Promoting Competitiveness, Growth, and Retirement Security:
A Tax Plan for the New Century

January 20, 1999

EXECUTIVE SUMMARY

Overview

ACCF proposes that, only if there is a federal budget surplus over and above the surplus in the social security trust fund and if Congress decides to enact a multiyear tax cut, at least one-third of the cuts should be dedicated to saving and investment initiatives. Such a plan, modeled on the brilliantly conceived Kennedy-Johnson tax cuts of the 1960s and the Reagan tax cuts of the early 1980s, would enhance competitiveness, increase economic growth, and promote retirement security.

As with past generations, a major responsibility of today's generation is to lay a strong economic base for future generations. To do so, the bias against saving and investment in the U.S. tax code must be reduced.

Impact of the U.S. Tax Code on Saving and Investment

The United States taxes investment and saving more harshly than do most of our competitors. The marginal tax on domestic U.S. corporate investment is 38 percent, higher than that of most other G-7 countries. The United States taxes foreign source income more than other G-7 countries. The United States lags behind many of our competitors in capital cost recovery for technological equipment. U.S. financial service firms face much higher taxes than do their competitors when operating in a third country. U.S. capital gains taxes exceed those of many of our competitors. The United States taxes interest and dividends more heavily than do many other countries and offers fewer and less generous tax-favored saving and insurance products.

ACCF Tax Plan for Competitiveness, Growth, and Retirement Security

Tax Cuts for Individuals:

Increase the deductible IRA contribution limit and/or raise the income level.
Provide a tax-free "rollover" for reinvested savings.
Reduce the capital gains tax and provide an annual exclusion for capital gains.
Increase pension portability.
Establish "personal retirement accounts."
Phase out the federal estate tax.
Provide a deduction for dividends and interest.

Tax Cuts for Business:

Phase in expensing for plant and equipment outlays.
Provide more favorable tax treatment for investment to promote environmental goals.
Reform the foreign tax provisions of the U.S. tax code.
Reduce the corporate capital gains tax.
Liberalize employer-sponsored pension plans.

Conclusion

Persistently low U.S. saving rates, and investment that lags that of our industrial competitors despite recent good economic growth and low unemployment, suggest the need for policy measures to reverse this pattern. Given the projected budget surplus and the desire of many in Congress to enact a major tax cut for Americans, there is clearly an opportunity to move the U.S. tax system in a pro-growth direction. We therefore urge Congress to give the most careful consideration to the pro-growth tax provisions discussed in our statement.

ACCF TESTIMONY

My name is Mark Bloomfield. I am president of the American Council for Capital Formation and I am accompanied by Dr. Margo Thorning, the ACCF's 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, and well-known business leaders. Our affiliated public policy think tank, the ACCF Center for Policy Research, includes on its board leading mainstream scholars from America's most prestigious universities, as well as prominent public finance experts from the private sector.

Mr. Chairman, we commend you for this timely hearing on tax policy as we prepare to enter the next millenium. We want to stress that we agree strongly with you that only if we have a federal budget surplus over and above any surplus in the social security trust fund should the 106th Congress move forward with a multi-year tax cut. We should emphasize that many respected experts would instead favor reduction in the federal debt as a top priority for use of part of the expected surplus. Clearly, however, since many members of Congress favor major tax reductions, the question becomes which taxes should be cut. Some policy experts are calling for using the surplus to promote social goals such as relief of the so-called "marriage penalty" that often results in married couples paying more federal tax than two single people with the same income levels. Other experts support using the budget surplus to reduce marginal income tax rates. The thrust of ACCF's testimony differs from those mentioned above in that we stress that if the Congress does indeed approve a large tax cut, any such cut should enhance competitiveness, increase economic growth, and promote retirement saving.

For our part, if Congress decides to consider a major multi-year tax cut, we offer as a model two well-thought-out tax initiatives enacted since World War II that moved this country toward a tax system suitable for the post-war period. We have the opportunity today to build on the Kennedy-Johnson tax cuts of the 1960s and the Reagan tax cuts of the early 1980s and put in place a tax system appropriate for the challenges of the new century.

In our view, the striking characteristic of the Kennedy-Johnson and Reagan plans for tax cuts today is that they were not confined to consumption but provided liberal reductions in tax rates on growth-producing saving and investment. To be sure, these earlier tax plans included badly needed cuts in marginal income tax rates, but in addition both included sharp reductions in capital gains tax rates. Moreover, the first Kennedy tax cuts (1962) liberalized some business depreciation rates and, of primary importance, created for the first time a tax credit for business investment in equipment. The Reagan tax plan included similar components and also liberalized Individual Retirement Accounts (IRAs). Both plans fueled economic growth in succeeding years. The Kennedy-Johnson initiative opened the way for the golden economic era of the 1960s, with 4 percent productivity growth until economic overheating set in as a result of sharp increases in deficit spending. Similarly, the Reagan tax cut set the stage for strong economic performance in succeeding years and laid the base for growth in the U.S. economy in the 1990s. One may quarrel about the financing of the Reagan tax cuts and whether there was sufficient balance in the form of spending cuts. Our point is that the tax cuts recognized the essentiality of stronger individual saving and lower business capital costs for investment to foster economic growth.

As with past generations, a major responsibility of today's generation is to lay a strong economic base for future generations. To do so, we should follow the wisdom of these earlier, brilliantly conceived tax plans and ensure that a significant proportion of any tax cut is dedicated to saving and investment initiatives. If we are genuinely concerned about our children, grandchildren, and generations beyond, we should have the discipline to deny a reasonable amount of consumption to ourselves today in order to enhance prospects for growth in the future and to provide retirement security for all. It is in that context that we strongly urge the Congress to dedicate at least one-third of any multi-year tax cut for competitiveness, growth, and retirement security.

In advocating this position we do not at all deny the merits of other tax proposals currently advanced. The marriage tax penalty should be corrected over time, and marginal tax rates are far too high and should be reduced. Indeed, lower marginal tax rates will foster economic growth but with less leverage than more direct tax cuts on individual saving and productive business investment. To this end, our testimony suggests a menu of a dozen direct tax cuts on pro-growth saving and investment (including investments to reduce pollution and increase energy efficiency in order to address the potential threat of global warming and other environmental concerns).

The central themes of our testimony are: The U.S. tax code treats saving (including retirement saving) and investment very harshly. Since saving is essential to investment and growth, this harsh taxation of saving in the United States works against higher living standards for coming generations and may also impair the economic strength that underlies our world leadership position. In addition, our tax code hits saving and investment harder than those of many of our international competitors. The foreign-source income of U.S. multinationals is also subject to higher taxes than that of many of our competitors. Both of these facts are of increasing concern as globalization continues.

Tax reform can be carried out through a broad-based restructuring in which consumption, rather than income, becomes the tax base, or it can be accomplished through incremental changes to the current income tax base which reduce the tax burden on various types of saving and on investment. Either type of tax restructuring would enhance U.S. productivity and economic growth and promote the achievement of environmental goals. Tax reductions, we want to stress, should not come at the expense of fiscal responsibility or saving social security.

As a predicate to our tax cut proposal to promote competitiveness, economic growth, and retirement security, we would like to set out the intellectual framework for such a plan by first discussing the impact of the current U.S. tax code on saving and investment.

Impact of U.S. Tax Code on Saving and Investment

• Taxes on U.S. Business Investment
  
  Economists are in broad agreement that capital cost for investment is significantly affected by tax policy. The "user cost of capital" is the pretax rate of return on a new investment that is required to cover the purchase price of the asset, the market rate of interest, inflation, risk, economic depreciation, and taxes. This capital cost concept is often called the "hurdle rate" because it measures the return an investment must yield before a firm would be willing to start a new capital project. Stanford University Professor John Shoven, an internationally renowned public finance scholar, estimates that in the United States about one-third of the cost of capital is due to taxes. In other words, hurdle rates are 50 percent higher than they otherwise would be due to the tax liability on the income produced by the investment. Quite clearly, therefore, the higher the tax on new investment, the less investment that will take place.
  
  Several measures show that the United States taxes new investment more heavily than most of our international competitors. For example, according to a study by the centrist Progressive Policy Institute (the research arm of the Democratic Leadership Council), the marginal tax rate on domestic U.S. corporate investment is 37.5 percent, exceeding that of every country in the survey except Canada (see Figure 1). The tax rate calculations include the major features of each country's tax code, including individual and corporate income tax rates, depreciation allowances, and whether the corporate and individual tax systems are integrated.

Figure 1	Effective Tax Rates on Domestic Corporate Investment
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).

Tax rates on foreign-source investment, which are indicators of how much encouragement domestic firms are given to enhance their economic viability by expanding operations abroad, again show the United States falling behind. The U.S. tax rate is 43.4 percent versus an average of 36.7 percent in the other G-7 countries (see Figure 2).

Figure 2	Effective Tax Rates on Foreign-Source Investment
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).

Prior to the 1986 Tax Reform Act (TRA), the United States had one of the best capital cost recovery systems in the world. For example, the present value of the deductions for investing in machinery to produce computer chips and in modern and competitive continuous casting equipment for steel production were close to 100 percent under the strongly pro-investment tax regime in effect from 1981 to 1985, according to a study by Arthur Andersen & Co. In contrast, under current law the present value of the capital cost recovery allowance for that same investment today for computer chips is only 85 percent and for continuous casting equipment is only 81 percent (see Table 1).

The Arthur Andersen study also shows that the United States lags behind many of our major competitors in capital cost recovery for equipment that is technologically innovative, is crucial to U.S. economic strength, or helps prevent pollution. Capital cost recovery provisions for pollution-control equipment are much less favorable now than prior to TRA's passage. For example, the present value of cost recovery allowances for wastewater treatment facilities used in pulp and paper production was approximately 100 percent prior to TRA. Under TRA, the present value for wastewater treatment facilities dropped to 81 percent. Allowances for scrubbers used in the production of electricity were 90 percent prior to TRA; the present value fell to 55 percent after TRA. As is true in the case of productive equipment, the loss of the investment tax credit and lengthening of depreciable lives in TRA both raised effective tax rates.

• Taxation of U.S. Multinational Firms
  
  A tax reduction plan should also focus on the need of U.S. multinational companies (in both the industrial and financial sectors) to be competitive and gain market share, both at home and abroad. Such a tax cut could enhance the ability of U.S. firms to compete in global markets by reducing the competitive disadvantages that they face. For example, as a 1997 study sponsored by the ACCF Center for Policy Research 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 3). A 12-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.

Figure 3	International Comparison of Tax Rates on Foreign Income Earned by Insurance Companies Operating in a Third Country Such as Taiwan
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).

• Capital Gains Taxation
  
  U.S. capital gains tax rates, which affect the cost of capital and therefore investment and economic growth, are still high compared to those of other countries. In fact, most industrial and developing countries tax individual and corporate capital gains more lightly than does the United States, according to a 1998 survey of 24 industrialized and developing countries that the ACCF Center for Policy Research commissioned from Arthur Andersen LLP.
  
  Both short- and long-term capital gains on equities are taxed at higher rates in the United States than in most of the other 23 countries surveyed. Short-term gains are taxed at 39.6 percent in the United States compared to an average of 19.4 percent for the sample as a whole. Long-term gains face a tax rate of 20 percent in the United States versus an average of 15.9 percentfor all the countries in the survey. Thus, U.S. individual taxpayers face tax rates on long-term gains that are 26 percent higher than those paid by the average investor in other countries. In addition, the United States is one of only five countries surveyed with a holding period requirement in order for the investment to qualify as a capital asset.
  
  Similarly, short- and long-term corporate capital gains tax rates are higher in the United States than in most other industrial and developing countries surveyed. Both short- and long-term gains are taxed at a maximum rate of 35 percent in the United States, compared to an average of 22.8 percent for short-term gains and 19.6 percent for long-term gains in the sample as a whole. In other words, U.S. corporations face long-term capital gains tax rates almost 80 percent higher than those of all but two of the other countries surveyed (Germany [45 percent] and Australia [36 percent], and only four of the 24 countries surveyed impose a holding period in order to be eligible for preferential corporate capital gains tax rates.
  
  
• Taxation of Interest and Dividends
  
  Interest and dividends received by individuals also are taxed more heavily in the United States than in many other countries, according to the 1998 Arthur Andersen survey of 24 countries. High tax rates on dividends and interest received raise the cost of capital for new investment and slow U.S. economic growth. The Center survey also shows that many countries provide tax incentives for small savers by exempting some portion of the income from tax. In addition, interest received by individuals is taxed at a higher rate in the United States than in many other countries; the marginal tax rate is 39.6 percent in the United States compared to an average of 32.4 percent in the countries surveyed as a whole. Nearly 40 percent of the countries surveyed tax interest income at a lower rate than ordinary income; for example, Italy taxes ordinary income at a top rate of 46 percent while its top tax rate on interest income is only 27 percent.
  
  In several countries surveyed, small savers receive special encouragement in the form of lower taxes or exemptions on a portion of the interest they receive. For example, in Germany, the first $6,786 of interest income for married couples filing a joint return ($3,393 for singles) is exempt from tax; in Japan, interest on saving up to $26,805 is exempt from tax for individuals older than 65; in the Netherlands, the first $987 of interest income for married couples ($494 for singles) is exempt from tax; and in Taiwan, the first $8,273 of interest received from local financial institutions is exempt from tax.
  
  Similarly, dividend income is also taxed more heavily in the United States than in the other countries surveyed; the U.S. tax rate is 60.4 percent (combined corporate and individual tax on dividend income) compared to an average of 51.1 percent in the surveyed countries as a whole. Of the countries surveyed, 62.5 percent offset the double taxation of corporate income (the income is taxed at the corporate level and again when distributed in the form of dividends) by providing either a lower tax rate on dividend income received by a shareholder or by providing a corporation with a credit for taxes paid on dividends distributed to their shareholders.
  
  In the case of dividends received, small savers receive preferential treatment in about one-fourth of the countries surveyed. In France, for example, the first $2,661 of dividends on French shares received by a married couple is exempt from tax ($1,330 for singles); in the Netherlands, the first $987 of dividend income for married couples ($494 for singles) is exempt from tax; and in Taiwan, the first $8,273 of dividends from local companies is exempt from tax.
  
  
• The U.S. Tax Code and Retirement Security
  
  Experts predict that today's federal budget surpluses may be relatively short-lived phenomena. The long-term prosperity of the United States remains threatened by the prospect of looming budget deficits arising from the need to fund the retirement of the baby boom generation in the next century. In addition, the U.S. saving rate continues to compare unfavorably with that of other nations, as well as with our own past experience; U.S. net domestic saving has averaged only 4.7 percent of GDP since 1991 compared to 9.3 percent over the 1960-1980 period (see Table 2). Though the U.S. economy is currently performing better than the economies of most other developed nations, in the long run low U.S. saving and investment rates will inevitably result in a growth rate short of this country's true potential.

The ACCF Center for Policy Research in 1998 sponsored a survey of the tax treatment of retirement savings, insurance products, social security, and mutual funds in 24 major industrial and developing countries, including most of the United States' major trading partners. The survey (also compiled for the Center by Arthur Andersen LLP) shows that the United States lags behind its competitors in that it offers fewer and less generous tax-favored saving and insurance products than many other countries. For example:

• Life insurance premiums are deductible in 42 percent of the surveyed countries but not for U.S. taxpayers; for many individuals life insurance is a form of saving;
  
  
• Thirty-three percent of the sampled countries allow deductions for contributions to mutual funds for retirement purposes while the United States does not;
  
  
• More than half of the countries surveyedallow a mutual fund investment pool to retain earnings without current tax, a provision which increases the fund's assets; the United States does not;
  
  
• Thirty percent of the countries with social security systems allow individuals to choose increased benefits by increasing their contributions during their working years; and
  
  
• Canada, for example, provides a generally available deduction of up to $9,500 (indexed) yearly for contributions to a private retirement account, compared to a maximum deductible IRA contribution of $2,000 for qualified taxpayers in the United States.

The Center's study demonstrates that many countries have gone further than the United States to encourage their citizens to save and provide for their own retirement and insurance needs.

A Tax Plan for Competitiveness, Growth, and Retirement Security

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 recent analyses by academic scholars and government policy experts including University of California Professor Alan Auerbach, Boston University Professor Laurence Kotlikoff, the Joint Committee on Taxation, and the Congressional Budget Office conclude that substituting a broad-based consumption tax, such as the Unlimited Savings Account Tax (USA Tax) which Senate Budget Committee Chairman Pete Domenici (R-NM) introduced several years ago, for the current federal income tax would have a positive impact on economic growth and living standards. A consumption tax exempts all saving and investment from tax; all income saved is tax-free and all investment is written off, or "expensed," in the first year. As a result, the cost of capital for new investment would fall by about 30 percent.

If, instead of fundamental tax reform such as the USA tax described above, political reality requires an incremental approach to tax reform, the ACCF recommends a menu cut of tax options that, taken either together or singly, could enhance competitiveness, increase economic growth, and promote retirement security. We have organized the menu into tax cuts for individuals and tax cuts for business.

Tax Cuts for Individuals

• Increase the deductible IRA contribution and/or raise the income limit. This step would make IRAs more accessible to middle and upper-middle income individuals and families. Many academic analyses by top public finance scholars indicate that IRAs do produce new saving that would not otherwise take place. An increase in the $2,000 deductible contribution for each employed person to $4,000 and/or raising the income ceiling for deductible contributions to $120,000 for married couples, for example, would tend to raise the personal saving rate.
  
  
• Provide a tax-free "rollover" for reinvested mutual funds, interest, dividends, and capital gains. Allowing individual savers to make tax-free investments from the proceeds from transactions of this type would significantly increase the mobility of capital and would be a powerful incentive to save.
  
  
• Reduce the individual capital gains tax rate and provide an exclusion. A significant reduction from the current maximum tax rate of 20 percent would reduce the cost of capital, stimulate investment, and encourage the entrepreneurial activity that is a major source of U.S. economic growth. In addition, an annual exclusion of $7,000, for example, would help encourage saving and reduce the complexity of the tax code by allowing middle income investors to realize a relatively modest amount of capital gains without paying tax.
  
  
• Increase pension portability. This reform would make it more attractive for workers to take part of their compensation in the form of a "nest egg" for retirement than under current law. For example, easing rollover rules to allow employees to transfer between different types of plans and easing benefit transfer rules between qualified plans so employees can move benefits to their new employers' plan would not only increase retirement security but also help productivity growth through not hindering workers from changing jobs among firms and industries.
  
  
• Establish personal retirement accounts. Both the Clinton Administration and members of Congress have proposed using part of the budget surplus to fund personal retirement accounts. For example, Senator William V. Roth Jr. (R-DE)'s Personal Retirement Accounts Act of 1998 would create a five-year program of contributions made from the budget surplus for working Americans. Thus, even low-income workers unable to take advantage of IRAs and 401(k) programs would be able to benefit from investing in the equities markets and thus supplement the benefits that they will eventually receive from Social Security
  
  
• Phase out the federal estate tax. Many public finance scholars support the elimination of the estate (or death) tax because it is a tax on capital and thus reduces the funds available for productive private investment, especially family-run businesses.
  
  
• Provide a deduction for dividends and interest received by individuals. Exempting, for example, the first $2,000 of dividends and interest received by married taxpayers ($1,000 for singles) is an approach used in many other countries.

Tax Cuts for Business

Comprehensive tax reform, to shift the federal tax base from income to consumption and thus permit the expensing of all investment, would have the strongest impact on capital costs and economic growth. However, more modest tax cuts on investment would also stimulate capital formation and growth.

• Phase in expensing for plant and equipment outlays. Scholars agree that expensing is the most efficient way of reducing the cost of capital for new investment. In the period 1981-1985, the United States had one of the best tax treatments for new investment in the world. In today's global economy, U.S. firms need every competitive advantage we can provide.
  
  
• Promote environmental goals and competitiveness. Tax credits or other provisions for environmental expenditures required to meet federal, state, and local standards or to enhance energy efficiency would ease the compliance costs facing U.S. industry. In addition, such tax measures would make it easier for capital-intensive manufacturing firms to continue operating their U.S. facilities.
  
  
• Reform the foreign tax provisions of the U.S. tax code. Moving to a consumption tax such as Chairman Domenici's USA tax in which all foreign source income is exempt from tax (a "territorial tax") would have the strongest impact on the international competitiveness of U.S. firms. However, such a fundamental shift in tax policy is not now "on the table." Still, firms' ability to compete abroad could be enhanced through a variety of reforms to U.S. foreign tax provisions. U.S. industrial and financial service firms face higher taxes on their foreign-source income than do their international competitors (see Figures 2 and 3). Using part of the federal surplus to lighten the tax burden on the foreign-source income of U.S. firms would be beneficial in terms of allowing them to be more competitive in foreign markets. For example, making permanent the one-year provision that reforms Subpart F of the Internal Revenue Code for financial service firms such as securities firms, insurance companies, banks, and finance companies would be an important step. As a matter of sound tax policy, U.S.-based financial service firms should be able to defer U.S. tax on the active income of their foreign subsidiaries until those earnings are returned to the U.S. parent company.
  
  It is equally important not to impose stringent new tax policies that make U.S. industrial and financial firms less competitive. For example, proposed changes that tighten the foreign tax credit and deferral would put U.S. firms at a further disadvantage.
  
  
• Reduce the corporate capital gains tax rate. A corporate capital gains tax cut would reduce capital costs and increase investment. Sound tax policy as well as economic considerations argue for a reduction in the U.S. maximum corporate capital gains rate of 35 percent, which is now the same as the top regular corporate tax rate. This would reinstate the historical U.S. treatment of corporate capital gains; an alternative corporate capital gains tax was part of the Internal Revenue Code from 1942 until its repeal by the Tax Reform Act of 1986. 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.
  
  
• Liberalize employer-sponsored pension plans. Improvements to employer-sponsored pension plans would increase saving and enhance retirement security. Small employers are often unable to provide pensions for their employees because of the cost and complexity of the system. A tax credit for businesses establishing new plans would be especially helpful to small employers. Creating a simplified defined benefit plan for small employers would promote the retirement security of small-firm employees.

Conclusion

Persistently low U.S. saving rates, and investment that lags that of our industrial competitors despite recent good economic growth and low unemployment, suggest the need for policy measures to reverse this pattern. Given the projected budget surplus and the desire of many in Congress to enact a major tax cut for Americans, there is clearly an opportunity to move the U.S. tax system in a pro-growth direction.

We therefore urge Congress to give the most careful consideration to the pro-growth tax provisions discussed here.