The Impact of Tax Reform on U.S. Saving,
Investment and Economic Growth

American Council for Capital Formation
February 12, 1998

Introduction

ACCF President Mark Bloomfield, accompanied by ACCF Senior Vice President and Chief Economist Dr. Margo Thorning, testified as a committee-invited witness on February 12, 1998, before the Committee on Ways and Means of the U.S. House of Representatives. The executive summary and full text of the ACCF's testimony are presented here.

Executive Summary

1. Overview. The ACCF strongly supports the emphasis Ways and Means Committee Chairman Bill Archer has placed on the significance of saving and investment for economic growth. Tax policy should be supportive of capital formation if real wages for U.S. workers are to increase, living standards are to advance at a faster pace, and the United States is to maintain the economic strength necessary to sustain its leading role in world affairs.

2. Impact of Tax Policy on Saving, Investment, and Economic Growth. The Ways and Means Committee is to be commended for its role in the pro-capital formation provisions in the Taxpayer Relief Act of 1997. We must now move ahead to further pro-saving and pro-investment tax policy initiatives. In order to maintain strong economic growth as we move into the twenty-first century, the United States must address new challenges such as demographic changes, more stringent environmental regulations, and inadequate levels of U.S. saving and investment.

3. Recent Evidence on the Impact of Tax Policy on Economic Growth. To those who favor a truly level playing field over time to encourage individual and business decisions to save and invest, thus promoting economic growth, capital gains and other saving should not be taxed at all. The key question is whether a totally new system would be worth the inevitable disruption, cost, and confusion the switch would create. Several new analyses 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.

4. Unfinished Business in Tax Policy Reform

a. Short-Term Agenda. While the long-term goal of U.S. federal tax policy should be to shift toward a broad-based consumption tax under which all income that is saved is exempt from tax, in the short term there are steps forward the Committee should take and steps backward the Committee should avoid.

• Steps Forward. We urge the Committee to shorten the 18-month holding period for capital gains; enact further reductions in individual capital gains rates; cut the corporate capital gains rate to restore the historic parity between individual and corporate capital gains; further expand IRAs; restore the dividend and interest received exclusion; and strengthen the pension system.
  
  
• Steps Backward. We urge the Committee to weigh carefully the proposals, including revenue raisers, that President Clinton has made to ensure that any negative impact on saving and investment is minimized.

b. Long-Term Goals. Voter discontent with the income tax; recognition that today's balanced budget is likely to be relatively short-lived; growing awareness that the U.S. tax code is biased against saving and investment; increasing concern with tax impediments to the ability of U.S. firms to compete in the global marketplace; and growing expert opinion that tax reform could raise total output all argue that fundamental tax reform should be a key long-term goal of U.S. policymakers.

5. Conclusion. Persistently low U.S. saving rates, despite good economic growth and low unemployment, indicate that short-term policy changes are needed to reverse this pattern. Over the long-term, as the United States faces the economic challenges of the twenty-first century, fundamental tax reform that moves the U.S. tax system toward greater reliance on consumption taxes can be an important policy lever for achieving stronger economic growth and higher living standards.

ACCF Statement

Introduction

My name is Mark Bloomfield. I am president of the American Council for Capital Formation (ACCF). I am accompanied by Dr. Margo Thorning, our senior vice president and chief economist.

The ACCF represents a broad cross-section of the American business community, including the manufacturing and financial sectors, Fortune 500 companies and smaller firms, investors, and associations from all sectors of the economy. Our distinguished board of directors includes cabinet members of prior Republican and Democratic administrations, former members of Congress, prominent business leaders, and public finance experts.

The ACCF is now celebrating its twenty-fifth year of leadership in advocating tax and regulatory policies to increase U.S. saving, investment, and economic growth. Our testimony today begins with a discussion of trends in U.S. capital formation and the impact of tax policy on economic growth. Next, we outline a short-term tax policy agenda, including shortening the 18-month capital gains holding period, reducing individual and corporate capital gains tax rates, expanding saving incentives such as Individual Retirement Accounts (IRAs), restoring the dividend and interest exclusion, and strengthening the pension system. We conclude with options for long-term, fundamental tax reform. These policies will promote increased U.S. saving and capital formation and lead to strong and sustainable economic growth as our nation enters the twenty-first century.

We vigorously support the emphasis that Chairman Archer has placed on the significance of saving and investment for economic growth. Tax policy should be supportive of capital formation if real wages for U.S. workers are to increase, living standards are to advance at a faster pace, and the United States is to maintain the economic strength necessary to sustain its leading role in world affairs.

The Impact of Tax Policy on Saving, Investment, and Economic Growth

The Ways and Means Committee is to be commended for its role in the pro-capital formation provisions in the Taxpayer Relief Act of 1997, including the reduction in individual capital gains tax rates, expansion of IRAs, estate and gift tax relief, and reform of the corporate alternative minimum tax.

We must now move ahead to further pro-saving and pro-investment tax policy initiatives. Although the short-term outlook for the U.S. economy suggests continued growth, long-term strength and economic stability require well-thought-out changes in tax policy. In order to maintain strong economic growth as we move into the twenty-first century, the United States must address new challenges such as the demographic changes that will leave us with a smaller ratio of workers to retirees, more stringent environmental regulations, and inadequate levels of U.S. saving and investment over the long term. Without sufficient saving and investment and cost-effective regulatory policies, the United States cannot continue indefinitely to enjoy one of the highest living standards in the world.

Investment spending in the United States in recent years compares unfavorably with that of other nations as well as with our own past experience. From 1973 to 1995, gross nonresidential investment as a percent of gross domestic product (GDP) was lower for the United States than for any of our major competitors (see Table 1). The U.S. net saving rate during the same period is also low relative to that of most other industrialized countries, averaging 5.9 percent compared to 18.8 percent in Japan, 10.4 percent in West Germany, and 8.0 percent in Canada. Though the U.S. economy is currently performing better than the economies of most other developed nations, in the long run our low saving and investment rates will inevitably result in a growth rate far short of our true potential.

Table 1	Saving and Investment as a Percent of Gross Domestic Product, 1973-1995
	United States	Canada	Japan	France	West Germanya	Germanyb	United Kingdom
SAVING
Net saving1	5.9%	8.0%	18.8%	9.1%	10.4%	8.4%	5.0%
Personal saving2	6.3%	6.9%	11.8%	7.6%	8.2%	8.0%	4.2%
Gross saving (net saving plus consumption of fixed capital)3	17.6%	19.6%	32.6%	21.3%	22.6%	21.4%	16.3%
INVESTMENT
Gross nonresidential fixed capital formation	13.7%	15.2%	24.1%	15.0%	14.5%	15.6%	14.2%
Gross fixed capital formation	18.2%	21.5%	30.4%	21.0%	20.5%	22.3%	17.8%
Notes: 1. The main components of the OECD definition of net saving are: personal saving, business saving (undistributed corporate profits), and government saving (or dissaving). The OECD definition of net saving differs from that used in the National Income and Product Accounts published by the Department of Commerce, primarily because of the treatment of government capital formation. 2. Personal saving is comprised of household saving and private unincorporated enterprise. 3. The main components of the OECD definition of consumption of fixed capital are the capital consumption allowances (depreciation charges) for both the private and the government sector. a. The statistics for West Germany refer to western Germany (Federal Republic of Germany before unification). The data cover the years 1973-1995. b. The statistics for Germany refer to Germany after unification. The data cover the years 1991-1995. Source: Derived from National Accounts, Vol. II, 1973-1985, 1981-1993, and 1983-1995. Organization for Economic Cooperation and Development (OECD), 1987, 1995, and 1997 eds. Prepared by the American Council for Capital Formation Center for Policy Research, February 1998.

International comparisons aside, even more disturbing is the fact that net business investment in this country has in recent years fallen to less than 60 percent of the level of the 1960s and 1970s. Net private domestic investment averaged 8.9 percent of GDP from 1960 to 1980; since 1991, it has averaged only 5.6 percent (see Table 2). The U.S. net private domestic saving rate, a key determinant of U.S. investment, has also fallen sharply from an average of 8.1 percent in the 1960-1980 period to only 5.7 percent of GDP in the 1990s.

Numerous scholarly studies by top-flight experts such as Harvard University's Dale W. Jorgenson, University of California's J. Bradford De Long, Treasury Deputy Secretary Lawrence Summers, and others conclude that investment in plant and equipment is the key factor in increasing productivity and economic growth. Thus, tax policy to promote higher levels of saving and investment is critical to the United States' future prosperity.

Recent Evidence on the Impact of Tax Policy and Economic Growth

To those who favor a truly level playing field over time to encourage individual and business decisions to save and invest, stimulate economic growth, and create new and better jobs, savings (including capital gains) should not be taxed at all. This view was held by top economists in the past and is held by many mainstream economists today.

This is primarily because the income tax hits saving more than once-first when income is earned, and again when interest and dividends on the investment financed by saving are received, or when capital gains from the investment are realized. The playing field is tilted away from saving and investment because the individual or company that saves and invests pays more taxes over time than if all income were consumed and no saving took place. Taxes on income that is saved raise the capital cost of new productive investment for both individuals and corporations, thus dampening such investment. As a result, future growth in output and living standards is impaired.

While fundamental reform of the U.S. federal tax code continues to interest policymakers, the public, and the business community, the key question is whether a totally new system would be worth the inevitable disruption, cost, and confusion the switch 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. The macroeconomic models used by the scholars in the studies described below incorporate feedback and dynamic effects in simulating the impact of adopting either a broad-based consumption tax or a "pure" income tax.

For example, in "Simulating U.S. Tax Reform," 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 analyze the impact of fundamental tax reform on equity, efficiency, and economic growth.¹

The authors use 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 "clean" income tax and four types of consumption taxes. These consumption taxes are: a) a "clean" consumption tax; b) a Hall-Rabushka flat tax; c) a Hall-Rabushka flat tax with transition relief; and d) 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 of the investment 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.

Auerbach et al. conclude that switching to a consumption tax can offer significant economic gains. The Bradford X tax, to which the authors give the highest marks for its impact on equity, efficiency, and economic growth, raises long-term output by 7.5 percent and 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. Transition relief and adjustments that prevent adverse distributional effects lessen the positive impact of tax reform on the economy.

Another recent study, the Joint Committee on Taxation's "Tax Modeling Project and 1997 Tax Symposium Papers," summarizes 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 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.

The economic impact of a "pure" income tax compared to a "pure" consumption tax is shown in Table 3. 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. The consensus seems to be that the economy would fare better under a "pure" consumption tax than under a "pure" income tax or under current law.

In still another new report, "The Economic Effects of Comprehensive Tax Reform," CBO analyzes the effect of switching from the federal income tax to a comprehensive consumption-based tax, using a general equilibrium model developed by University of Texas's Don Fullerton and Diane Lim Rogers of CBO.³

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.

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 significantly affects that nation's prospects for long-term economic growth, 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.

The new studies described above reach the same conclusion about the beneficial effect on economic growth of switching to a broad-based consumption tax as earlier research by scholars such as Lawrence Goulder of Stanford University, Dale Jorgenson of Harvard University, and Joel Prakken of Macroeconomic Advisers.⁵

Unfinished Business in Tax Policy Reform: Short-Term Agenda

The long-run goal of U.S. federal tax policy should be to shift toward a broad-based consumption tax under which all income that is saved is exempt from tax. In the short term, there are steps forward the Ways and Means Committee should take and steps backward the Committee should avoid. With regard to the latter, President Clinton has made proposals, including revenue raisers, that the Committee must weigh carefully to ensure that they minimize any negative impact on saving and investment. As to the former, we will comment on new saving and investment incentives and modifications to the capital gains law, as requested in the notice of this hearing.

• Shorten the 18-Month Holding Period for Capital Gains
  
  The 1997 tax act contained a substantial reduction in individual capital gains tax rates. For example, the Taxpayer Relief Act of 1997 reduced the top capital gains rate from 28 to 20 percent on assets held for 18 months or longer. Under prior law, the holding period for a long-term gain was only 12 months. While the capital gains tax rate reduction with a 12-month holding period was estimated by Allen Sinai of Primark Decision Economics and David Wyss of DRI/McGraw-Hill to reduce capital costs by three to four percent, the requirement that assets be held for 18 months rather than 12 months as under prior law tends to diminish the effectiveness of the tax cut. The longer the required holding period before an investor can realize a capital gain, the greater the risk. A higher risk premium means a higher cost of capital; thus less investment will be planned than if the holding period were 12 months. The 18-month holding period also adds an unnecessary layer of complexity to the code. For example, prior to the Taxpayer Relief Act of 1997, Schedule D, the IRS form for reporting capital gains and losses, had only 23 lines. The Schedule D for 1997 contains 54 lines—more than double the previous number.
  
  In addition, most of our international competitors have a holding period for long-term capital gains of one year or less (in fact, many exempt long-term gains from tax). Restoring the 12-month holding period would be a positive step toward lightening taxes on saving and investment.
  
  
• Cut Individual Capital Gains Tax Rates
  
  Additional capital gains tax reductions would help move the U.S. tax code toward a consumption tax base and enhance economic growth. Previous studies by Allen Sinai and David Wyss show that individual capital gains tax rates in the 14 percent to 15 percent range have stronger positive effects on capital costs, saving, and investment than does a top rate of 20 percent. Further reductions in the individual tax rate reduce the cost of capital and increase investment, GDP, productivity growth, and employment. Also, such a tax cut would essentially be revenue neutral, when unlocking and macroeconomic consequences are included.
  
  In addition, a 1997 CBO report documents the widespread ownership of capital assets among middle-income taxpayers. According to the CBO report, in 1989, 31 percent of families with incomes under $20,000 held capital assets (not including personal residences) and 54 percent with income between $20,000 and $50,000 held capital assets.⁶
  
  
• Reduce Corporate Capital Gains Tax Rates
  
  The 1997 tax reforms failed to include a reduction in the corporate capital gains tax from the 35 percent rate in effect since the 1986 Tax Reform Act, although such a measure was included in the bill reported out by this Committee and later passed by the House. Reducing corporate capital gains tax rates would also help move the U.S. tax code toward a consumption tax base by lightening the burden on income from investment. It could also help increase the federal revenues needed to assure projected budget surpluses, according to reputable econometric analyses.
  
  The failure to reduce corporate capital gains tax rates in conjunction with the 1997 individual rate cuts heightens the inequities already inherent in the double taxation of corporate profits under current law, leading to excessive tax planning, and may accentuate the trend away from the traditional corporate form of organization.
  
  Compared to other industrialized nations, the United States taxes corporate capital gains very harshly. The United States taxes corporate capital gains at the ordinary income rate of 35 percent, does not provide for indexation of such gains for inflation, and does not allow capital losses to be used to offset ordinary income. These last two factors increase the risk, and therefore the cost of capital, for corporate investments expected to yield capital gains. Fourteen out of 16 countries surveyed tax corporate capital gains more favorably than does the United States, either through lower tax rates, by allowing capital losses to offset ordinary income, or by indexing gains for inflation. For example, Germany, the Netherlands, Japan, and Korea permit corporate capital losses to be deducted from ordinary income, and France taxes corporate capital gains at 18 percent. In several of the Pacific Basin countries such as Hong Kong, Singapore, and Malaysia, corporate capital gains are exempt from taxes.
  
  We therefore urge the committee to restore the historic parity between individual and corporate capital gains tax rates.
  
  
• Expand Individual Retirement Accounts
  
  Under the Taxpayer Relief Act of 1997, the traditional "front-loaded" (tax-deductible) IRAs were substantially expanded and were made more flexible through the addition of penalty-free withdrawal options. In addition, two new types of "back-loaded" IRAs were created-the Roth IRA PLUS and the education IRA. Specifically, income limits on the traditional deductible IRAs were phased-up over time. The income limits for the $2,000 IRA deduction, which under prior law phased out between $40,000 and $50,000 of adjusted gross income for joint returns and $25,000 and $35,000 for individuals, are increased gradually beginning in 1998 when the income phase-out range will be between $50,000 and $60,000 of adjusted gross income for joint returns and $30,000 and $40,000 for individuals, until 2007, when the income phase-out range will be between $80,000 and $100,000 for joint returns and $50,000 and $60,000 for individuals.
  
  Further expansion of the income limits and contribution ceilings for both front- and back-loaded IRAs-in particular the education IRA, which is limited to only $500 per year-would help move the U.S. tax system toward a consumption tax base by lightening the tax burden on saving. Prominent public finance economists and scholars, including former Council of Economic Advisers Chairman Martin Feldstein; Treasury Deputy Secretary Lawrence Summers; and Professors David A. Wise of Harvard University; James M. Poterba of Massachusetts Institute of Technology; Steven E. Venti and Jonathan Skinner of Dartmouth College; and Richard A. Thaler of Cornell University, have concluded that IRAs—especially tax-deductible IRAs—do result in new saving.
  
  More than a dozen scholarly studies, using a variety of data sources and employing several different statistical approaches, have examined whether targeted saving vehicles such as IRAs impact saving. For example, Professor Steven Venti's testimony before a Senate Finance Subcommittee in 1994 examined saving data from a Survey of Income and Program Participation for three different age groups (families reaching age 60-64 in 1984, 1987, and 1991).⁷ Professor Venti found a striking increase in saving the longer the family has been exposed to the targeted retirement programs: IRAs, 401(k)s, and Keoghs.
  
  The growth in IRA asset balances is astounding, Professor Venti noted. The typical member of the youngest age group family-with nine years of exposure to targeted retirement saving programs-has nearly three times the targeted retirement assets of the oldest group. There is a comparable increase in total assets as well. In contrast, among families without IRAs, the youngest families have only about 75 percent the financial assets of the older families ($1,691 vs. $2,247 in constant dollars). Professor Venti concluded that since total financial assets, including balances in IRAs, are much larger for the younger group in 1991 than for the older group that reached age 60-64 in 1984, targeted retirement saving programs did stimulate new saving over the period.
  
  
• Restore the Dividend and Interest Received Exclusion
  
  The Tax Reform Act of 1986 repealed the deduction for the first $100 of dividends received by individual shareholders ($200 by a married couple filing jointly) on the grounds that the provision did little to reduce the double taxation of corporate income because its monetary limit was so low. In addition, the Joint Committee on Taxation concluded that the deduction benefited high-bracket taxpayers more than those in low brackets.
  
  The 1984 Deficit Reduction Act repealed the 15 percent interest-received exclusion that allowed a taxpayer to exclude up to $3,000 of net interest ($6,000 on a joint return). The reason for the change was that revenue losses under the IRA provisions were higher than expected and also that the provision might direct saving away from equity investment and toward debt.
  
  Restoration (and expansion) of the dividend and interest received deductions would be a positive step toward shifting the tax base from income to consumption. By reducing the double tax on corporate income, even if only by a small amount, those provisions would tend to reduce capital costs and encourage saving and investment.
  
  
• Strengthen the Private Pension System
  
  With over $3 trillion in accumulated retirement assets, the employment-based pension system provides a critical part of national savings. But the effectiveness of that system as a savings generator continues to be hampered by layer upon layer of unnecessary regulation. Regulations limit who can save, where and when they can save, how much they can save, and when and how they must withdraw savings.
  
  Over the last two years-with the creation of a new SIMPLE plan for small business and the repeal of a variety of pension rules-Congress has begun the process of peeling away some of those unnecessary layers of regulation. There is still a long way to go. A good place to start would be continued simplification, including especially the limits on the amount that can be saved and the rules that force withdrawal of existing savings.

Unfinished Business in Tax Policy Reform: Long-Run Goals

Fundamental reform of the U.S. federal tax code remains a key goal for many policymakers. I want to take advantage of this opportunity to express special thanks to Chairman Bill Archer for his dedication and valuable leadership in this regard.

Other prominent members of Congress, including House Majority Leader Richard Armey (R-TX) and Senator Richard Shelby (R-AL); Senator Pete Domenici (R-NM); and Representatives Dan Schaefer (R-CO) and Billy Tauzin (R-LA), have all introduced legislation to replace the federal income tax with a broad-based consumption tax. House Minority Leader Richard Gephardt (D-MO) has proposed broadening the current income tax base while lowering rates. In addition, other reform plans are being developed. For example, Senator John Ashcroft (R-MO) has proposed reforming the income tax by reducing marginal rates and providing a deduction for payroll taxes. Also, Americans for Fair Taxation, a private group based in Texas, has proposed replacing the federal income, social security, medicare, and estate taxes with a 23 percent national sales tax.

In addition to political factors such as voter discontent with the income tax, several factors contribute to the current interest in tax reform:

• The recognition that today's balanced federal budget is likely to be a relatively short-lived phenomenon. A new study by the General Accounting Office (GAO) predicts that, absent improvement in GDP growth rates or policy changes such as reduced social security benefits, budget deficits will reemerge by 2012 as baby boomers begin to retire. Tax reform, by encouraging more saving and investment, could be an important tool as we seek to ensure a strong economy in the twenty-first century.
  
  
• A growing awareness that the U.S. federal tax code is biased against the saving and investment that is crucial to improving U.S. economic growth. The new GAO study observes that even though federal budget deficits have declined recently, total national saving and investment remain significantly below the average of the 1960s and 1970s (see Table 2). In addition, the United States has one of the highest tax rates on new investment in the industrialized world. According to a 1994 study by the Progressive Foundation, the think tank affiliate of the Progressive Policy Institute, the effective combined corporate and individual federal tax rate on new investment in the United States is 37.5 percent, compared to an average of 31.1 percent in other G-7 countries (see Figure 3).⁸

Figure 3	Effective Tax Rates on Domestic Corporate Investment, 1991
Note: Tax rates include both the corporate and personal income tax on investment. Source: Enterprise Economics and Tax Reform (Washington, D.C.: Progressive Foundation, Progressive Policy Institute, October 1994).

• U.S. multinationals' goal of competing in the global marketplace. Fundamental tax reform could enhance the ability of U.S. firms to compete in global markets by reducing the competitive disadvantage that they face. For example, as a 1997 study sponsored by the ACCF Center for Policy Research, the public policy affiliate of the ACCF, showed, U.S. financial service firms face much higher tax rates than do their international competitors when operating in a third country such as Taiwan (see Figure 4).⁹ A twelve-country analysis shows that U.S. insurance firms are taxed at a rate of 35 percent on income earned abroad compared to 14.3 percent for French-, Swiss-, or Belgian-owned firms. As a consequence of their more favorable tax codes, foreign financial service firms can offer products at lower prices than can U.S. firms, thereby giving them a competitive advantage in world markets. Under the broad-based consumption tax reform proposals discussed above, all foreign-source income is exempt from tax.

Figure 4	International Comparison of Tax Rates on Foreign Income Earned by Insurance Companies Operating in a Third Country (By country of residence of parent company)
1. "Parent" means residence country income tax on parent company. 2. "Subsidiary" means local income tax on foreign subsidiary. Source: Thomas Horst, The Impact of the U.S. Tax Code on the Competitiveness of Financial Service Firms (Washington, D.C.: American Council for Capital Formation Center for Policy Research, July 1997).

• The conclusions of new economic studies by academic and public-sector tax policy experts that fundamental tax reform could raise rates of saving, investment, and output. As discussed earlier in this statement, a number of new academic and government studies conclude that switching to a consumption-based tax system would increase national saving, reduce the cost of capital, and lead to higher levels of capital formation and GDP.

Conclusions

Persistently low U.S. saving rates, despite recent good economic growth and low unemployment, suggest the need for short-term policy measures to reverse this pattern. In particular, we need to build on the recent progress in capital gains taxation, IRAs, pension and estate tax relief, and the AMT. The restoration of an exclusion for dividends and interest received would also further the goal of lightening the taxation of saving. In addition, a substantial body of research suggests 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 that moves the U.S. tax system toward greater reliance on consumption taxes can be an important policy lever for achieving stronger economic growth and higher living standards.

Endnotes

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 of 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).

5. Dale W. Jorgenson, "The Economic Impact of Taxing Consumption," testimony before the Committee on Ways and Means of the U.S. House of Representatives, March 27, 1996. Joel L. Prakken, "The Macroeconomics of Tax Reform," in The Consumption Tax: A Better Alternative? (Cambridge, Mass.: Ballinger Publishing Company, 1987). Lawrence H. Goulder, "Deficit Reduction through Energy, Income, and Consumption Taxes: Impacts on Economic Growth and the Environment," Tax Policy for Economic Growth in the 1990s (Washington, D.C.: American Council for Capital Formation Center for Policy Research, March 1994).

6. Congressional Budget Office, "Perspectives on the Ownership of Capital Assets and the Realization of Capital Gains," May 1997.

7. Steven F. Venti, "Promoting Saving for Retirement Security," testimony before the Finance Subcommittee on Deficits, Debt Management, and Long-Term Growth of the United States Senate, December 7, 1994.

8. Enterprise Economics and Tax Reform (Washington, D.C.: Progressive Foundation, Progressive Policy Institute, October 1994).

9. The Impact of the U.S. Tax Code on the Competitiveness of Financial Service Firms (Washington, D.C.: American Council for Capital Formation Center for Policy Research, July 1997).