A Tax-Cut That Would Sink the Economy

U.S. media are expending a lot of ink and air time evaluating the potential economic effects of George Bush's new tax-cut proposal. So far, most of the discussion has centered around how much economic stimulus the plan will provide and how long it will take to work. No one, however, is discussing the very real possibility that George Bush's tax-cut, especially the elimination of taxes on dividends, could harm the U.S. economy and drive it deeper into a recession.

To understand how this might happen, let's look at consumer spending, the one thing that has kept the U.S. economy afloat amidst massive layoffs and corporate bankruptcies. Low interest rates are primarily responsible for keeping consumer spending alive; big-ticket items -- like new homes and cars -- are a great bargain right now because of low rates on mortgages and auto loans. Despite the worst Christmas shopping season for retailers since 1970 (when the government began to keep track of shopping patterns), consumer spending is still going strong.

The Bush plan could change that by raising interest rates. Removing the tax on dividends would make dividend-paying stocks more attractive to investors than interest-paying investments: bonds, certificates of deposits (CDs), money market funds, treasury bills, bank savings accounts, etc., which are all taxable. To attract investors to those interest-bearing investments, interest rates would have to rise to offset what people pay in taxes. So banks and finance companies, corporations, and the federal government would have to pay more interest on their debts.

To recoup some of that interest paid out on CDs, bonds, savings accounts, etc., banks and finance companies would have to raise the interest rates they charge on home-equity loans, auto loans, credit lines, credit cards, and business loans. Mortgage rates would rise, too. Rising interest rates could stop the hot housing market in its tracks, just as increased rates on auto loans would make people decide to drive their old car a little while longer than they're inclined to do today. As finance companies raise the rates on credit cards, more Americans would spend less on new purchases and focus instead on paying down their credit card debt. This would send consumer spending into a tailspin.

Currently, low interest on corporate bonds and bank loans to businesses have allowed many debt-ridden companies to continue to make payments on their debts. Once interest rates rise, however, companies that are just barely keeping their heads above water could find themselves squeezed from both ends: Lower consumer spending would mean lower profits, while higher interest rates would mean the companies would have to pay more to banks or to investors on their debts. This could start a second wave of corporate bankruptcies.

Meanwhile, another fallout of cutting taxes on dividends would negatively effect state and local governments. Currently state and local governments, which are required to balance their budgets and not operate in at a deficit like the federal government, are struggling to plug enormous gaps between their incoming tax revenue and their increasing expenses. The Bush tax-cut plan could make those gaps even wider.

Here's how: State and local governments, including school districts, fire districts, and cities, have the ability to issue municipal bonds to pay for special projects, construction, and even operating costs. For example, the State of California has just issued bonds to help it pay for the high energy costs the state incurred during its recent energy crisis.

Municipal bonds are tax-free for the investor, making them highly attractive investments -- there's no shortage of people who want them. Because they are one of the few tax-free investments available, municipal bonds carry very low interest rates, and this helps state and local governments keep a lid on their debt costs.