Bush's Nuclear Option on Taxes


The Dow Jones industrial average is now back within 2.5 percent or so of its all-time high after rallying 3 percent from its 2007 nadir. (The Shanghai Sneeze and all that.) But should the Dow eclipse its old mark, there are some people–other than massive short sellers, of course–who won't be cheering. As they see it, stock market "records" are phony because the various averages and indexes don't take inflation into account. Here is how economist Jason Furman, in an analysis for the Center on Budget and Policy Priorities, dismissed the Dow when it hit a nominal high last October at 12,090:

"Adjusted for inflation, [the Dow] is down 14 percent from its all-time high on January 14, 2000. The Dow would need to rise another 1,946 points to set a new record, adjusted for inflation. It is only when no adjustment is made for inflation that the Dow can meaningfully be said to have closed at a record high. ... To fail to adjust for inflation, and to say that the Dow has passed its previous peak, is like saying that a worker whose wages are a few cents an hour above where they were six or seven years ago is better off today, even though the purchasing power of his or her wages has fallen significantly."

Or as one succinct poster to the megapopular Daily Kos website directly put it: "Adjusted for inflation, DOW 12k doesn't mean $H#&."

Yet investors pay capital gains taxes on their noninflation-adjusted investment gains every year. So instead of paying an effective rate of 15 percent–the current cap gains rate–or 39.9 percent–the high-water mark for the tax back in the 1970s–inflation may push that effective rate to 50 percent when inflation is relatively low like back in the 1990s to more than 100 percent when inflation is high like in the '70s. (Indeed, a study by economists Martin Feldstein and Joel Slemrod found that taxpayers paid $500 million more than they should have on their $4.5 billion in nominal capital gains back in 1973, which–when adjusted for inflation–was really a $1 billion loss.)

Last summer Republican Reps. Michael Pence of Indiana and Eric Cantor of Virginia introduced a bill that would amend the tax code to index investment gains or losses for inflation. But that bill never came to fruition, and it is almost inconceivable that the new Democrat-controlled Congress would go for such a plan given that there seems to be scant interest in keeping even the 2003 tax cuts on capital gains and dividends–much less effectively lowering the cap gains rate.

So here's an interesting scenario: Let's say Democrats choose to pay for AMT reform by undoing the 2003 tax cuts. That would be a tough veto for Bush since the AMT will hit hard millions of middle-class taxpayers. So Bush could sign such a bill and then simply ring up Hank Paulson next door at Treasury and tell him to tell his staff to begin indexing capital gains for inflation by using its little-known and admittedly legally fuzzy power to define the word "cost" in the part of the tax code that concerns capital gains. Treasury did just the opposite back in 1913 after the income tax was ratified. So essentially, it would merely be undoing what it did back then. This would also be a way for a future president to save the 2003 tax cuts if Congress wants to let them expire at the end of 2010. Would many Democrats scream? Surely. Would a lawsuit be filed? Assuredly. That's why it's good for Bush that he's got a solid attorney general ... wait ... uhmmm ...

March weather warms job market.

New Labor Department data show that initial jobless claims declined to 316,000 from 320,000 in the week ending March 17. The four-week average also fell, to 326,000 from 329,750. (The average was 287,000 in January and 331,000 in February.) As the analysts at Action Economics explain, "Today's report joins the ranks of indicators that have reinforced the assumption that the February economic indicators were subject to considerable weather distortions." They're looking for the economy to add 160,000 jobs this month after a 97,000 gain in February. Economist Abiel Reinhardt of JP Morgan Chase, where they're looking for 120,000 new jobs, concurs, "There may be upside risk to that forecast as improving weather should provide an additional boost to job growth this month."

This is all important good news since many economy bulls are counting on continued job and income growth to offset housing weakness and keep the economy from sinking into a recession. The Federal Reserve's statement yesterday also helped diminish the risk of recession due to the subprime mortgage meltdown spreading to other borrowers and depressing consumer spending. As the bullish economist Ed Yardeni puts it this morning: "That risk is greatly diminished now that the Bernanke Put is on the table. If there is a widespread financial crisis and the Fed lowers interest rates, the stimulus from the huge wave of mortgage refinancing would certainly avert a recession."