflation over 8 percent, a 20 percent tax on capital gains quickly rises above 100 percent in its average impact on assets held more than a few years.” Contrasting the situation of the late 1970s with that of the early 1960s, when top marginal rates on income and capital gains ranged as high as 91 percent, he noted that “the real tax rate is far higher, not lower, than it was during the days of Kennedy’s Camelot. … The real tax was not 70 percent, but 70 percent of a nominal amount of earnings that was mostly inflation, combined with a decline in the value of principal equal to the rate of inflation.”

What Gilder was pointing to here was in fact important. Because tax brackets and capital gains are not indexed, the combination of rapid inflation and high taxes ends up eating away most real gains. It works something like compound interest in reverse. In the 1970s, just staying ahead of the game took a lot of effort.

The really important blow against this state of affairs was not the Reagan tax cuts but rather Paul Volcker’s interest-rate hikes, which ended double-digit inflation. And in any case, the reduction of the capital-gains tax on long-term investments to 20 percent had already happened (in 1978) by the time Wealth and Poverty was published. Regardless, though, there was something to the idea that in a time of high inflation, high marginal tax rates acted as a disincentive to both investment and labor.

But we don’t live in a time of high inflation anymore. Actually, we don’t seem to live in a time of inflation at all. And with a rate of inflation of 2 percent or so, a capital-gains tax of 20 percent has an average impact on assets of about, well, 20 percent. And if you look at the trading volume on U.S. stock exchanges, it’s pretty clear that the 39.8 percent rate on short-term gains isn’t keeping too many people from investing. As for bracket creep, I’m not sure anyone even remembers what that is. Which doesn’t mean that we need to go back to 1979. But it does mean that, from an economic perspective at least, ardent tax-cutters need to come up with a new idea. Perhaps they could call it the Post-Inflation Paradigm.