Capital Markets

It’s the Deficit…

Neither Bush nor Kerry would close the federal budget gap. But that's where the policy resemblance ends.
Ronald FinkSeptember 1, 2004

How would four years of a John Kerry Administration differ from a second term under George W. Bush? With the November election only two months away, finance executives must soon wrestle with that question, and they must do so as corporate managers as well as individual citizens.

Their current inclinations are clear enough. According to a recent poll of 145 readers of CFO magazine, finance executives favor the President over his Democratic challenger from Massachusetts by 71 percent to 28 percent. And 75 percent thinks Bush will be better than Kerry for their businesses.

At the same time, most businesspeople subscribe to political views that were famously summed up as, “It’s the economy, Stupid.” Although Bill Clinton likes to take credit for the 1990s economy, most businesspeople also agree that the economy is driven less by the President than by the Federal Reserve. That view gains support from a new study by the CFA Institute (formerly the Association for Investment Management and Research), in Charlottesville, Virginia. The results show that from 1937 to 2000, the Fed’s monetary decisions had a much greater correlation with the direction of the financial markets than the fiscal and regulatory policies of the executive branch. “Monetary policy overwhelms everything else,” says CFA executive vice president Robert R. Johnson.

But most mainstream economists believe that monetary and fiscal policies are intertwined, and that the state of the federal budget thus has a big impact on interest rates — and the economy. All things being equal, bigger federal deficits mean higher rates. And no one has a keener appreciation of the impact of the deficit on interest rates and the cost of capital than finance executives. CFO’s survey notes that a whopping 86 percent of CFOs are concerned about the size of the deficit, which the Congressional Budget Office projects will reach $2.7 trillion by 2014.

So far neither Bush nor Kerry has demonstrated much real interest in the federal deficit. (To be fair, Kerry did once vote for a balanced budget as senator, and in his Presidential nomination acceptance speech promised to cut the deficit in half. Bush promises to do much the same.) A closer look at the actions and words of both candidates and their advisers shows, however, that they would take radically different approaches to addressing this issue over the next four years. And the effectiveness with which either handles the deficit most likely will determine much of the next Administration’s agenda.

The Limits to Growth

Leading economists in the Bush camp, from current advisers such as Gregory Mankiw and Stephen Friedman to former aides like Lawrence Lindsey and Glenn Hubbard, have argued that the United States can run large budget deficits without significant economic consequence, as long as the growth of the economy outpaces that of the deficit. “We’re generating a lot more [tax] revenue per dollar of GDP than we were in 2001,” notes Randall Kroszner, a former member of Bush’s Council of Economic Advisers and now a professor of economics at the University of Chicago Graduate School of Business. Kroszner contends that as long as that trend continues, a deficit that falls within the current projected range “isn’t a problem.”

But the prognosis for the economy remains guarded, despite assertions by the Federal Reserve that the current “soft patch” is temporary. The Office of Management and Budget projected a 2004 fiscal deficit of $445 billion, while GDP growth ran at a disappointing 3 percent annual rate in the second quarter. The deficit, which grew faster than expected in July, now stands at 3.5 percent of GDP. Jobs grew by an anemic 32,000 in July, and, all told, there are 1.1 million fewer jobs than there were in January 2001. That can hardly do much for the confidence of consumers, whose spending represents roughly two-thirds of GDP.

Eugene Steuerle, a former Treasury official in the Reagan Administration and now a senior fellow at The Urban Institute, a Washington, D.C.-based think tank, says that the rising personal-debt levels and their accompanying interest payments pose just as great a threat to recovery as higher interest rates — and perhaps a greater one. He concludes that relying on economic growth to shrink the deficit is not a viable option, because of looming increases in entitlement programs like Social Security and Medicare. The baby boomers’ coming retirement, Steuerle argues, will dampen consumer demand even as it adds to the burden already borne by the Medicare system. “We’re in a gigantic bind” because of the rise in both health-care costs and the number of workers soon to retire, he says. “You can’t grow your way out of it.”

Unpopular Options

But if the economy can’t grow out of federal deficits, politicians must either increase taxes or cut spending — neither of which appeals to voters.

Some political observers suggest that the size of the budget deficit makes a tax increase inevitable no matter who is elected President. Recall that tax hikes passed by Presidents Reagan, George H.W. Bush, and Clinton played a role in reducing the deficits of the early 1980s and 1990s.

Tax advocates aren’t limited to the left; even Bruce Bartlett, an early supply-side enthusiast and former Reagan and Bush I adviser who is now a senior fellow at the National Center for Policy Analysis in Washington, D.C., believes that a tax increase will be necessary to close the deficit.

The current Bush Administration has made its position on taxes perfectly clear: tax cuts, not increases, offer the best chance to stimulate the economy.

That leaves spending. On this point, the Bush record is also clear. Quite apart from the cost of creating the Department of Homeland Security ($26.6 billion in 2003) and fighting the wars in Afghanistan and Iraq ($185 billion as of this past June, with an estimated $46 billion more to come in Iraq alone), the President has also signed into law the prescription-drug benefit for Medicare recipients. Enacted in 2003 by a Republican-dominated Congress, that benefit is expected to cost $534 billion over 10 years.

Bartlett says even Republicans lack the political will to make large enough cuts in social programs to address any budgetary bind. “All deficit-reduction packages dating back to 1982 have depended very little on cutting spending,” he says. “What got done was the tax increases.” And he points to the costly Medicare drug benefit as evidence that such a trend is unlikely to change.

Revenue Neutral?

The Kerry campaign has not addressed the deficit issue in depth. Kerry would make many of Bush’s tax cuts permanent and cut corporate tax rates by 5 percent. He has said on the stump that he will close corporate loopholes, meaning tax shelters. For instance, he would “crack down on corporations that are hiding their money in Bermuda to avoid paying their fair share,” and “stop giving government contracts to corporations breaking the rules.”

One “loophole” that Kerry wants to close is the ability of U.S. companies to defer tax on income earned outside the country. (In contrast, multinationals based in other countries typically pay tax to their home countries only on income they earn within them.) Doing so would drastically tilt the playing field against U.S. multinationals, say critics. The impact would be “significantly negative for this community,” says Deloris R. Wright, a managing principal in the Denver office of economic consultancy Analysis Group. Kerry says this hike would go to pay for his proposed 5 percent rate cut, so it would be revenue-neutral.

The only good news for business about this proposal is that it is unlikely to see the light of day, as Kerry would need legislative support to enact it.

Kerry would repeal the tax cut for the wealthiest 1 percent of taxpayers — those making more than $200,000 a year — which would increase federal revenues by $632 billion from 2005 through 2014. That would mean a personal hit for CFOs at almost all the 21,000 companies with more than $100 million in revenues. Individual pocketbooks aside, Kerry’s vow to eliminate corporate loopholes is clearly aimed at their tax planning departments.

But instead of directing that revenue toward reducing the deficit, Kerry would use much of it — roughly $430 billion — to fund new initiatives. Some ($177 billion over 10 years) is allocated to cutting health-care costs. The rest is intended to support small businesses and create new jobs. His proposed tax credits for business include credits for deploying broadband telecom service in rural and other underserved areas, creating new manufacturing jobs, and buying energy efficient buildings and equipment.

On the other hand, Kerry has publicly espoused restoring the pay-as-you-go rule of the 1990s, which would require tax cuts or entitlement hikes to be offset by spending cuts.

Beyond Partisan Babble

Kroszner, the former Bush aide, complains that Kerry’s proposals ignore “incentive and growth consequences.” He embraces Bush’s proposals for their firm reliance on what Kroszner terms “the four pillars” of growth — smart regulation, privatization, a stable economic environment, and transparent and effective corporate governance. Some in finance may question whether growth and regulation of any kind are compatible. And privatization — if applied to Social Security — will be tough to pass through even a Republican Congress. But few would argue with the view that effective corporate governance and a stable economic environment are essential to business.

Kerry supporters characterize Bush’s agenda as containing little besides tax cuts that fail to do enough for the economy. As Kerry economic adviser Jason Furman told a gathering at the Brookings Institution last June: “There is no evidence that the tax cuts are working and that we should be continuing them as a centerpiece of our macroeconomic strategy.”

What we need, beyond partisan debates, is a strategy to deal forthrightly with the long-term deficit. On balance, Kerry’s plan suggests he is the more fiscally conservative of the candidates. Yet neither one does much to address the gap between federal tax revenue and the projected needs of Social Security, Medicare, and Medicaid. “You can’t get there from here without major entitlement reforms,” argues The Urban Institute’s Steuerle.

Bartlett thinks a value-added tax might be what’s required to clear the political logjam, despite past opposition to this solution from both sides of the aisle. Those on the right have derided the VAT as “a money machine,” while those on the left point out that a consumption tax hits the middle class and poor harder than income taxes do. But Bartlett thinks the size of the deficit might cause opponents to reverse their positions. And some of his liberal counterparts agree that it is possible, as long as a switch from a tax system based on income to one based on consumption doesn’t turn corporations into tax shelters. (Democrats are likely to go only for an end to income taxation on wages, so dividend income would remain subject to tax. But if corporations themselves don’t have to pay income taxes on earnings, then they could be used to shelter dividend income.)

Without something to close the federal budget gap, prospects for the recovery seem terribly shaky.

Ronald Fink is a deputy editor of CFO.

Issue: Small Business

While the Bush administration has been roundly criticized for gutting the financial support available from the Small Business Administration, the White House claims that its plan to do away with the estate tax will go a long way toward supporting entrepreneurs. George W. Bush also proposes to allow small businesses to pool their resources to buy group health coverage for workers, presumably at a much lower cost.

For his part, John Kerry vows to expand loans and equity to small businesses, although he has yet to spell out how, other than to propose a tax credit to offset start-up costs. The Democrat’s health-care plan includes tax credits to small businesses for up to 50 percent of the cost of insurance coverage for employees, and he proposes to give small businesses access to the federal health-insurance plan available to Congress, which he claims will cut the cost of such coverage by approximately 15 percent. Finally, Kerry proposes to allow small businesses to pool the administrative costs of offering pension plans to employees. —R.F.

Issue: Trade

Both John Kerry and George W. Bush Claim to be free traders. Kerry voted in favor of the North American Free Trade Agreement in 1994 and for the establishment of the World Trade Organization in 1995. But Kerry’s campaign proposals put much greater emphasis on labor and environmental protection than Bush’s proposals do. Former Bush aide Randall Kroszner says Kerry’s promise to hold off on new trade agreements unless they contain sufficient labor and environmental safeguards could amount to protectionism.

Given Bush’s actual record, however, that’s a brash charge. Most notably with steel tariffs, but also with sugar and cotton, Bush has been unabashedly protectionist when it has suited his political purposes. Moreover, the first three years of his Administration were marked by uncharacteristic U.S. passivity in the WTO. That resulted in a raft of cases lost to Europe (including one declaring the steel tariffs illegal) and little U.S. progress in battling protectionism and intellectual-property violations elsewhere.

Kerry claims he will pursue cases on behalf of U.S. companies against WTO member countries that violate the rules more vigorously than Bush has done. True, the Bush Administration can point to its recent settlement with China over that country’s value-added tax on semiconductors to fend off criticism that the President has failed to adequately defend U.S. business interests abroad. But critics contend the Administration has acted belatedly on that front. “Kerry can say Bush was late,” observes William Reinsch, president of the National Foreign Trade Council, in Washington, D.C., and a former Undersecretary of Commerce in the Clinton Administration. —R.F.

Issue: Health Care

President Bush proposes to expand medical savings accounts so as to give workers “more control” over their health-care insurance and costs. He also proposes to reduce frivolous and excessive lawsuits against doctors and hospitals, which he claims are a big reason costs are rising so rapidly. “The Administration’s plan is much more limited” than John Kerry’s, says Kenneth E. Thorpe, a professor of health policy at Emory University and a former Clinton Administration aide.

Kerry would use the savings from his proposal to tax foreign corporate income, along with those from closing other corporate loopholes and from rolling back Bush’s tax cut for the wealthiest, to provide an incentive to businesses to add or maintain health benefits. Essentially, Kerry plans to provide an estimated $290 billion over 10 years to employers to defray the cost of the most expensive medical cases. Under this proposal, the federal government would reimburse eligible employers for 75 percent of the cost of the most expensive patients; that is, those who run up bills of more than about $30,000, according to an estimate by Thorpe. Kerry contends that this would cut health-insurance premiums by 10 percent. —R.F.