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AS ECONOMISTS MARK UP their estimates of the first quarter's economic growth, the least relevant question for investors is what number the Commerce Department will publish Friday for gross domestic product. Three percent? Four percent?

Vastly more important is whether rebound of the last two quarters is sustainable, given certain contractionary changes in fiscal and monetary policy, perhaps starting late this year and certainly in 2011.

As the tax law currently stands, the Bush tax cuts are due to expire (or "sunset" in the semi-literate usage of Washington bureaucrats who never saw a noun they didn't want to use as a verb) at the end of the year.

That would mean all joint filers with incomes over $67,900 would see tax hikes, with the top bracket returning to 39.6%. The investor-friendly 15% top rate on dividends and capital gains also will end; dividends will revert to being taxed at ordinary-income rates while cap gains levies return to 20% under current law.

The Obama administration proposes limiting the increases on earned income to the two top brackets, taxing dividends and cap gains at 20%, while proposing limiting deductions, such as for mortgage interest and charitable deductions, for those in the highest brackets. These all would require Congressional approval, however, which is by no means certain.

If Congress fails to act, Citigroup economists Steven C. Wieting and Peter D'Antonio estimate the tax hikes would take a huge, 2% bite out of 2011 GDP. For that reason, they look for something less draconian, close to what the White House proposes, to pass Congress, resulting in a 1% hit to GDP.

But they do not expect these tax hikes to derail the recovery. For one thing, tax revenues will rise from an increase in employment and income, an outcome earnestly desired all around. Moreover, just as tax and interest-rate cuts of 2007 and 2008 didn't prevent the worst recession since the Great Depression, neither will the coming tax and rate hikes stop the recovery, the economists contend.

But, Wieting and D'Antonio also acknowledge that while the one-shot tax rebates of 2001 and 2003 had minimal stimulative effect, "an argument can be made that the 'permanent' income-tax-rate reductions that followed in 2003 more lastingly swayed expectations."

In other words, there are taxes and there are taxes. Short-term changes in taxes and spending have limited, transitory effects on economic activity while permanent changes affect how people and businesses work, save and invest to create real wealth.

Among Milton Friedman's greatest contribution to economics was his Permanent Income Hypothesis, which found that people, by and large, weren't drunken sailors. Their spending depends on their long-term income prospects, so a one-shot boost has little impact on the economy.

Conversely, the coming tax hikes are permanent and are likely to have lasting effects. Even if the hikes are confined to couples making over $250,000, who comprise just 5% of the population, this cohort accounts for 30% of personal income, Wieting and D'Antonio point out.

"Also note that the highest income brackets represent a preponderance of small businesses, and account for a disproportionably large share of spending. So, sharply raising tax rates in the top brackets should have a quite measurable, large effect on the economy, far in excess of the population share. This then affects employment and income more broadly," they write.

As for the impact from the increases on taxes on capital, the question is how negative they will be. There's no telling, given that nobody knows what future taxes on dividends and capital gains are likely to be.

That uncertainty alone has a cost, the Citi economists say. The worst case -- dividends taxed as high as 39.6% and a 3.8% additional Medicare tax on top earners starting in 2012 -- would reduce the present value of the U.S. stock market by 10%-15%, they estimate.

None of this takes into account the impact of monetary policy. As the Federal Open Market Committee gathers for a two-day meeting that will break up Wednesday, the panel will mull eventual increases in its 0-0.25% federal-funds rate target and, perhaps more importantly, when to reverse its "quantitative easing" -- the $1.75 trillion in purchases of long-term Treasuries, U.S. agency securities and agency mortgage-backed securities.

QE arguably has provided the main impulse for the rebound in the capital and equity markets, but it has failed to fuel an expansion in money and credit. To use the tired cliché, the benefits of the Fed's policy have flowed mainly to Wall Street rather than Main Street. At some point, the central bank will reverse course to normalize policy, perhaps late this year or more likely in 2011.

That would add up to a tightening in both fiscal and monetary policies next year, which would be analogous to the move to restrictive policies in 1937. Then, taxes were increased and the Fed effectively absorbed the excess reserves in the banking system.

The contractionary fiscal and monetary moves of 1937 precipitated the second phase of the Great Depression, all out of misplaced fears of inflation. History, it's said, doesn't repeat but it rhymes.

While the markets concentrate on the recent history of first-quarter results, they also ought to take note of the ancient history of the 'Thirties.

Comments: randall.forsyth@barrons.com