While the president and Congress haggle over trillion-dollar tax cuts, the declining stock market has already done most of the work for them. That giant sucking sound from Wall Street is not just investors' money going down the drain, it is also all those taxes that would have been paid on the $4 trillion in lost wealth, the taxes that in happier days contributed to generating much of the surplus in the first place.
Let's do the math. On average, capital gains from sales of stock held outside retirement accounts are taxed at less than the maximum of 20 percent. This is because some taxpayers are in lower tax brackets, because people who die are excused from paying capital gains taxes, or because the stock is held in a not-for-profit institution. A large fraction of household wealth is now held in IRAs and 401(k)s, so capital gains in those retirement accounts are taxed as ordinary income.
Brianna Dusseault of the Monitor Group and I estimated that the average tax rate on IRA pension withdrawals was about 27 percent. Add in the estate tax, and one gets about a 20 percent tax rate on stock-market capital gains. A drop of $4 trillion in the stock market times 20 percent translates to a loss in revenue of $800 billion, or two-thirds of the proposed $1.2 trillion Senate tax cut.
Now, one could quibble about when this hypothetical $4 trillion would have been cashed out of the stock market.
Presumably, some of it would have been held, unrealized, beyond the 10-year horizon of the president's proposed tax cut. But even if the effects of these revenue losses aren't felt for a couple of decades, the government will miss that revenue about the time Medicare and Social Security are scheduled to implode.
Another quibble is a more obvious one: What kind of tax cut is this? It hasn't lowered tax rates, and won't do anything to spur saving, expand economic growth, or make people feel better about the economy.
Unfortunately, it has the same impact on the balance sheet of the federal government as a feel-good tax cut. Like it or not, the government's tax base depends more and more on equity markets, not just in an indirect sense, with regard to business and consumer activity, but in terms of direct revenue. Anything that chops stock market wealth does the same to the government's future revenue.
The involuntary tax cut of $800 billion has important implications for the president's and the Senate's own plans for tax reductions. The Senate's proposed $1.2 trillion tax reduction is scheduled to be funded out of the surpluses projected for the next decade.
Can we count on those surpluses actually appearing? In the most recent Congressional Budget Office projections, the assumed ratio of tax collection to gross domestic product is pegged for the next decade at above 20 percent of GDP, nearly 2 percentage points above the level that prevailed for decades before 1992.
True, tax rates are higher now than they were in 1992, but a good fraction of the hefty tax collections in recent years has been the consequence of highly paid executive stock options and fat capital gains realizations, things that may soon become as dated as Y2K survival kits.
Time will tell whether tax revenues start falling off, but I'd bet on downward revisions in the budget surplus in the fall.
One could still argue that it is all the more important to get a short-term tax cut out there to kick-start the economy. And another half-point interest rate cut from Mr. Greenspan would no doubt provide short-term relief in the stock market. But neither policy alone will bring a quick end to the looming recession. As long as corporate earnings are disappointing, stock-market wealth will continue to drain from Wall Street.
And for those of you who don't think that the federal government should be involved with equity markets, I hate to deliver the news. It already is.
Jonathan Skinner is the John French Professor of Economics at Dartmouth College.
(c) Copyright 2001. The Christian Science Monitor