Why The Bush Tax Cuts Weren't Enough

Last night I mentioned how the Bush tax cuts were almost certainly not the cause of the current bull market in stocks. In fact, the Bush tax cuts, while a nice and kind gesture, won't have their effects felt for years, possibly even well into the next decade. So if they weren't enough to have a real lasting effect on the stock market, what good were they and what would be needed to create that kind of effect?

What good were the tax cuts? Well, they were certainly better than a swift poke in the eye. And they did provide a short-term boost to the economy, in the form of the rebate checks, at a time when it was really on the verge of a demand collapse. In that sense, they were good and well-timed, plus anything that reduces the government's confiscation of resources is good in and of itself.

The biggest problem with the Bush tax cuts is that they were too little, too targeted, and too phased. In short, they were a half measure compromise.

In order to effect a real and lasting economic boost, there needs to be a fundamental and profound structural change in the tax system. The marginal rates need to be reduced across the board, and it needs to be a real and significant reduction, not just a token cut here or there. The long term capital gains rate needs to be significantly reduced. I don't agree with eliminating it completely, but for long term gains it should be small, on the order of 5 or 10%, not the current 20%. The tax on dividends needs to be eliminated, or if that is politically unpalatable, reduced to the long term capital gains rate.

Before I go further on some of the fundamental changes that need to be made, I want to explain the dividend rate cut in a little more depth. I had a long discussion with my father about this last night and I think that there were a number of important points as to why it would be wise to cut the dividend tax rate.

The theory of financial rationality tells us that a company should always look for the most efficient use of capital in order to maximize the return to the shareholders. Some years the company may have investment opportunities that would lead to them retaining more earnings than in other years, all depending on the expected rate of return for those retained earnings. If the expected internal rate of return is less than what the investor could expect to earn on their money in another investment, then the company should pay a dividend. If the expected rate of return is greater than what an investor could expect to earn in another investment then the company should retain those earnings, invest the money, and maximize the return to the shareholder through capital gains. In an efficient market, where companies are driven by strict financial rationality, dividend payments would fluctuate wildly from year to year or even quarter to quarter.

Obviously we don't function in a world driven by financial rationality. There are companies, like Coca-Cola, GE, GM, and Kellogg that like to maintain a constant, stable dividend payout as a shareholder service. They have made a conscious decision that stability is more important than absolute financial rationality - and this is not to be unexpected in a market where there is such stiff competition for investing dollars.

But the current tax system, which taxes dividends as ordinary income, adds a third level of complexity to the decision. Now companies no longer just take into account their financial needs when making their dividend/retained earnings decisions, they now also try to balance the tax burden that they are imposing on their shareholders.

Eventually, this leads to a situation like you currently have with Microsoft. Microsoft is no longer a growth company. It has become a mature, stable company, not unlike a GE or a Boeing. It has grown to a size where the internal rate of return on retained earnings is no longer significantly greater than what investors would earn in other investments. It has grown to a size where the law of large numbers indicates that the growth rate has to slow down. Even in the annual report the company is indicating that it is having trouble finding adequate investment opportunities for the cash on hand. This is why it is now hold cash measured in tens of billions of dollars.

Financial rationality says it is time for Microsoft to start paying a dividend. The structure of the tax system, and the burden a dividend would levy on the shareholders, says not to pay it (there is also the desire to maintain the perception of Microsoft as a growth company that is almost certainly playing into the decision also).

When the company sits on large piles of cash like that, it reduces the overall return on assets for the company. That in turn allows more suspect and questionable projects to proceed, as they appear to exceed the corporate return on assets. Over time, this would serve to further drag down to corporate return on assets, until a point is reached, where the expected return is essentially the same as the return the company can receive on cash. This appears to be where Microsoft is now.

Cutting the dividend tax rate would make companies much more likely to return some of the excess capital to the shareholders in the form of dividends. The money could then be reinvested more wisely and more efficiently, with the end effect of improving the state of the economy.

The other big tax that needs to be eliminated is the estate tax. All that it is is a tax on success. The elimination of the death tax, as the estate tax is often called, would obviate the current need for tax havens and tax dodges. The amount of wealth lost every year to this sort of legal tax evasion is staggering. And every bit of that money is wasted, not going back into productive use in the economy, which helps to hold us back. Bush realized this with his tax cut proposal, but it only eliminates the death tax in the tenth year of the plan - the final year unless Congress chooses to make the cuts permanent.

My purpose with this post isn't to denigrate what Bush has tried to do with his tax cuts. The idea and the reasoning for the plan was sound, it is only in the implementation that it loses effectiveness, and the implementation was watered down into little half-measures through politics and compromise.

As a result, the cuts had a temporary effect on the economy - which likely kept us from falling into to a depression induced by a drop in demand. Over the long term though, they will be of minimal consequence as they do little to nothing to change the structural disincentives of the existing tax structure. Only a true overhaul, no half measures, no compromise solutions, will truly create a tax system that works for us, instead of against us. And that in turn is why I personally favor (somewhat lukewarmly, granted) a move to a National Sales Tax.