John McCain has talked up marginal tax cuts in this campaign, but as no viable Republican candidate could decry decreases, it's fair to ask (particularly considering he voted against the 2003 reductions) if this isn't simple rhetoric on his part.  Whatever his newfound beliefs on taxes, comments from his chief economic advisor (Douglas Holtz-Eakin) to U.S. News's Jim Pethokoukis on the alleged mystery that was the 1970s combined with executive-pay bashing this week by that same advisor might better reveal how McCain would govern.  It's not very inspiring.  Written for RealClearMarkets.

April 10, 2008

Who Has McCain's Economic Ear?

By John Tamny

Owing to his historically questionable economic views, including his apostasies on the Bush tax cuts of recent vintage, much has been made of Republican presidential candidate John McCain's picks to advise him in that area. That the brilliant Steve Forbes is part of his economic team has given market-friendly types cause for optimism, and sure enough, McCain has at least talked up the idea of reducing marginal tax rates once in office.

Unfortunately, recent comments from his chief economic advisor, Douglas Holtz-Eakin, are a reminder that McCain will be very much a wild card on economic matters should he win in November. Indeed, if it is the views held by Holtz-Eakin that are shaping those of McCain, it's fair to question whether economically-conscious voters will be pleased with a McCain presidency. In a Reuter's interview this week, and in an interview with U.S. News and World Report's James Pethokoukis last week, Holtz-Eakin gave us a clearer picture of his economic thoughts, and they're not exactly inspiring.

Commenting on executive compensation to Reuter's on Monday, Holtz-Eakin declaimed that, "Job No. 1 of the president is to use the bully pulpit to shine a light on behavior that is less-than-exemplary," and when asked about executive pay, he said, "That's certainly the case here."

According to Reuters, Holtz-Eakin said McCain would like to see shareholders and company boards take action to make sure "that pay packages for CEOs are reasonable and in line with performance." And in a speech on Sunday, McCain joined the executive-bashing echo chamber when he blasted the "outrageous" and "unconscionable" compensation of Bear Stearns and Countrywide executives, along with their "co-conspirators" on corporate boards. Holtz-Eakin and McCain miss the point on numerous levels.

For one, companies serve at the pleasure of shareholders, not the president. As such, companies should be allowed to make decisions when it comes to pay in either transparent or opaque fashion; the decision ultimately an economic one relating to what attracts investors. Importantly, investors are free to sell shares in companies that tend toward opacity or that compensate in ways they don't approve.

Secondly, as investors have found over the years, top management is priceless. While Michael Eisner, Jack Welch and the late Roberto Gouizueta respectively left Disney, GE and Coca-Cola as billionaires, one would be hard pressed to find a shareholder who objected given how the shares of each company strongly outperformed the S&P 500 during their tenures. More modern evidence supporting the idea of the importance of CEOs comes from the rally in Starbucks' shares after Howard Schultz resumed there as CEO, not to mention the 5.3 percent jump in the market cap of Merrill Lynch on the day that John Thain's arrival as CEO was announced. It is because top executives can have such a positive impact on companies that their pay is so high, but the process is not foolproof. If it were easy, investing would be easy.

Thirdly, for Holtz-Eakin and McCain to assume that shareholders and company boards can know in advance whether pay packages might be "reasonable" defies common sense. The world of sports offers up myriad examples here in that ahead of the 1998 NFL Draft, many GMs had future bust Ryan Leaf rated ahead of future Hall of Famer Peyton Manning. Back in 1984, Sam Bowie was drafted before Michael Jordan. Former Home Depot CEO Bob Nardelli's pay package would likely fall into the category of what Holtz-Eakin and McCain would deem "less-than-exemplary" corporate activity, but he was able to command it because he was heavily in demand by numerous corporate boards hopeful that some of his GE magic would rub off on the companies they served.

If we're willing to ignore the views on executive pay, it would be very difficult to brush off Holtz-Eakin's comments to U.S. News' James Pethokoukis last week. It's what he did not say, and what he did not seem to understand that should have those who think McCain will be good on tax policy a little bit worried.

To be fair, when asked by Pethokoukis about the economic boom under Bill Clinton, Holtz-Eakin said, "The economy survived higher taxes" that doesn't mean the higher taxes caused it. I am sure it was not true, and it doesn't mean the higher taxes were a good idea." He also noted the positive impact of lower taxes and deregulation in the '80s.

But in discussing U.S. productivity over the last few decades, he observed that it disappeared in the '70s, and "no one knew why." There lies the concern. It seems pretty obvious what caused productivity to fall in the '70s, and it had to do with a top tax rate of 70 percent that was made even more confiscatory by a falling dollar; the latter a productivity killer for driving a great deal of capital away from the innovative economy into real assets such as gold, housing and art. Shades of today?

Holtz-Eakin also failed to mention that until 1969, the top rate on capital gains taxes was 25 percent. In '69 Congress raised the minimum rate on investment success to 50 percent, and as Bruce Bartlett pointed out in his 1981 book Reaganomics, the "effect of this tax change was immediate and dramatic." Indeed, with productivity-enhancing companies heavily reliant on capital, the new capital gains rate caused the annual number of IPOs to fall from a high of 1,298 in 1969 all the way to a low of eighteen in 1978. New companies raised $3.5 billion in 1969, but with capital taking safe haven from inflation and a 50 percent investment-success penalty, by 1978 a measly $54 million was raised.

When we consider Holtz-Eakin's positive comments about the '80s tax cuts, to some degree we can say this is a basic and shrewd political calculation to talk up the Reagan era. In short, Republicans traditionally run on tax-cutting platforms, while Democrats campaign for tax increases.

More crucial is a core understanding of why economies soften, particularly in the present environment when so many assume we're either in or headed for a recession. For Holtz-Eakin to pass off the 1970s economic failures as mysterious along the lines of sunspots or draughts speaks volumes. He should know exactly why the economy underperformed in the '70s, because in understanding that failure, he would be able to help McCain articulate the need for the marginal tax cuts and improved dollar policy that will help us emerge from today's "1970's-lite."

So when we contemplate a John McCain presidency, we have to ask whether his beliefs match the kind of rhetoric we'd expect from any successful GOP candidate. The commentary coming from his top economic advisor suggests the more optimistic among us might be disappointed. Just like the man he serves, Holtz-Eakin doesn't seem quite on board with why tax cuts are so effective. That being the case, McCain partisans should hope for a lot more Steve Forbes on the campaign trail, and a lot less Douglas Holtz-Eakin.

John Tamny is editor of RealClearMarkets, and a senior economist with H.C. Wainwright Economics. He can be reached at jtamny@realclearmarkets.com