by Larry Kudlow
October 21, 2006

Most supply-siders believe that if the Democrats manage to take the House and Senate two-and-a-half weeks from now, President Bush’s investor tax cuts will be safe. First, the tax cuts already have been extended to 2010. Second, the president will surely veto any tax-hike legislation that a new Democratic Congress might pass. (Think Grover Cleveland, the greatest presidential veto-er in American history.)

Maybe so, but the political story will be more complicated, especially if a Democratic Congress passes new “pay-as-you-go” rules. This could put the tax cuts in jeopardy as early as next year.

There are essentially two kinds of pay-go. One is a spending limitation that was used by the Gingrich Congress to balance the budget in the 1990s. This would be good. The other is a revenue pay-go, which is not so good. In this scenario, if the Democrats cobbled together a big-bang deficit-reduction package, large tax hikes would be put in place to meet the new deficit targets. Since Congress scores the investor tax cuts on dividends and capital gains as static revenue losses — even though the evidence shows they pay for themselves — these tax cuts would be subject to repeal or rollback.

Should revenue pay-go materialize, President Bush might be confronted with a Hobbesian choice of vetoing a so-called $500 billion deficit-reduction package that would increase the cap-gain, dividend, and top-income-bracket tax rates.

Truth be told, the Democratic party desperately wants to return the income-tax rate to President Clinton’s 39.6 percent. It’s an obsession that’s lodged in the Democratic DNA, a class-warfare mentality that seeks to penalize the rich and soak American success. In practice, it would be a Soviet-style income-leveling exercise in the name of making the non-rich feel better.

And it’s nonsense.

President George W. Bush’s tax cuts have done an amazing job of reigniting the U.S. economy. The 2003 tax cuts rallied the stock market, generated 6.5 million new jobs, and produced soaring revenues that have, in turn, slashed the deficit.

But all this is in peril if the new pay-go rules go through.

So let me warn my conservative friends and fellow members of the American investor class: A Democratic sweep come November 7 will put Bush’s hugely successful tax cuts on the chopping block.

It’s a sobering thought, particularly in light of sinking Republican fortunes.

On Tradesports, the online betting parlor, the House GOP 2006 contract has dropped to a new low of 32 percent. In late September, prior to the Mark Foley scandal, it had been 57 percent. Bettors, it seems, are giving up on the contract.

On the Senate side, the contract is still a 70 percent bet the Republicans will hold the upper chamber. This points to a congressional split, meaning Washington will “do no harm” on pro-growth measures, especially tax policy. But it is still possible that a phony pay-go revenue deal could surface with a coalition of House Democrats, liberal Republican Senators, and Senate Democrats.

Just as troubling is an anti-growth surge toward protectionist trade activity. The Democrats are against free trade almost uniformly, with 30 to 40 percent of Republicans considered unreliable on the subject. A Wall Street Journal story this week reveals a strong push for textile protectionism against China, Vietnam, Africa, Haiti, and South America. The supply-side growth model stresses a steady dollar, low tax rates, and free trade to promote growth. Hence, should protectionist legislation trudge forth, it would be an anti-growth lose-lose situation for the U.S. and its trading partners.

All this said, the roaring stock market remains very much in favor of a divided Congress. Republican polls are going down, and stocks are going up? Is this the Pelosi bull market? Perhaps so. But if both chambers shift Democrat, taxes, trade, and spending may all go the wrong way. In the New York Times this week, Robert Pear details Democratic plans to control drug prices and attack health insurers and pharmaceutical companies. It’s Hillarycare all over again; a takeover of 15 percent of our economy.

President Bush’s economic approval rating has risen 5 points to 44 percent in a new Wall Street Journal/NBC News poll. Republicans should follow the president’s lead and flog away on the economy, the benefits of lower tax rates, and dropping gas prices. They also should loudly trumpet the splendid stock market rally. Indeed, across the next 18 days, this is the GOP’s best chance to generate an enthusiastic vote turnout from the investor class.

Pollster Scott Rasmussen shows that entrepreneurs (49%) and investors (46%) are the two groups most appreciative of the job the president is doing. Message to the GOP: Talk up the low-tax, Goldilocks stock market economy and get these folks to the polls.

It’s your last chance boys and girls.

 

— Larry Kudlow is host of CNBC’s “Kudlow & Company”, economics editor for National Review Online and a nationally syndicated columnist. He served in the Reagan Administration and on the Bush-Cheney transition team.