The long-term benefits of
tax reform will be many. A lot of investors have become as hooked on
our distorted tax code as an addict on heroin, undertaking unproductive
investments solely for tax benefits. Lower tax rates and fewer tax shelters
will provide a better basis for economic decisions, and will bring more
growth and a healthier economy. However, many analysts are misreading
the short-term effects of shifting "cold-turkey" from a high-rate-shelter-rich
tax regime to a low-rate-shelter-poor tax regime--effects I believe
will be sharply deflationary.
To most economists, lower tax rates will put more cash in consumers'
jeans, which they will use to buy more goods, thus stimulating the economy.
To them, lower tax rates mean more growth and the danger of renewed
inflation, so the appropriate Federal Reserve policy is to tighten credit
conditions to offset the tax-cut stimulus. And the appropriate investment
strategy is to sell bonds, which are losers when interest rates rise,
and to increase holdings of growth-sensitive stocks, to take advantage
of the growth in profits that accompanies a strong economy.
The positive effects of lower taxes on spending and labor supply initially
will be swept aside by the deflationary effects of tax reform on the
asset markets. Years of high tax rates and liberal deductions for "tax
advantaged" investments have caused investors to build up an array
of investments, such as shopping centers and office buildings, which
would otherwise not have been made.
More Money Will Be Needed
All of these shelters require the investor to take physical ownership
of some tangible asset, and to be responsible for the debt that was
incurred to purchase the asset. Lower tax rates and fewer shelters will
hit the asset markets like a further reduction of inflation, by destroying
the reasons for owning hard assets and triggering a massive switch of
investors' asset demands away from oil. gas, real estate and other sheltered
assets, and toward bonds, stocks, money-market investments and other
producers of taxable income. The resulting attempts by investors to
disgorge their holdings of tangible assets will unleash a wave of deflation
much like the one we've been living through, imparting additional damage
to the already weakened hard-asset sectors.
When this happens it will be extremely important that the Fed stand
ready to print the additional money required to offset the initial deflationary
impulse of tax reform. Restructuring has produced a glut of hard assets.
Thats why the 13% to 15% money growth of the past two years has
not led to the rising inflation that many feared. It has taken higher-than-normal
money growth to sop up the tidal wave of office buildings, oil assets,
farm land and equipment that were dumped back onto the resale markets
by their owners.
When forecasting prices, we need to remember that an existing office
building being pushed back onto the market by its current owner will
depress property values just as much as the sale of a new one. Undesired
assets held by current owners should be added to current GNP when figuring
the aggregate supply of goods in the economy. To keep the price level
stable the Fed must print the money required to make demand grow fast
enough to absorb this total supply of both new and old goods. If the
Fed doesnt, prices will fall.
Stirring tax reform into the pot will mean the Fed will need to tolerate
still higher money growth--15% to 20% in both 1987 and l988--to keep
the economys nose above water. But this increased money growth
will not cause inflation. If the Fed falls to deliver the needed stimulus,
or worse yet, if it tightens monetary policy, as many economists will
be urging, the current relatively minor deflation could snowball and
push us back to the 1930s.
Tax reforms deflationary impact is not caused by the direct effects
of lower tax rates on spending, savings and income flows, but by the
indirect effects on the economys portfolio. Most economists pay
little attention to balance-sheet conditions-since the 1930s macroeconomics
has focused a/most exclusively on explaining variations in the GNP accounts.
I believe this is the reason many forecasters failed to predict the
major events of the 1980s. For example, rising budget deficits in the
early 1980s led to a consensus view that interest rates would rise.
Instead, they fell sharply, even as deficits rose. And rapid money growth
after mid-1982 led many analysts to expect rising inflation and higher
interest rates, views that led many investors to sell bonds and buy
cash and real estate, providing a market for investors who were aware
of the ongoing repricing and restructuring of balance sheets.
Fluctuations in GNP-just over $4 trillion in 1986-or its components
are important because they have a direct bearing on paychecks. But they
cant compare with the shock waves that roll across the country
when something big is going on in the countrys $30.9 trillion
portfolio of assets, of which $12.5 trillion (41%) were held as tangible
assets, like houses, boats and boxcars, and the remaining $18.4 trillion
(59%) were held as financial assets, like stocks, bonds and bank accounts.
When investors are content to hold existing assets at current prices,
the portfolio economy, like a sleeping giant, has a benign influence
on the production economy. But a radical change such as tax reform can
dramatically change the relative attractiveness of holding tangible
and financial assets. When this happens, investor attempts to rebalance
their portfolios can unleash hundreds of billions of dollars in transactions
that can swamp the influence of more normal flows of funds in setting
price levels, interest rates and economic activity. David only beats
Goliath in books. In the real world, Goliath wins every time.
In the 1980s, for example, a more than 10-percentage-point drop in
the inflation rate led to a sharp deterioration of the return on tangible
assets, because price increases were such an important part of asset
yields in the 1970s. In addition, the 1981 tax cuts on interest and
dividend income made stocks and bonds more attractive. These changes
caused investors to attempt to reduce the portions of their portfolios
held in tangible assets and increase the portions held in cash, bonds,
stocks and other financial assets. Collectively, of course, this could
not be done, since the existing stock of assets must always be held
by someone. But the attempted portfolio shift played havoc with asset
prices. Gold, farm land and other commodity prices plummeted. Fortune
500 companies alone announced the sale of nearly $200 billion of fixed
assets in 1985. In total, tangible assets have lost more than $1 trillion
in market value since 1981.
Tax reform is taking place while we are already in a deflation. The
adjustment of the economy to lower inflation and to the 1981 tax cuts
is not yet complete. We are perhaps two-thirds of the way through a
10-year wringing-out, or withdrawal, process, required to wean the economy
of its despondence on rising prices. It takes several years just to
break people out of their inflation psychology.
While this is going on, capital-goods prices and profit margins are
weak--the markets way of telling rig producers to stop the presses.
Disinflation means a glut of certain kinds of capital goods on the resale
markets. As long as you can buy capital goods cheaper than you can make
them, growth is going to stay weak.
The Feds role in this withdrawal process is to deliver methodone
treatments. By printing more money the Fed has the power to blunt the
deflation symptoms caused by the change in asset demands. Since 1982
I believe it has done a good job in keeping money growth low enough
to keep disinflation working, yet high enough to keep deflation from
getting out of control. Recent announcements that the Fed has backed
away from money targets and will instead stabilize prices is good news.
This is no political accident. Last year's 120 bank failures were the
highest in any year since 1934. This "bank-failure standard"
is the right policy for managing the difficult transition before us,
and absolutely crucial in light of tax reform.
Tax reform will severely test the Fed's new policy. Lower tax rates
on interest and dividend income will make financial assets even more
attractive to hold, and fewer deductions and tighter rules on shelters
will make tangible assets less attractive to hold. This will worsen
deflation by making corporate managers accelerate restructuring plans
by dumping more fixed assets to repay debts and repurchase shares on
the stock market. Unless the Fed prints the money to create the demand
to take these additional assets off the market, the price level will
Magnification of Effects
We can roughly estimate the amount of money the Fed will have to print
in order to offset the deflation that will accompany lower tax rates.
A cut in the maximum personal tax rate from 50% to 28% will increase
the after-tax return on a one-year bond paying 10% interest from 5%
to 7%. This two-percentage-point improvement in financial-asset returns,
relative to the returns on sheltered investments, will affect the asset
markets about like a two-percentage-point drop of inflation, so the
Fed will have to raise money growth by about 2% from this year's level
in order to offset the deflationary effects of tax cuts.
But the ongoing disinflation adjustment will magnify the effects and
increase the work the Fed must do. Disinflation means falling interest
rates, and falling rates mean very large total returns on long-term
bonds. In 1985, for example, the 30-year Treasury bond had a total return
in excess of 30% for the year. Reducing the tax rate from 50% to 30%
means an after-tax return in this case would increase from 15% (half
of 30%) to more than 21%. The Fed may have to increase money growth
by as much as six percentage points to offset the implied deflation
Tax reform, with lower rates and fewer shelter gimmicks, is as imperative
for the country as purging the dependence on drugs is for a narcotics
addict. But we mush not ignore the deflationary withdrawal pains that
we experience during the decade-long transition from the high-inflation,
high-tax economy of the 1970s to the stable-price, low-tax-rate environment
that we have chosen for our future.