Washington, DC, May 27, 2003 --  

Now that Congress has passed a $350 billion tax cut¹, the time has come to see politicians' overblown predictions -- both dire and buoyant -- fall by the wayside. Supporters dubiously claim that the long-term cut will give a short-term boost to the economy. Detractors scream the usual demagoguery about "tax cuts for the rich" keeping the poor from getting needed social programs.

The latter argument received an 11th hour boost from an unlikely spokesman -- billionaire investor Warren Buffett. As one of the richest men in the world, Buffett has built a cult-like following in the investment community, where he is known as the "Sage of Omaha." The Sage was particularly busy in the days before the congressional vote, appearing on ABC News' Nightline and writing an op-ed in the Washington Post to decry legislation cutting the dividend tax.

The dividend tax cut will do little to stimulate the economy, Buffett says, because investors like him will just re-invest tax-free dividends.² Reinvesting a tax-free dividend has the exact same effect as if the companies never paid a dividend at all, he says. Thus, there is no stimulating effect. His analysis is correct, save one fatal flaw -- most investors aren't like Warren Buffett. Most don't have $30 billion. And most don't buy stocks for personal fulfillment; they buy stocks to make money that they eventually plan to spend.

Cutting dividend taxes provides an incentive for companies to pay dividends. And this is not a bad thing. Throughout the 1990s, when dividends were out of fashion, investment advisors repeated the mantra that dividends don't matter. If you trust a company's prospects enough to buy its stock, the argument goes, then you should trust it to reinvest your earnings and make you even more money. This trust weakened accountability and helped fuel the irrational exuberance of the last decade. Unprofitable companies saw stocks soar in value, even though they could never manage to pay a single dividend. In 20:20 hindsight, it is not surprising that the bubble popped.

This was not a problem for companies owned by Buffet's Berkshire Hathaway. The Sage doesn't pay dividends -- he hates them because they take away his power to reinvest profits. But Buffett has used this power successfully, and his honest, straightforward investment style has been quite rewarding for his shareholders. But unless we are to entrust all of America's companies to the wisdom of Buffett, investors will need something else to go on. That's where a dividend is helpful. And to the extent that the tax cut encourages dividends, the tax cut is helpful, too.

Buffett's other anti-tax-cut argument -- that the cut will have little short-term stimulating effect on the economy -- is absolutely correct. But the tax cut offers something better than short-term stimulus. It offers to help keep government spending in check.

The size of the federal government increased last year by $147 billion -- the largest amount in history.³ Much of growth in government came from ill-advised security measures rubber-stamped by a drunk-on-patriotism Congress in the months following September 11. But spending actually accelerated starting in 2000, with the budget increasing at a rate of over 4 percent per year for the first time since Clinton's first year as president.⁴ The driving factor was the budget surplus from the huge increase in tax revenues that came out of the ?90s boom. Back in 2000, the year tax receipts peaked at $2.0 trillion, politicians were tripping over themselves to find ways to spend the windfall.⁵

President Clinton wanted to spend the new revenues on prescription drug coverage for Medicare. Presidential candidate Al Gore wanted to burn it all in the bottomless furnace of his Social Security "lockbox." Bush, thankfully, has managed to let give some of the money back to the people who pay the taxes.

The return to deficit spending, while not ideal, is far better than the alternative of skyrocketing tax payments fueling new government spending. Now that the budget is back in the red, every politician who dreams up a worthless government program will be subject to greater fiscal scrutiny. This is the hidden dividend of the tax cut -- keeping the money out of the hands of the politicians.

The side effect of this benefit, of course, is that wealthy Americans will get to keep more of their money. If this bothers civic-minded billionaires like Buffett, nothing stops them from donating their tax savings to civic causes. Build a library. Send a few thousand poor kids to college. But for heaven's sake, Mr. Buffet, please don't fund new government bureaucracies to wreak havoc on the rest of us.

Related Web Columns:

Deficit Nostalgia, July 13, 1999

Notes:

1. The Washington Times, Bush Accepts Size of Tax Cut, May 22, 2003

2. The Washington Post, Dividend Voodoo, May 20, 2003

3. Congressional Budget Office, The Budget and Economic Coutlook: Fiscal Years 2004-2013, January 29, 2003

4. Ibid.

5. Ibid.