A Lexus tax cut suits the jalopy driver

In the great tax contest between the Lexus and the muffler, the muffler appears to be gaining ground.

The battle got started back in February, when Tom Daschle, the top Democrat in the Senate, attacked President Bush's tax cut plan. Mr Daschle said it would give tax cuts worth the price of a leather-lined Lexus auto to high earners. More modest earners meanwhile would merely get enough cash back to buy a new muffler - the term, of course, is "silencer" in the Queen's English - for the family jalopy.

So stymied are Senate Republicans by this argument that they are now talking about divvying out a compensatory extra $60bn family-by-family to the muffler crowd. To watch the defensive Senators scramble, you'd think that benefits for Lexus-owning types had no effect on humbler muffler people.

This might appear to be true in the zero-sum world of federal budget writers.

But it is not true in reality. In fact even small adjustments at the top of the tax schedule affect the whole economy. What's bad for the Lexus people is bad for everyone, including families so humble they can never hope to own a car. Conversely, what's good for the Lexus people is good for everyone. Sometimes, breaks for the Lexus crowd translate into dramatic improvements in the well-being of the poorest of Americans.

Let's start with the "bad" example.

Back in 1990, President Bush, Senior, was worried about the deficit. He decided to raise $1.5bn by collecting it from groups so flush they'd never notice the loss - namely, Lexus types.

The first Bush Administration imposed a 10 per cent surtax on luxury goods. Purchases affected included yachts priced at more than $100,000, jewelry costing over $5,000 (presumably 1.5 carat diamonds were "luxury" but .75 carat diamonds were for the working woman). Also in the group were cars with sticker prices more than $30,000, a group that, even back then, included some Lexus models.

President Bush and his colleagues were sure their plan wouldn't hurt regular people. Richard Darman, the President's Budget Director said in fall, 1990, that "this compromise in the end will tax the rich". Their supporters in Congress were equally convinced.

But within half a year, Washington knew it was wrong. That's because taxes on luxury items hit not only luxury good consumers but also luxury good makers - and the very blue collar people that they employed. Yacht sales dropped, and boat makers were in trouble. The papers reported that the staff of Pearson Yachts of Portsmouth, New Hampshire shrank from 220 down to 50. Other boatyards announced similar lay offs. The papers reported that Mercedes sales were down by about 25 per cent in the Northeast. Furmakers, whose products also fell into the "luxury" category, found demand for their product was down as well.

In other words, the "Lexus" tax hike was a big Edsel. Not only did it kill jobs - thousands of them - but it also netted disappointing revenues. Chagrined lawmakers rescinded their wrongheaded legislation - eventually. "We thought we were doing the right thing," Senator John Breaux of Louisiana told the press. "No one expected the tax would have such a devastating impact on the marine manufacturing industry."

The flip side of this story is that cuts that look like they are exclusively for the rich usually end up helping everyone.

Remember 1986, when the Reagan Administration and a Democratic Congress pulled down the top marginal rate of the income tax as easily as if were a Venetian blind? Everyone said this was a giveaway to the rich. The Reagan cut was said to come at cost to the middle class - and at cost to America's poorest. Just as with the Bush tax plan today, the critics were particularly vociferous in charging that the new lower rates would reduce charitable giving. The trust fund crowd would no longer give to their favourite charities, people said, if the value of their precious tax deductions was eroded.

Wrong again. As economists Alvin Rabushka and Robert E. Hall have noted, charitable giving rose from $80bn in the year the tax cut was passed to $107bn by 1989 and $112bn in 1990.

What happened? The tax cuts powered the economy. The Gordon Gekko class spent plenty on themselves, but they also had more than before left over to create jobs and give to churches, or the United Way.

These were valuable lessons. Unfortunately, they were never completely acknowledged. In fact, Democrats dedicated most of the 1990s to using the tax code as a vehicle to bash the rich.

Once in a while, of course, they would suspend the rhetoric. That's what happened in the late 1990s, when the capital gains tax - historically viewed as a classic Lexus tax - was cut. Treasury Secretary Robert Rubin wanted the extra revenue he knew the rate cut would generate so badly that he dropped his class warfare. And the capgains cut did indeed pull in billions in extra cash. The change unlocked capital (people sold stocks that had been sitting in the safe for years) and inspired new business creation. This in turn did much to build today's surplus.

But that change was the exception. And now even some Republicans - the Senators who aren't backing President Bush - are showing they too are susceptible to anti-rich rhetoric. It's a shame, because the history of taxes has made things pretty clear. Lexus people and muffler are in this together. What's good for "them" is also good for us.

© Copyright 2001 Financial Times

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