WALL STREET GIBBERISH, 2005 FOURTH QUARTER NEWSLETTER

This one may be better described as Washington Gibberish since the topic is more political than investing related. However, it reflects a frequently stated editorial position of the Wall Street Journal, and the particular instance I discuss comes from a column on the paper’s editorial page this past December 8 by Martin Feldstein, who was President Reagan’s chief economic advisor.

The “supply side” crowd, which includes Feldstein and the Journal, claims that lower tax rates on investment returns are an important—they would likely say a necessary—factor for economic growth. They want the current 15% rate on long-term capital gains and corporate dividends to be extended beyond 2008, and Congress is currently considering that issue.

Feldstein would like to see that rate also applied to interest earned, which is now taxed at a higher rate like “ordinary” income. His column has an example that claims to show that failure to do that will hurt our economy. He considers the case of “Joe.” By choosing that name, presumably he wants us to think of a typical worker. However, his Joe is in the top 35% marginal income tax bracket, which this year applies to taxable income above $326,450. That may be typical for Feldstein’s crowd, but he is hardly an “average Joe.”

Feldstein assumes that his Joe has the opportunity to earn an extra $1,000. After deducting the federal income tax, he has $650 left, and Feldstein further assumes that Joe will consume $550 and save $100 by investing it in government bonds. Joe is 40, and using some reasonable assumptions, Feldstein shows that if the interest paid by the bond is taxed at a 15% rate, then Joe’s $100 will turn into $291 in after-tax, inflation-adjusted dollars, but at a 35% rate, it only grows to $193 when Joe is 75! Now the gibberish kicks in a big way. Feldstein uses those numbers to conclude that Joe won’t want to earn the extra money due to having less of an increase in purchasing power 35 years in the future. So Joe cares more about not having an extra $98 in current dollar purchasing power 35 years from now than he does about the $550 he could go out and spend right away. Maybe that is the type of thinking it takes to get into the top income bracket, but I doubt it.

Even if we accept Feldstein’s conclusion as being right, what he says is still gibberish. The unstated implication is that somehow the economy will be worse off because Joe does not want to do the work to earn the extra money. There is no reason to believe that. If the work really needs to be done, then someone else, who I will call Oscar, will be paid to do it. Does it matter to the economy whether Joe or Oscar does it? Highly unlikely that it does. What if the work isn’t that vital and it doesn’t get done? Let’s say a company, which I’ll call Killer Enterprises, was willing to pay for Joe or Oscar to do the work. If the work isn’t done, then they have $1,000 (assuming Oscar would earn the same as Joe) more in their coffers that they may well spend in another way. It is also possible that the government would collect less tax if the work isn’t done, but that is another issue. Overall, the size of the economy is not affected by whether or not the particular work gets done. All in all, using the initials of those in the story, Feldstein’s thinking is a J.O.K.E.

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