Jewish World Review Jan. 25, 2001/ 2 Shevat 5761
http://www.jewishworldreview.com -- ALL THE economic news is bad. Day after day each new statistic is worse than the last. Sales are falling, production is dropping, inventories are rising, income is growing less than consumption, debt is piling up, consumer sentiment is plummeting, recession looks to be almost inevitable.
You know, if you believe all this stuff you could really go out behind the barn and break both kneecaps. Just kidding. But, really everyone's getting just a little too pessimistic.
Wealth is more important than GDP. And the outlook for wealth creation is improving, even while the national income accounting for gross domestic product is deteriorating.
So let's look on the brighter side. Inflation is falling. Lower inflation spells higher wealth. This is absolutely key. From the standpoint of the long run, it is far more important than all those GDP flows.
Inflation is the cruelest tax of all. It reduces the value of everyone's money and buying power. It lowers rewards for risk-taking and returns on investment.
Declining inflation is illustrated by a sinking gold price, which has slipped to $265 from $325 (it was $400 in early 1996). It is also illustrated by the decline of 10-year Treasury rates to 5.30% currently from 6.75% a year ago and by a shrinking spread between Treasuries and TIP yields (on inflation-adjusted Treasury notes) that has narrowed to 170 basis points from 240.
Broad inflation measures corroborate market price indicators. The chain-type GDP price index has dropped from 3.3% annualized in the first quarter to 2.4% in the second quarter to 1.6% in the third. Measured over three month periods, the core consumer price index has eased to 2% from 3.4% last spring, while the core producer price index has declined to 0.8% from nearly 2%.
So, the inflation tax is falling. That is, the tax on money, wages, savings, investment, wealth and risk-taking is falling. Supply-side father Art Laffer taught us that if you tax something, you get less of it. Tax something less, and you get more of it. So as the inflation tax comes down, we can look forward to a more plentiful supply of work, investment and wealth.
In particular, the inflation tax poses a great burden on unindexed capital gains, which is the preeminent tax on wealth and risk-taking. And, by proxy, the stock market. Which, in turn, predates the outlook for economic growth.
When inflation increases, so does the effective tax-rate on real capital gains. Gains from the sale of an asset are taxed twice: once for the true gain derived from new market value, and a second time for the illusory gain caused by higher inflation. As a result, rising inflation scales the effective cap gains tax rate above the 20% federal rate. The higher the inflation, the greater is the total cap gains tax burden on the true gain.
For example, at 3.3% inflation a year ago last winter, the effective capital gains tax moved up to 36˝%. However, in mid-1999, a 1% inflation rate generated a record low 25% effective cap gains tax, meaning, in real terms, the risk-taker kept 75 cents on the extra dollar earned, while Uncle Sam got a quarter. By winter, however, the 36.5% cap gains tax generated by higher inflation left the risk-taker with only 63˝ cents -- a 15% incentive decline. That 15% penalty is not far from the declines of the S&P (9%) and Nasdaq (37%) stock indexes last year. It also foreshadowed the economy's slowdown.
Better times are coming, however. Using the third quarter's 1.6% inflation rate, the effective cap gains tax has dropped to 28%. This leaves 72 cents for the extra risk taken, a 13% incentive improvement from last winter's 63˝ cents.
So it stands to reason that the declining inflation tax and its positive impact on a lower effective cap gains tax will push stock prices higher by roughly 13%. Add in lower interest rates and reduced marginal tax-rates on personal income (a big help to small business proprietors), and the stock market and the economy over the next year may produce a surprisingly strong recovery.
The capital gains tax model of the stock market has worked for 50 years, as illustrated by the accompanying chart. Numerically, the linkages do not correlate one-for-one. But directionally, the model has never failed.
What remains to be seen in order to close the circle on this bullish logic is whether the inflation tax will remain low. I believe it will. A gold price model of inflation suggests about 1.5% inflation over the next 12 months. The TIPS spread model comes in with nearly the same estimate. I'll take market price forecasts over Phillips curves or other people's republics of Cambridge or New Haven econometrica anytime.
Actually the story gets better. Not only is there an inflation tax cut in the cards, there's a good chance that George Bush's increasingly popular tax-cut plan will be bolstered by a reduction in the statutory cap gains tax rate to 15% from 20%. Sen. Trent Lott has suggested this to the President, and surely Bush's economic advisors recognize that reduced tax-rates on capital investment produce a Laffer curve-style increase in tax revenues.
So investors should not despair. Better times are
JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.
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