Ways and Means Chairman Archer Inaugurates ACCF's 25th Anniversary

Fundamental Tax Reform: Impact on Economic Growth

ACCF President Mark Bloomfield Testifies Before Ways and Means

Ways and Means Chairman Archer Inaugurates ACCF's 25th Anniversary

“If we are really interested in encouraging capital formation, we need to accept the premise that any income tax places a burden on saving. I want to abolish the income tax and tax spending so that we have a zero tax on saving," House Ways and Means Committee Chairman Bill Archer (R-TX) said at the February 4 Capital Formation Forum sponsored by the American Council for Capital Formation. Mr. Archer is a longtime advocate of tax reform to raise the level of saving and investment in the United States in order to promote strong and sustained economic growth and job creation.

Chairman Archer's remarks at the Capital Formation Forum inaugurated the ACCF's 25th anniversary year. The Texas Congressman told the capacity crowd that "no other organization has done more to promote sound public policies to encourage saving and investment over the past two and one-half decades than the American Council for Capital Formation." He added that he took great pride in helping the ACCF celebrate its quarter of a century of "valuable contributions to tax, regulatory, and environmental policies."

Speaking to ACCF supporters before the Ways and Means Committee opened its hearings on proposals to reduce the federal tax burden, Chairman Archer explained that he would like to take steps in 1998 to simplify the tax code. However, he said, "this may be a year to 'catch our breath' rather than make significant changes. I would like to say we can reduce the capital gains tax rate to 15 percent and eliminate the corporate alternative minimum tax this year, but I can't. It's far more likely that the 1998 tax bill will be devoted primarily to tax relief for middle-income taxpayers, which will give many people a greater opportunity to save." He added that he would like to cut the new 18-month holding period for long-term capital gains back to 12 months and perhaps enact a modest exclusion for dividends and interest.

Turning to President Clinton's 1999 budget released earlier in the week, Chairman Archer noted that it proposed a series of "loophole" closers, adding, "Of course, we need to close 'loopholes' that go beyond the intent of Congress. However, there are some proposals, notably the suggested taxation of exchanges between annuities, that we have to fight because they impede saving and investment."

"This year what Congress does to block anti-capital formation proposals may be as important as making substantial progress in enacting pro-saving and -investment initiatives," Chairman Archer concluded.

Fundamental reform of the U.S. federal tax code continues to interest policymakers, the public, and the business community. A key question, however, is whether fundamental reform would be worth the inevitable disruption, cost, and confusion that switching to a totally new system would create. Several new analyses by academic scholars and government policy experts suggest that substituting a broad-based consumption tax for the current federal income tax could have a positive impact on economic growth and living standards.

Auerbach, et al. Analysis

"Simulating U.S. Tax Reform," by Professors Alan Auerbach of the University of California and Laurence J. Kotlikoff of Boston University, Drs. Kent A. Smetters and Jan Walliser of the Congressional Budget Office (CBO), and David Altig of the Federal Reserve Bank of Cleveland, analyzes the impact of fundamental tax reform on equity, efficiency, and economic growth.¹

Auerbach et al. define "fundamental tax reform" as simplifying and integrating the tax code. Simplification means eliminating most deductions and tax preferences in both the corporate and personal tax codes, and integration means applying common marginal rates to all sources of capital income independent of the point of collection.

The Model

The analysis uses a general equilibrium model developed by Professors Auerbach and Kotlikoff to examine five tax reforms spanning the major proposals now under discussion. Each of the reforms replaces the federal personal and corporate income taxes, and each is simulated assuming the same growth-adjusted levels of government spending and government debt. The reforms are a) a "clean" income tax; b) a "clean" consumption tax; c) a Hall-Rabushka flat tax; d) a Hall-Rabushka flat tax with transition relief; and e) Princeton University Professor David Bradford's "X tax."

The clean income tax eliminates all personal exemptions and deductions, and taxes labor and capital income at a single rate. The clean consumption tax differs from the clean income tax by permitting expensing of new investment (meaning that the total cost is deducted in the first year). This tax is implemented as a tax on wages with all saving exempt from tax at the household level, and as a cash-flow tax on businesses.

The Hall-Rabushka flat tax differs from the consumption tax by including a standard deduction against wage income and by not taxing the rental value of owner-occupied housing and the value of services provided by consumer durables. The flat tax with transition relief permits continued depreciation of capital in existence as of the reform. Finally, the Bradford X tax combines a progressive wage tax with a business cash-flow tax where the business cash-flow tax rate equals the highest tax rate applied to wage income.

Results

The clean income tax raises the long-run level of output by over 5 percent, and generates sizable increases in the capital stock and the supply of labor. However, the reform hurts lower-income individuals whose burden under the current tax system is low due to its deductions and exemptions.

The clean consumption tax raises long-run output by almost 11 percent. This reform proposal reduces the welfare of the generation who are middle-aged and elderly at the time of the reform because they have already paid income tax on previous saving, but their losses mean more national saving, investment, and utility for most future generations. In addition, eliminating the progressivity of the existing tax structure lowers the welfare of the poorest members of society in the long run by roughly 4 percent.

The Hall-Rabushka flat tax's standard deduction alleviates some of the distributional concerns raised by the clean income and clean consumption taxes, but increases the tax rate needed to satisfy the government's long-term budget needs. Consequently, the long-run income gain is only 6 percent. Although the flat tax's standard deduction insulates the poor from welfare losses, it hurts some middle-income groups in the early phases of the transition, and its tax on capital hurts high-income elderly at the time of the reform.

Adding transition relief to the flat tax limits the welfare losses of capital owners at the time of the reform. But this modification of the flat tax reduces aggregate income gains further, with long-run output now rising by only 3.6 percent. Furthermore, because replacement tax rates must increase to compensate for the lost revenue associated with transition relief, all but the richest and poorest lifetime-income groups suffer welfare losses in the long run.

The Bradford X tax, which raises long-term output by 7.5 percent, provides no transition relief from its expensing provisions. It also hits the rich with higher marginal tax rates than the poor. It is not surprising, then, that in the long run the X tax helps those who are poor by more than it helps those who are rich, the authors note. Still, under the X tax there are no long-run losers; even the rich are better off.

Auerbach et al. conclude that fundamental reform of the U.S. tax system can offer significant economic gains. However, those gains come at the economic sacrifice of certain groups. Transition relief and adjustments that prevent adverse distributional effects lessen the positive impact of tax reform on the economy.

Joint Committee on Taxation Analysis

The Joint Committee on Taxation's "Tax Modeling Project and 1997 Tax Symposium Papers" summarize the results of a number of scholars who compared the macroeconomic consequences of a broad-based unified income tax (a "clean" income tax in Auerbach's terminology) to those of a broad-based consumption tax.²

The Models

The Joint Committee on Taxation (JCT) invited a group of academic, commercial, and government economists to participate in the modeling project. Participants included Roger E. Brinner, DRI/McGraw-Hill; Eric M. Engen, Federal Reserve Board of Governors; Jane G. Gravelle, Congressional Research Service; Dale W. Jorgenson, Harvard University; Laurence J. Kotlikoff, Boston University; Joel L. Prakken, Macroeconomic Advisers; Gary Robbins, Fiscal Associates; Diane Lim Rogers, CBO; Kent A. Smetters, CBO; Peter J. Wilcoxen, University of Texas; John G. Wilkens, Coopers & Lybrand; and Jan Walliser, CBO.

Most of the participants in this project had already developed models to simulate some form of consumption-based tax reform. JCT staff worked with participants to standardize both the restructuring proposals to be simulated and the accompanying fiscal and monetary "framework" assumptions, developing two generic tax restructuring proposals that could be simulated by all participants. In addition, the JCT staff and the participants agreed on a set of common assumptions about the paths of state, local, and federal government spending; monetary policy; and government deficits to be followed as closely as possible.

The two types of tax restructuring proposals simulated were a broad-based unified income tax and a consumption tax. The unified income tax proposal included three types of changes to the tax code: (1) integrating the corporate and individual income taxes; (2) broadening the tax base; and (3) flattening the individual income tax rate schedules. Corporate and individual income tax systems are integrated by repealing the taxation of dividend income and excluding from capital gains the pro rata share of retained earnings in the taxable income of corporate stockholders, insuring that corporate income is taxed only once. Depending on modeling capabilities, the participants could simulate the consumption tax as either a value-added tax or as a consumption-based flat tax. The two variations were designed to have economically equivalent tax bases, and to be extended into the future for 10 to 50 years, depending on the capability of the model.

Results

The results of the simulations are shown in Table 1. The effects of the consumption tax proposals on GDP are generally positive over the medium and long terms, although the magnitude of these effects varies widely. For example, the Jorgenson-Wilcoxen model predicts that under a consumption tax real GDP would be 3.3 percent higher each year in the long run compared to 1.3 percent higher under a unified income tax. The Auerbach, Kotlikoff, Smetters, and Walliser model predicts even greater gains in the long run (7.5 percent) under a consumption tax and losses (-3.0 percent) of GDP under a unified income tax. Similarly, the Engen-Gale analysis shows that the capital stock would be 9.8 percent higher in the long run under a consumption tax but 1.6 percent smaller under a unified income tax compared to current law.

Table 1	Impact of Tax Reform on GDP and Capital Stock Growth Percent differences from current tax code baseline
	Consumption Tax			Unified Income Tax
Summary variables	2005	2010	Long run	2005	2010	Long run
REAL GDP
Fullerton-Rogers-low1	-	-	1.7	-	-	1.8
Fullerton-Rogers-high2	-	-	5.8	-	-	3.8
Auerbach, Kotlikoff, Smetters, & Walliser	4.0	5.0	7.5	-1.7	-2.1	-3.0
Engen-Gale	1.8	2.1	2.4	-0.2	-0.3	-0.5
Jorgenson-Wilcoxen	3.6	3.3	3.3	1.6	1.4	1.3
Macroeconomic Advisers (transition relief)	1.4	1.3	5.4	-	-	-
Robbins	16.4	16.9	-	14.6	15.4	-
DRI Inc./McGraw-Hill	4.7	-	-	-1.1	-	-
DRI Inc./McGraw-Hill-"VAT"	-4.2	-	-	-	-	-
Gravelle	0.7	1.0	3.7	0.6	0.7	1.8
Coopers & Lybrand	1.2	-	-	1.1	-	-
CAPITAL STOCK
Fullerton-Rogers-low1	-	-	5.2	-	-	5.4
Fullerton-Rogers-high2	-	-	23.8	-	-	11.8
Auerbach, Kotlikoff, Smetters, & Walliser	14.0	19.1	31.5	-4.2	-5.9	-10.5
Engen-Gale	7.0	7.6	9.8	-0.7	-1.0	-1.6
Jorgenson-Wilcoxen	0.9	0.6	0.3	-2.0	-2.3	-2.6
Macroeconomic Advisers (transition relief)	4.3	4.8	13.2	-	-	-
Robbins	47.0	57.2	-	38.8	48.6	-
DRI Inc./McGraw-Hill	13.7	-	-	-1.5	-	-
DRI Inc./McGraw-Hill-"VAT"	-0.7	-	-	-	-	-
Gravelle	1.7	2.7	11.2	0.5	0.9	4.1
Coopers & Lybrand	1.5	-	-	1.1	-	-
1. Assumes leisure-consumption (intratemporal) and intertemporal elasticities both are 0.15. 2. Assumes leisure-consumption (intratemporal) and intertemporal elasticities both are 0.50. Source: Adapted from Joint Committee on Taxation, "Tax Modeling Project and 1997 Tax Symposium Papers," November 20, 1997.

Congressional Budget Office Analysis

In "The Economic Effects of Comprehensive Tax Reform," CBO analyzes the effect of switching from the federal income tax to a comprehensive consumption-based tax-a tax that would exempt the return from capital and treat all forms of investment more uniformly.³

The Model

The CBO study uses a general equilibrium model developed by University of Texas's Don Fullerton and Diane Lim Rogers of CBO to simulate some of the potential effects of replacing the current federal corporate and individual income tax system with a generic, broad-based consumption tax. The results of the simulation illustrate only the general effects of a comprehensive consumption tax reform with no deductions or exemptions and no relief for owners of existing assets during the transition.

The Fullerton-Rogers model captures the shifts in resources from eliminating capital income taxation, integrating personal and corporate taxes, and achieving greater neutrality among types of capital. It also includes the effects from redistributing income among different types of households (young and old, rich and poor).

Results

CBO's analysis shows that substituting a broad-based consumption tax for an income tax would probably increase national saving and ultimately raise the living standards of future generations. It would increase the capital stock and raise the level of national output by between 1 percent and 10 percent, although CBO concludes that increases at the upper end of that range are unlikely.

The reform might be expected to increase economic efficiency as well as output for a number of reasons, according to the CBO study. First, the switch to a consumption base would eliminate the influence of taxes on the timing of consumption. Second, the new system might treat different sources' uses of income more uniformly by including more of them in the tax base and subjecting all of them to similar tax rates. Third, a broader base would allow lower overall marginal tax rates, reducing the amount by which taxes affect relative prices and hence all kinds of economic decisions. CBO notes, however, that efficiency is not the only criterion to use in judging the desirability of tax reform. Administrative and compliance costs are other important factors. If a consumption tax offered substantial gains from reduced complexity, then even a minimal gain in economic efficiency would be an added bonus.

Skinner and Engen Analysis

Another relatively recent study, "Taxation and Economic Growth" by Eric M. Engen of the Federal Reserve Board of Governors and Professor Jonathan Skinner of Dartmouth College, examines evidence on taxation and growth for a large sample of countries.⁴ The type of tax system a country chooses is important, according to Engen and Skinner. Figures 1 and 2 show the correlation in the OECD countries between income taxes and economic growth and between consumption taxes and economic growth over the period 1965-1991. These scatter plots, largely confirmed in regression analysis, suggest that income taxation is more harmful to growth than broad-based consumption taxes, the authors note. Engen and Skinner's study also suggests that tax policy does affect economic growth and that lower tax rates do enhance economic growth. For example, a major tax reform plan which reduces marginal tax rates by 5 percentage points will increase growth by 0.2 to 0.3 points.

Figure 1	Growth and the Capital Income Tax	Figure 2	Growth and the Consumption Tax
Source: E.G. Mendoza, G.M. Milesi-Ferretti, and P. Asea. "On the ineffectiveness of tax policy in altering long-run growth: Harberger's superneutrality conjecture." Journal of Public Economics 66 (1): 101-128 (October 1997). Engen and Skinner (1996) cited a 1996 mimeo version of this work.

Even modest growth effects can have an important long term impact on living standards, Engen and Skinner note. For example, suppose that an inefficient structure of taxation has, since 1960, retarded growth by 0.2 percent annually. Accumulated over the past 36 years, the lower growth rate translates to a 7.5 percent lower level of GDP in 1996, or a net reduction in output of more than $500 billion annually. Thus, the potential effects of tax policy, although difficult to detect in the time-series data, can have potentially very large effects over the long term.

Conclusions

The results of the studies described above suggest that fundamental tax reform and more reliance on consumption taxes could have a profound positive effect on long-term economic growth. Even small changes in economic growth rates can make a big difference in living standards. As the United States faces the economic challenges of the twenty-first century, fundamental tax reform can be an important policy lever for achieving stronger economic growth and higher living standards.

Notes

1. Alan J. Auerbach, David Altig, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser, "Simulating U.S. Tax Reform," NBER Working Paper No. 6248 (Cambridge, Mass.: National Bureau of Economic Research, October 1997).
2. Joint Committee on Taxation, "Tax Modeling Project and 1997 Tax Symposium Papers," November 20, 1997.
3. Congressional Budget Office, "The Economic Effects Comprehensive Tax Reform," July 1997.
4. Eric M. Engen and Jonathan Skinner, "Taxation and Economic Growth," NBER Working Paper No. 5826 (Cambridge, Mass.: National Bureau of Economic Research, November, 1996).

ACCF President Mark Bloomfield Testifies Before Ways and Means

ACCF President Mark Bloomfield, accompanied by ACCF Senior Vice President and Chief Economist Margo Thorning, appeared as a committee-invited witness at a hearing before the House Committee on Ways and Means on February 12. The hearing examined the impact of tax reform on U.S. saving, investment, and economic growth. Mr. Bloomfield argued that fundamental tax reform-which several new studies show could enhance economic growth-should be a key long-term goal of U.S. policymakers. In addition, he urged the Committee to take interim steps to promote saving and investment, including reducing the 18-month holding period for capital gains, expanding IRAs, and strengthening the pension system.