Stimulus, Capitalism Style

There is much talk of Barack Obama and the newly enlarged Democratic Congress passing shortly after the inauguration a large stimulus plan, perhaps $500-700 billion, with the expectation that such a plan will mostly rely upon new government spending. This plan shares a key premise with the stimulus plan passed earlier this year, which comprised tax rebates: if the government puts money in people's pockets, it will stimulate economic activity.

The problem with such efforts is that the money has to come from somewhere. Specifically, both efforts are paid for with additional government borrowing, which means there is less money available for other forms of investment or spending. So the impact is not nearly as great as it seems.

Instead, an economic stimulus plan can be crafted that can change the behavior of individuals, businesses, and investors to increase economic activity. An across-the-board cut in all income tax rates, including corporate, capital gains, and dividend tax rates, increases the incentives for everyone to make new investments, start new ventures, and in general work harder - since the payoff from all such efforts is now greater.

Yes, such a tax cut puts money in taxpayers' pockets like a tax rebate or infrastructure spending, but it does much more by encouraging effort and risk-taking - which is the key to stimulating real economic growth.

John McCain did a poor job in the campaign explaining why his plan to cut corporate tax rates was so beneficial. The reason such a tax cut promotes economic growth is simple. When companies make decisions to build a new factory or R&D facility, they compare many variables, all with the goal of maximizing their after-tax income from the investment. If corporate tax rates are reduced for investments in the U.S., then companies (both domestic and international) will be find investments in America more profitable and hence more likely to make such investments in America.

Ireland has experienced dramatic economic growth by using a low corporate tax rate to induce companies to locate operations there. And since the U.S. corporate tax rate is now among the highest in the world, cutting that rate will make investing here more competitive. That will mean more jobs, and more tax revenue, generated in the U.S.

A 30% cut in all such tax rates would cost the government approximately $500 billion, before any stimulating effects of higher economic activity are considered. For individual taxes, the 15% tax bracket would be 10.5%, the 25% tax bracket would become 17.5%, and the 35% tax bracket would be 24.5% - all dropping by 30%. The corporate tax rate of 35% would be 24.5%, which when adding in state taxes would make it about 29% - higher than many countries but much more competitive than today.

A second important element of a pro-growth stimulus plan is to expand free trade globally, rather than threaten to reduce trade as Barack Obama did during the campaign by suggesting he would change the terms of NAFTA or refuse to approve free trade agreements with Colombia, South Korea, and Panama as the Democratic Congress has done. Approving these trade agreements and in general seeking to expand free trade will send a strong signal of America's commitment to expanding trade - which will encourage economic activity as businesses seek new opportunities that more open trade permits.

A third element of a pro-growth stimulus plan is to look to cut regulations that impede economic activity. The auto industry has long been hamstrung with fuel efficiency standards and limits on rationalizing its dealer network. Reducing or eliminating those restrictions won't immediately solve the auto makers deep woes, but will help - and are an example of the type of constraints that limit business activity throughout the economy.

Lastly, pro-growth government policies would not be attacking businesses and Wall Street to score PR points. Creating an atmosphere of fear is not conducive to executives taking risks on new investments.

All of the above suggestions stand in sharp contrast to the policies pursued during the Great Depression, when taxes were raised significantly; free trade was devastated with high tariffs; new regulations were unleashed; and business leaders were subject to verbal and legal assault.

Contrary to the popular mythology of the New Deal, all of these policies exacerbated the crisis of the 1930's and prevented a full recovery from occurring for over ten years. After six years of the New Deal, unemployment was about 19% - down from 25% in 1933 but still at depression levels. Note that today's unemployment rate is 6.5%.

Let's not repeat the same mistakes again. Pro-growth policies, consistent with our capitalist heritage, give us the best chance to begin a sustainable recovery.