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Dole's Gamble


Cover Story: ELECTION `96

DOLE'S GAMBLE

Why he took the leap, and how he and his brain trust hammered out a dramatic proposal

Munching pizza at his campaign headquarters on the night of July 11, GOP nominee-in-waiting Bob Dole subjected his economic advisers to a 2 1/2-hour grilling. Under mounting pressure to ignite his sputtering campaign with a dramatic economic plan, Dole had already signed off on a $500 billion-plus tax cut. But he had dithered for two months on specifics. Now, with the convention a month away, Dole had to figure out which taxes to cut and how much growth the cuts would produce.

Two competing camps of advisers--supply siders, led by publisher Steve Forbes, and traditional economists, led by University of Chicago Nobel Laureate and BUSINESS WEEK columnist Gary S. Becker--were locked in debate. Supply siders believed that huge tax cuts would generate so much growth that new revenues would offset up to 50% of the cost. Traditionalists argued that even a program pairing tax reduction with regulatory reform and education and training incentives would only recapture 30% of the cuts--eventually. More than $100 billion in gut-wrenching spending reductions would ride on Dole's choice.

Behind these economic arguments lurked a vital political question: How could Bob Dole, lifelong budget-balancer and deficit hawk, credibly adopt an economic plan built on big tax cuts offset by vague and dubious spending cuts?

Ever the pragmatist, Dole decided to keep one foot in both camps that night: He adopted supply-side economics without fully accepting its tenets. That instinct to split the differences has led Dole to a program that pins hopes for stronger growth on both tax cuts and such Republican orthodoxy as deregulation, budget balancing, and education reform. Dole's economists convinced him that with this eclectic mix, he can return America to its economic golden age, lifting growth from the current annual rate of 2.3% to a sustainable 3.5% pace by 2002. "We must commit ourselves to a far more ambitious path," Dole declared, unveiling his plan in Chicago on Aug. 5, "that puts growth, expanding opportunity, rising incomes, soaring prosperity at the heart of our economic policy."

But a closer look at the Dole plan--and the tortuous way he put it together--reveals much about Dole's thinking and the economic splits rending his party. The plan rewards each key constituency of a fractured GOP: A 15% across-the-board tax cut and the promise of tax reform for supply siders; capital-gains cuts for country club Republicans; a balanced-budget promise for traditionalists; and a $500-per-child tax credit for social conservatives.

The result of these compromises is an economic agenda that attempts to marry the philosophy of Ronald Reagan with the rhetoric of Labor Secretary Robert B. Reich. Dole vows to ease worker anxiety, narrow income inequality, raise living standards, and hike wages. But his plan could fail for reasons that would be obvious to the old Bob Dole: The proposed spending cuts don't come near to paying for the tax cuts (box). Even if all goes according to plan, the package would add $184 billion to the federal debt during the next six years. And if the additional red ink pushes up interest rates, growth could slow. Even conservatives are skeptical. "It's designed to keep a diffuse coalition together," says William Niskanen, president of the Cato Institute. "It's not really coherent on economic grounds."

SKEPTICS. Many economists and business leaders are even more concerned. "Cutting taxes without a detailed plan [for spending cuts] is not acceptable," says Leonard Miller, chairman of homebuilder Lennar Corp. He's echoed by an executive at a Big Three auto company: "How the heck can you just cut taxes by 15% when the economy is still running substantial deficits?"

The public is skeptical as well: In a BUSINESS WEEK/Harris Poll taken on July 26-31, only 11% of 1,007 respondents said that personal tax cuts were the best way to boost the economy and family incomes (page 38). And unless he follows up with a star turn at the GOP convention, which gets under way in San Diego on Aug. 12, Dole can expect the economic package to give his faltering campaign only a short-lived political boost (page 35).

How was tax hiker Bob Dole persuaded to gamble on a $548 billion tax cut? The key: convincing the Kansan that he could adopt the theme of rapid growth without fully embracing the supply-side philosophy he has long abhorred. Economists Becker and John B. Taylor, a Stanford University professor who served in George Bush's White House, put the stamp of respectability on growth forecasts by insisting that a broad range of social and economic reforms would contribute as much to unshackling the economy as tax cuts. "Dole is genuflecting toward the supply siders," says a top GOP strategist advising the Kansan. "But his means are consistent with his background."

But getting Dole to adopt even moderate supply sideism wasn't easy. To observe Dole agonizing over this plan is to watch a venerable Republican driven by two desperate imperatives: to narrow a 20-point deficit in the polls and to bridge deep splits in his party. Those drove Dole forward--but his caution held him back, and he repeatedly postponed key decisions. The resulting plan, hammered out during a frenzied weekend of Aug. 2-4, shows the scars of that ordeal.

The path to Dole's growth plan began on May 8, when he and Elizabeth Dole invited economists and fellow senators to a barbecue dinner in his Capitol office. The group agreed that Dole should mount an economic assault on Bill Clinton, tapping into workers' economic anxieties by calling for tax relief and stronger growth. The vehicle offered by Senator Spencer Abraham, a freshman Republican from Michigan: a 15% across-the-board cut in tax rates. Hatched by economic consultant Bruce R. Bartlett, a Treasury aide in the Bush Administration, the rate cut was simple and harkened back to Ronald Reagan's 25% tax cut in 1981.

The idea found a receptive audience in Taylor, who had been advising California Governor Pete Wilson on a 15% cut in state taxes. Taylor took the lead in championing the tax-cut idea among the academics. Some economists, notably Harvard University's Robert J. Barro, argued for more fundamental reforms, such as replacing the income tax with a sales tax or a levy that exempts savings. But Dole wasn't ready to go that far.

The other key participant was Senate Budget Committee Chairman Pete V. Domenici (R-N.M.). Dole's ally through a decade of budget battles, Domenici is deeply hostile to tax cuts that might bust the budget. As the plan evolved, Dole would be counting on him to decide whether spending could be squeezed enough to balance the budget while cutting taxes. "Pete's assurance would be very important to Dole," says a campaign official.

KEMP CHIMES IN. Although Dole wasn't ready to commit publicly to a plan immediately after the confab, Taylor's memo summarizing the discussion set the direction: tax cuts first, with a promise of fundamental reform by 2000. That program infuriated former Housing & Urban Development Secretary Jack F. Kemp. The dean of supply siders had thrown his weight behind sweeping tax reform, along the lines of the 17% flat tax championed by Forbes. Rate cuts, Kemp feared, would take the steam out of a radical overhaul of the tax code.

Kemp summoned his supporters to devise a strategy to derail Dole's plan. But the supply-side faithful, eager to convert Dole, wouldn't join in. So he shifted gears: In mid-May, he enlisted Forbes to lobby for a different tax cut. Their plan would wipe out the three top tax brackets--31%, 36%, and 39.6%--added by the deficit-cutting packages of 1990 and 1993. Kemp and Forbes figured the resulting two-rate system would carry them toward flat-tax nirvana.

The dueling tax cuts slowed Dole's already ponderous decision process. Hopes for a late-May rollout of a plan faded as the camps squabbled. On June 7, Dole shook up his team by installing as co-policy director an old friend, former Ford White House Chief of Staff Donald H. Rumsfeld, who had since resurrected G.D. Searle & Co. and General Instrument Corp. Rumsfeld was paired with a supply-side favorite, former Representative Vin Weber (R-Minn.). Finally, GOP traditionalists and supply siders were working together, albeit uneasily.

The new team broadened, then narrowed, the tax-cut options. Rumsfeld pushed for decisions, only to see Dole move in agonizing half-steps. "We had a guy on the road five days a week who wanted to micromanage every decision from his plane," recalls one campaign source. Dole continued to fret that he would be criticized for busting the budget. By early July, he was back where he started: torn between two tax packages, with no way to pay for them.

The breakthrough came on July 11. Dole dropped in on his advisers, only to stay more than two hours while Becker and Forbes debated how much growth the Dole plan could produce. "That night, Dole was really fixated," says one insider. "He kept saying, `Look, what kind of numbers can we realistically expect to get?"' Forbes argued that lower tax rates would ignite an explosion of work output and savings. Judy Shelton, an economist from Empower America, Kemp's think tank, insisted that cutting the capital-gains rate would "unlock" $7 trillion in assets that investors would sell and pay taxes on. The supply siders maintained that 50% of the $500 billion tax cut could be recouped by 2002.

But Dole was swayed by Becker, who argued the gain would be more like 30%. What mattered most to Dole, though, was assurance from the Chicago economist that growth wouldn't be due to tax cuts alone. Becker explained how regulatory reform, school choice, and worker training--issues Dole had long championed--could also boost the economy by making workers and firms more productive. Becker and Taylor dubbed this the "income growth effect"--a foggy way of saying that higher growth would produce more tax revenue. Satisfied, Dole locked in a target of 3.5% long-term growth and left convinced that his plan could achieve it.

By July 20, Dole's conversion was complete. Appearing at a Saturday morning session in khakis and a blue dress shirt, Dole took command of the meeting. "He knew all the numbers, all the options, the timing," recalls Shelton. Domenici, too, gave his blessing, telling Dole: "This is doable in budgetary terms." The next week, Rumsfeld and Domenici appeared at a Kemp-sponsored press conference to assert Dole's tax-cutting credentials.

Which tax cut, though? Forbes, working inside the campaign, and Kemp, agitating outside, kept up the pressure to eliminate top rates. Taylor fought for the 15% cut, aided by Senators Abraham, Domenici, and Connie Mack of Florida. "The guys who've actually won elections are for the 15%," one Dole aide noted sarcastically.

But Dole didn't decide until Saturday, Aug. 3--two days before his scheduled speech in Chicago. The clinching argument: The 15% cut was easy to explain and gave all income groups a proportional tax cut. Eliminating top rates would tilt the benefits to the rich, requiring other complex steps--such as deductions for Social Security payroll taxes--to balance out the plan.

With the centerpiece set, the economic team scurried through a wild weekend. To limit the impact on the deficit, the reduction in rates would be phased in--5% in 1997, 10% in 1998, and 15% in 1999. Dole's earlier plans to cut the gasoline tax and offer new small-business tax breaks were junked. To assuage growth fans, Dole decided to halve the capital-gains rate, to 14%, below the 19.8% rate passed by the GOP Congress in 1995. Social conservatives such as Christian Coalition leader Ralph Reed and conservative values czar William J. Bennett got their $500-per-child tax credit, phased in over two years. And to score points against Clinton's 1993 tax increase on upper-income retirees, Dole proposed cutting the share of Social Security benefits subject to tax from 85% to 50%.

The team spent much less time debating how to pay for the tax cuts. Once they settled on the growth payback--$147 billion, or 27% of the tax-cut package--the economists adopted several simple ideas to get there: Trim Washington's spending on paperclips, close two Cabinet departments, and auction more airwaves. Dole also pledged to sock it to the tax man, proposing a 30% cut in IRS staffing by 1999--a move that could imperil the agency's ability to round up revenues (box).

The plan is clearly ambitious. But is Dole holding a royal flush? Or will his wager turn out to be little more than a riverboat gamble--former Senate Republican Leader Howard H. Baker's memorable description of Reagan's supply-side experiment? If Dole can boost long-term growth to 3.5% a year--a 50% increase--it will be a monumental achievement.

But most private economists and many business executives say they wouldn't bet much on the plan. At best, they say, it would increase the rate of growth by a fraction of a percentage point in coming years. Every tenth of a percentage point increase in growth means an extra $70 billion for American workers and investors. That's real money, but it won't really change an economy in the midst of a dramatic transition. "It's a proposal that--if paid for--should spur labor supply and investment modestly," says former Congressional Budget Office Director Robert D. Reischauer. "But the fundamental reasons why we have slower growth can't be changed by magical tax plans or spending proposals." One major reason the economy is expanding more slowly than in the 1960s is that the labor force isn't growing as fast. And no President can do much about that.

KICKING BACK? With slower population growth, the key to higher growth without inflation is more productivity. Dole's across-the-board rate cut may provide an incentive for some middle-income people to work harder, since they would keep more of what they would make. But it could as easily induce the wealthy to kick back: If aftertax pay is up, why not spend more time on the boat?

Of course, the economy could always make better use of the people it has. Here Dole's ideas have some merit, economists say. He proposes converting $12 billion in educational aid into vouchers that would promote school choice, figuring competition will force schools to turn out better educated workers. Dole also would turn federal job-training programs over to the states in a bid to boost job skills and productivity. But neither move will produce the kind of quick growth that Dole is counting on.

Labor is only half the story. The rest is capital. And some of the Dole tax cuts are geared toward encouraging more investment. Cuts in both marginal rates and in the capital-gains rate should, in theory, boost investment, since aftertax returns will rise. "If he can improve investment, he could well achieve growth in the economy without inflation," says Eric Tomlinson, CEO of GeneMedicine Inc.

Much of that incentive, though, is diluted by other Dole proposals. The $500-per-child tax credit is likely to spur consumption, not investment. So are a new tax credit for charitable donations and the rollback in taxes on retirees. Worse, not all new investment may be productive. The big gap between a 14% capital-gains rate and a 34% top rate on earned income could mean a return to the world of pre-1986 tax shelters (page 32). "As long as interest payments are still deductible, it doesn't make sense to have a preferential capital-gains rate," says Cato's Niskanen.

Can any economic plan deliver the payoff Dole promises? Reagan's 1981 fiscal plan provided a powerful test (page 36). His tax cuts are still being touted by supply siders as kicking off a burst of economic growth. But the evidence shows strongly that much of the 1980s' growth in investment and the labor force was due to a strong recovery engineered by the Federal Reserve's tough inflation-fighting policies.

Four years after the 1981 recession hit bottom, economists at WEFA Group Inc. found, labor force growth indeed outpaced normal expansions, but only by a small amount. Capital spending actually lagged behind a typical expansion. WEFA chief economist Daniel Bachman says the Reagan experience shows just how hard it is for tax policy to buck powerful demographic trends and the business cycle: "To get the effect Dole wants, you'd have to have massive changes in labor force participation."

Without such changes, Dole's plan isn't likely to boost growth by much. If it blows a hole in the deficit, all bets are off: His growth agenda will end up in a Carteresque scrap heap of well-intentioned but failed economic plans. Skyrocketing interest rates set off by panicky bond traders and a none-too-pleased Fed could derail the economy.

Already, analysts doubt whether Dole really has a way to pay for tax breaks. His spending cuts are sketchy, and aides are unwilling to fill in details. A quarter of the tax cuts are financed by Dole's "income growth effect." Another $225 billion comes from cuts in Medicare and Medicaid included in this year's GOP budget package. Dole says other entitlement cuts are "off the table."

That leaves more than $400 billion to come from deep but unspecified cuts in other domestic spending. Clintonites ridicule the magnitude of these reductions: "The FAA will be watching one out of every three planes," scoffs a senior Administration official. But even allowing for political hyperbole, the cuts would be huge. After inflation, a broad range of federal programs would have 40% for their operations by 2002.

Such dramatic cuts would push more federal programs--including community development, mass transit, highways, and environmental protection--back to the states. That policy, which Ohio's Republican Governor George V. Voinovich used to call "shift and shaft," would mean higher state and local taxes.

Dole's decision to exempt defense, Social Security, and most of Medicare from the cuts has budget hawks furious. "The thing that disappoints me most is that once again the political system doesn't seem to lend itself to an intelligent discussion about what to do about entitlements," says David H. Resler, chief economist at Nomura Securities International Inc.

Without real spending cuts, Dole becomes Reagan Redux--backing big tax-cut goodies and not paying for them. "If you pass the tax cuts without credible fiscal restraint at a time when the economy is close to full employment, inflation and interest rates will rise sharply," says Joel Prakken, chairman of consultants Macroeconomic Advisers.

For more than a decade, Dole has been telling a joke about a bus full of supply siders. The good news: The bus went off a cliff. The bad: There were three empty seats. Now, Dole seems to have climbed aboard and grabbed hold of the wheel. The question is: Will his plan take the nation down the road to prosperity--or over that precipice?By Mike McNamee, Howard Gleckman, and Lee Walczak in Washington, with Paul Magnusson in Chicago and bureau reportsReturn to top


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