Reaganomics 2.0 in the Driver's Seat

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On a historic night this past Thursday, a new Tea Party Republican Congress completely transformed U.S. economic policy. Elections matter, and so do their ideas. Smaller government, low taxes, and less spending were key election themes in the Republican landslide. And those themes triumphed this week as a large tax-cut bill finally passed the House and a monstrosity of a spending bill was defeated in the Senate.

In one fell swoop, Obamanomics is out the window. Reaganomics 2.0 is now in the driver's seat.

Perhaps the most amazing part of the story was the work of Mitch McConnell and John McCain (among others) to kill the 2,000-page, $1.2 trillion omnibus spending bill in the Senate, along with its 6,600 earmarks totaling $8 billion. This budget monster dripped with contempt for voters and taxpayers. But business as usual was overturned.

I had an inkling of this when Sen. McCain told me in a CNBC interview earlier that night that, if need be, he would favor a government shutdown over passage of the spending bill. And now, under a short-term continuing resolution, the whole current-services budget baseline can be lowered by anchoring it to 2008 spending.

Hundreds of billions of dollars can be saved, producing a smaller government that will be, in effect, a tax cut for the private economy. And the symbolism of overturning massive spending only two years after Obama's debt-laden stimulus package is enormously important.

Of course, the tax deal is far from perfect. But low tax rates will be preserved for personal incomes, capital gains, dividends, and estates. This is pro-growth and pro-capital formation, and it's a confidence builder, too.

Tax cuts for businesses, which are new to this bill, may prove more effective than most people think. And while the payroll tax cut has only a small labor incentive, it is not nothing.

Yes, there's too much spending in the tax bill, as some cranky conservatives keep reminding us. However, it's only about 12 percent of the total $857 billion legislation. Unemployment benefits come to $56 billion, the refundable tax credits are about $44 billion, and the utterly stupid ethanol subsidy is about $5 billion.

Meanwhile, 88 percent of the bill goes to tax cuts - where people get to keep their own money and where there are some significant incentive-effects on the supply-side.

It's not a panacea. Hopefully broad-based flat-tax reform will materialize in the next few years, along with entitlement reform and deep spending cuts. But it is worth noting that late Thursday night, according to the Washington Post, negotiators removed more than 70 temporary programs from the bill.

For those conservatives who are still complaining, I urge you to reconsider the importance of marginal tax-rate incentives for the economy. Tax-rate increases will depress growth and worsen the budget deficit. There's no way America's financial position will improve without economic growth, nurtured by low tax-rate incentives. And if the compromise tax plan had been defeated, the economy would have been held hostage for as much as six months, before the implementation of some kind of new plan to extend the Bush tax cuts through the complicated budget process.

In this sense, the tax-cut compromise does far more good than bad. A new batch of statistics shows recent economic improvement: rising retail sales and industrial production, a jump in the Index of Leading Indicators, and lower jobless claims. The trick here is to nurture the new economic improvement, not snuff it out with higher taxes.

In the new session of Congress - which will feature a true Tea Party GOP conservative majority - new spending-limit policies can fill in the blanks left by the tax deal. But if President Obama has the acumen to see that a pro-growth economic policy is tied to low tax rates, the GOP should take great care not to cede that message and lose the economic-growth high ground.

A great battle will be joined over the spending, taxing, and regulatory mandates of Obamacare, which is probably the biggest job-killer of all. Conservative reformers in the new Congress will force this fight, along with tax, spending, entitlement, and monetary reform. Behind all this, however, the new Tea Party GOP must maintain a message of economic growth and prosperity.

Crankiness is no substitute.

Larry Kudlow is a senior contributor at CNBC, and also co-author with Brian Domitrovic of the new book JFK and the Reagan Revolution: A Secret History of American Prosperity.  

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