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Jewish World Review Nov. 5, 1999 /24 Mar-Cheshvan, 5760

Lawrence Kudlow

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Econophone

Rosy Lives

http://www.jewishworldreview.com -- SOMEHOW, IT CAME to me in the middle of the night: The Commerce Department's long-term revisions of past economic data, going all the way back to 1959, would include an update of Rosy Scenario.

Rosy Scenario! Would she be wearing a new dress? Would she look as beautiful today as she did then?

Now, for those of you who may not have ever met Ms. Scenario, let me fill in the blanks.

Back in 1981, Reagan economic advisors put together an economic growth forecast for the first five years of expected recovery under the new supply-side policy of personal tax-rate reduction.

Projections were worked out by a subcabinet group that included Jerry Jordan, Beryl Sprinkel, Norman True, Paul Craig and myself.

We reported to the cabinet-level group, of Don Regan at Treasury, Dave Stockman at OMB and Murray Weidenbaum at the Council of Economic Advisors.

Assuming steady disinflation and a reduction in the top marginal tax-rate to 50% from 70% (it later dropped to 28% in the 1986 tax reform bill), we projected that real economic growth would average 3.7 percent per year during the recovery cycle upturn.

We thought inflation would descend to the 6% zone, after the CPI averaged 13% in 1979-80.

Well, these estimates caused a major uproar inside the Beltway.

The Washington Post dubbed it "Rosy Scenario," and proceeded to rip our faces off collectively and individually over the next few weeks and months.

In fact, we were called "snake oil salesmen" who were "cooking the books" with "blue smoke and mirrors."

The attack-mantra expanded from the beltway press to the Keynesian economics established in academia, who ridiculed tax cuts and argued that inflation would have to increase from excessive consumer spending.

Meanwhile, they said, tight money would actually deepen the recession.

Sorry, folks. It didn't work out that way. Not then, not now.

According to the new Commerce Department data, real economic growth averaged 4.5% per year between 1983 and 1987, nearly a 1% increase above the pace predicted by Rosy Scenario's authors.

Imagine, almost twenty years later, Rosy looks even better. A real turn-on, actually.

What's more, the 1980s inflation rate slowed to 3.2% per annum, only half as much as the original 1981 estimate.

Actually, it was the faster-than-expected inflation drop that caused most of the budget deficit gap. Disinflating the economy generated a deflation of government revenues.

But the dire deficit consequences proclaimed by the Keynesian economics establishment never materialized. That's because the Federal government's revenue loss became the private sector's incentive gain.

At substantially lower tax-rates, working people were able to keep more of what they earned.

Central planning was blocked, free enterprise took over. At the margin, since it paid more to work and invest, the supply of work and investment surged. Economic growth replaced stagflation, and the boom is still going on today.

The Clinton Nineties are still benefiting from Reagan's tax cuts and Volcker's tight money.

The whole policy idea was dreamed up by a little-known economist named Robert Mundell, who was finally awarded a Nobel Prize twenty years later.

Speaking of the Clinton Nineties, the recent Commerce Department revisions again underscore the importance of marginal tax-rates on economic growth.

The new Internet Economy, which is throwing off more growth at lower inflation, expanded at a 3.5% annual rate over the 1992-1998 recovery cycle.

It's a great performance, but not quite as great as the Reagan expansion of 1983 to 1990, which registered a 4% yearly rate of gain.

Why not? Well, the top personal tax-rate moved up from 28% in 1986 to 40% in 1993.

This means that people now keep only 60 cents of the marginal new dollar earned, instead of 72 cents. The difference is a 17% rollback of incentives. Add 17 percent to the 3.5% Nineties growth rate (1.17 times 3.5) and you get the 4% Eighties growth rate. How about that?

Now, go back to the bad old days of stagflation, which I date from 1970 to 1982.

With a top personal tax-rate of 70%, average growth came in at 2.5% per year. Keeping only 30 cents of each new dollar earned, people in the 1970s suffered a 58% incentive loss compared to the 28% top tax-rate of the 1980s.

Add 58% back in to the 1970s growth rate (1.58 times 2.5) and you get -- you guessed it -- 4%!

The point of all these back-of-the-envelope calculations is to remind people that marginal tax-rates matter. Incentives matter.

When it pays to work, produce, invest and take risks, then more of each is supplied to the marketplace. Raise tax-rates, however, and the supply is reduced.

Another point. The class warfare crowd will never admit it, but upper-end earners -- described as "economic activists" by Irving Kristol many years ago -- are the real drivers of the economy.

Like it or not, these people tend to be the wealth-creators and the risk-takers. That is why the top personal tax-rate is so vitally important.

Those of us who are not so blessed with incomes that qualify for the top tax-rate still need those upper-end folks to open their wallets to finance new inventions, innovations, and ideas that otherwise could never be commercialized and brought to market. When they are brought to market, all the rest of us benefit.

Not only from the new products that make life easier and more enjoyable, but also the brand new business and job opportunities that enrich everyone.

In our upwardly mobile free society, more people become rich. The rich get richer and the poor get richer.

Then they get to pay the top tax-rate. Which, by the way, throws off about one-third of all personal income taxes paid to Uncle Sam.

The 3.5% real growth rate that has prevailed during the long boom of the past seventeen years shows that incentive rewards from low tax-rates can, in fact, increase long-term growth.

Phillips curvers and other Malthusian limits-to-growth believers who insist that our full capacity to grow is only 2% to 2 1/2% miss this point entirely.

Then we can look to the additional growth benefits of the information age New Economy that is spurring even greater economic potential.

Philadelphia Fed economist Leonard Nakamura has long tracked the New Economy and has accurately predicted its upward revisions.

Nakamura believes that when the Commerce Department properly accounts for the massive technology inputs from telecommunications, the Internet, software, and research and development (along with necessary downward price adjustments for food, housing, and health care), then actual economic growth since the mid-1980s will be revised to 6% per year with no inflation. Six percent? Awesome.

"We are living in one of the great creative times in world economic history," he told me in a recent interview. "A remarkable world of creative discovery."

It's a Schumpeterian period of gales of creative destruction, where the old law of diminishing returns is being replaced by the new law of increasing returns.

Scarcity is giving way to abundance. Economic statistics will only capture this accomplishment many years after the fact. Probably five to ten more years, according to Nakamura. But that's okay.

Ordinary people realized our economic success long before the statistics captured it. That's what the stock market has been telling us for nearly two decades.

Then again, we mustn't rest on our laurels. Lower tax rates in the years ahead will nurture and expand the Internet Economy.

Here's a forecast: Cut marginal tax rates for material benefits, get to synagogue and church over the weekend for spiritual enhancement, and good things will always happen. Rosy Scenario will live on for a long, long time.


JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.

Up

10/29/99: Drain Reserves
10/22/99: Supply-Side Is Mainstream
10/14/99: Y2K will likely bring more prosperity
10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth


©1999, Lawrence Kudlow