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A Tax Cut That Works for All the Wrong Reasons

It makes the dollar so weak that U.S. goods become irresistible.

As a revision of the tax code, it's so convoluted that only a tax accountant could love it. As a goad to investor behavior, it's shockingly ineffective. And as a piece of fiscal policy, it's a disaster.

Yep, the new tax cut President Bush signed into law last week is so bad that it will inadvertently give a sizable boost to the economy and the stock market -- but not in the ways anybody intended.

How complicated is this new law? The child tax credit, to take one example, increases to $1,000 in 2003 and 2004, then goes to $700 for 2005 through 2008 as the size of the credit reverts to the limits set by earlier tax legislation, then goes back up to $800 in 2009, and finally returns to $1,000 in 2010. And if your income is above $110,000 for married couples filing jointly or $75,000 for singles, the credit declines by $50 for every $1,000 your income is above the threshold.

The Dividend Labyrinth

Want to rejigger your portfolio to take advantage of the new, lower tax rates on dividends? Good luck. Yes, the tax on dividends was cut by the bill to 15%, as was the rate on capital gains. For taxpayers who were paying rates of 27%, 30%, 35% or 38.6% on dividend income, depending on their tax bracket, the reduction to the new 15% rate could be huge. Could be, that is, as long as the dividends you're collecting are the right kind of dividends.

Take the payments that real estate investment trusts (REITs) make to investors. They're not dividends as far as the tax bill is concerned. Investors in REITs will still owe taxes at the higher rates for regular income because the REITs don't pay corporate taxes on the income they distribute to investors.

But some REIT payouts will qualify for the new lower tax rate on dividends if they're a result of capital gains or other taxed activity. Similarly, some part of a corporation's dividend payout may face exclusion from the tax break, depending on the source of the income. In fact, many investors won't know how much of their dividends qualify for the new, lower tax rate until they get their Form 1099 for tax purposes next year.

Tally the Fiscal Scorecard

Remember that one of the other arguments for this tax cut was a need to get the economy rolling again. The increase in the size of the federal deficit was portrayed as good policy, because running a bigger deficit in an economic downturn is one way for the government to get the economy rolling at a faster rate.

So what's the fiscal scorecard on added stimulus and increased debt? How about a big fat goose egg for stimulus? Economists at ISI Group, a broker-dealer specializing in economic research, figure that the tax cuts could add about 0.4% to economic growth in 2003. But increased taxes and fees from the 50 state governments are likely to cut growth by 0.7%.

That's because the states are likely to run a budget deficit of about $85 billion this year, and by law the states have to balance their budgets. For most that means higher taxes because they used up the easy budget cuts and fiscal gimmicks last year to close 2002's almost $200 billion shortfall.

So even though the true size of the tax-cut package is closer to $810 billion than to the advertised $350 billion over 10 years, the current economy won't get much bang for all those bucks. (Why $810 billion instead of $350 billion? That's because so many of the current bill's tax cuts are temporary, and the administration's math assumes that Congress will simply allow those cuts to expire and for the older higher taxes to resume.)

But the long-term federal budget will certainly pay the price. If Congress lets all these cuts stand for the full 10 years, this bill easily wipes out all the budget surpluses the administration had projected for 2004 through 2013.

That's the bad news about this tax-cut bill.

Global Investors Are Spooked

The good news is that global investors, especially European investors, have been so spooked by the size of these cuts and by the prospect of U.S. budget deficits stretching as far as the eye can see that they've launched a wave of selling that has driven the price of the U.S. dollar down 12% against the euro so far this year. (The dollar is down about 8% against a basket of the currencies of our biggest trading partners.)

Here's what the Europeans see: a total lack of fiscal restraint, a steely ideological commitment in Congress to more tax cuts, red ink and more red ink flowing out of Washington, an administration committed to tax cuts and unworried by the falling dollar, and a central bank that's decided to roll the printing presses.

That would be enough to make investors dump dollars even if the U.S. didn't owe the world a net $2 trillion.

Dollar Falling ... and Falling

So how is this good news? Well, a falling dollar makes U.S. goods and services cheaper for the rest of the world to buy. A U.S.-made machine tool or airplane is 12% cheaper for a European buyer than it was at the end of 2002.

In the short run, that kind of drop doesn't change buying behavior much. Companies are reluctant to change suppliers just to reap a transitory 10% -- if that discount is only going to last for a month or two. Suppliers will eat the de facto price increase against the dollar to keep market share if they're convinced the exchange rate will rebound in the near future.

But no one who looks at U.S. fiscal and monetary policy can feel certain that the recent weakness of the dollar is just a short-term trend. All the signs, in fact, point in the opposite direction: The dollar is likely to fall further and stay down for quite a while.

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And that's the kind of forecast that gives companies outside the U.S. real incentives to sign new contracts with U.S. suppliers.

Effects on Overseas Sales

The drop in the dollar has already given U.S. companies that make substantial sales overseas a big boost in the first quarter. Currency effects, the increased number of dollars that a U.S.-based company reports when it translates sales that were denominated in euros or yen back into dollars for its financial reports, added an extra 5 cents or so a share at many companies in the first quarter. That kind of quick boost from exchange rates will help corporate earnings as a whole in the second quarter as well.

But the longer-term power of a weak dollar to increase revenue for U.S.-based companies is just now starting to kick in. With European economies growing only slowly, and set to grow more slowly still in the months ahead, any gains will come slowly as U.S. companies gain share in a stagnant market. But there is no way that a 12%-and-counting cut in effective price from a falling dollar won't boost revenue for U.S.-based companies.

Real-World Effects

The tax cut as written targets most of its dollars to consumers and does almost nothing for the manufacturing and capital-equipment sectors that have been hit hardest in this growth-recession. The tax cut's real-world effects, however unintentional they might be, provide a substantial benefit for this sector.

And that's not the end of the tax cut's positive economic effects. A falling dollar also makes goods and services imported into the U.S. more expensive, creating a wave of weak-dollar inflation to combat the deflation that Alan Greenspan so fears.

This works two ways: First, goods actually made in nondollar countries go up in price when foreign manufacturers decide to pass currency costs through to their customers. That pair of Italian shoes goes up to $336 from $300.

Second, those direct price increases for imported goods give domestic manufacturers cover for their own price increases. If the Italian shoes cost $336, an American maker can raise prices too.

This kind of currency- and import-driven pricing pressure won't put an end to Alan Greenspan's deflation worries. But they do make actual deflation less likely.

So much for the positive effects on the economy. Now what does the tax cut do for the stock market?

Timing and the Tax Cut

Most projections have focused on the power of cuts in the dividend tax rates to push stock prices higher. The theory was investors would be willing to pay more for stocks if a tax cut increased the post-tax value of a dividend. The Bush administration estimated that the jump in stock prices might amount to 8%.

While the cut in the tax rate for dividends has certainly helped lift dividend-rich stocks such as utilities, the structure and complexity of the final dividend-cut provisions in the bill doesn't give me any faith in economists' or analysts' ability to project exactly how much of an increase in price that cut in dividends is worth.

Instead, I think the tax cut has pushed up prices because it was signed at a time when the market was already rallying. Its passage added more momentum to the recent move off the March 11 bottom.

But I suspect most of the intended effect of that cut in dividends is now priced into stocks.

Earnings Surprises Ahead?

The unintended effects released by the fall in the dollar aren't priced in, however. Most of the stories investors have read about the dollar have emphasized the negative effects rather than the positive short-run benefits to corporate profits from a weaker dollar.

That creates the possibility for earnings surprises in the second quarter that aren't yet in the price of stocks. And it increases the possibility that companies will issue positive earnings guidance for the rest of the year when they report those second-quarter results.

With investors having set expectations so low for second-quarter earnings, even modest surprises in those July reports could extend the current advance in stock prices.

The effects of the weaker dollar created by this tax bill are no less powerful, even if unintended.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EDT. At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.