Entire List for U.S.

1
The Impact of Taxes on Saving, Investment, and
Economic Growth
Meeting of the Presidents Advisory Panel on
Federal Tax Reform San Francisco March 31, 2005
Dr. Michael J. Boskin T. M. Friedman Professor
of Economics Hoover Institution Senior
Fellow Stanford University
2
The Impact of Taxes on Saving, Investment, and
Economic Growth

• Real per capita income grows with productivity,
  which in turn rises with the growth rate of
  capital per worker and the growth rate of
  technology
•  
• Taxes affect the capital stock by affecting
  saving and investment
•  
• Taxes may also affect hours of work and human
  capital investment
•  
• Taxes, and some government spending, may affect
  the rate of advance in technology
•  
• Tax effects on human investment and/or technology
  can permanently affect the growth rate of the
  economy
•  
• Taxes on saving and investment affect the level
  of future income and hence the interim growth
  rate whether they permanently alter the growth
  rate depends upon whether investment affects the
  rate of technical change, on which economists
  disagree
•  
• At the very least, we should strive for
  neutrality in the tax code toward saving and
  investment.

3
National Personal Saving in the Postwar U.S.(
of GDP)
4
National Income and Product Accounts
(NIPA)Measures of U.S. Saving( of GDP,
alternative periods)
Gross national saving personal saving
business saving government saving Net national
saving gross saving - depreciation
5
Issues In The Measurement And Interpretation Of
The Low And Declining Saving Rate

• The exclusion of capital gains (losses) means
  NIPA saving is not synonymous with wealth
  accumulation
• Wealth effect of rising equity and home prices
  accounts for perhaps half the decline in personal
  saving
• Stock market gains decrease firm contributions to
  DB pension plans higher DB plan benefits are
  consumed, but not counted as part of income,
  which decreases the saving rate
• Higher capital gains tax revenue reduces
  disposable income and hence saving
• (these two items account for another quarter of
  the decline in the personal saving rate.)
•  
• Consumer Durables purchases are a form of saving
  including durables would raise the level of the
  saving rates by about 3 percentage points, but
  because there is no trend in recent decades it
  does not help explain the decline in saving rates.

6
Tax Treatment of Capital Income

• Business firms earn the before-tax return to
  private investment firms then pay corporate
  taxes on these profits, at tc, the effective
  marginal corporate tax rate
•  
• Suppliers of the capital receive the
  before-personal-tax return to savers, and then
  pay personal taxes on their returns (interest,
  dividends, capital gains) at rate tp, the
  marginal effective personal income tax rate on
  capital income
• Thus a wedge, or distortion, is created
  between the before-tax return to private
  businesses on their investment and the after-tax
  returns to savers supplying the capital for the
  investment
•  
•    The tax wedge tc tp
•  
• The excess burden of tax goes up with square
  of tax rate tc tp

7
Long-Term Effects of Taxes on Saving and
Investment(real future value of 1 invested
earning 10 before tax when taxed at 0 and 40)
Tax rate on capital income tc tp So, while a
small capital income tax may not be too
distortionary between consumption today and
consumption next year, it is very distortionary
between consumption today and consumption many
years in the future.
8
It Is Difficult to Measure Capital Income

•  
• Measuring capital gains and losses, changes in
  asset values, for non-publicly-traded assets is
  difficult
•  
• 2. Measuring depreciation, decline in the value
  of an asset due to wear-and-tear and
  obsolescence, for assets not sold on used
  market is difficult lemons problem
•  
• 3. Measuring real income, separating out real
  gains (or losses) from inflationary gains or
  losses, is difficult
•  
• Timing issues
• ? Very difficult to measure real effective
  tax rates and to prevent
• financial engineering, e.g. of equity
  into debt

9
Single and Double Taxation of Saving

• Ordinary saving taxed twice under the income tax
• Earn income 1, pay tax t, save (1-t)
• Saving earns return r, is taxed at t, your net
  of tax return is r(1-t)
• Thus, you end up with (1-t)(1r(1-t))
•  
• 2. IRAs, 401(k)s saving taxed once, on
  withdrawal
• Earn income 1, save and deduct it, so saving
  1
• Saving earns return r, no tax while builds up
• On withdrawal pay tax t (can be higher or lower
  than tax rate when contributed)
• Thus, you keep (1r)(1-t)
•  
• 3. Roth IRA backloaded, saving not deductible,
  so no tax at withdrawal
• Earn income 1, pay tax t, saving (1-t)
• Earns return r, no tax on withdrawal
• So you keep (1t)(1r)

10
Tax Neutrality Toward Saving And Investment

• Pure income tax double taxation of saving
• Pure consumption / consumed income tax neutral
• Add corporation income tax third tax on saving
• Combination of tax rate, interest deductions on
  debt and PV of depreciation allowances determines
  effect on investment (I)
• Tax income but allow true economic depreciation
  of equity financed investment (no debt) gt
  neutrality among types of investment.
• Consumption tax consumption (C) income (Y)
  investment (I)
• Neutral with respect to types of investment
• Neutral between investment / saving and
  consumption
• Immediate deduction of I called expensing (first
  year write-off)

11
Tax Neutrality Toward Saving And Investment

• Think of a football field
• Pure income tax level sideline-to-sideline, but
  saving (S) and investment (I) running uphill
• Pure consumption tax level sideline-to-sideline
  (among types of I) and goalpost-to-goalpost
  (between S and C)
• Debt raises the potential of negative effective
  tax rates (subsidies) on investment
• The case for subsidizing investment
• The treatment of housing
• Estate tax can be third or fourth tax on saving
• 8. Taxes and human capital investment

12
Human Capital Investment

• Types Education (50), On the job training
  (30), Mobility, Health (20)
• Note Virtually all on the job training (ojt) and
  sizeable fraction of higher education and some
  fraction of mobility and health costs are
  foregone earnings, which ARE NOT TAXED.
• Example Early years of work and informal ojt
  (Heckman estimates 1/3 of time).
• So a 60,000 per year worker is actually
  paid 90,000 at annual
• rate 60,000 is cash and 30,000 is ojt
• The in-kind ojt is not taxed. This is
  economically equivalent to
• including it in income and then giving an
  immediate deduction (expensing)
• So a flat rate tax does not distort the bulk of
  human investment decisions. However, a
  progressive rate structure does do so, as the
  human capital investment raises earnings and
  drives people into higher tax brackets.

13
The Effects Of Taxes On Saving

• Income taxes affect saving both by reducing the
  after-tax rate of return received by savers and
  by reducing after tax incomes
• By taxing the return (interest, dividends,
  capital gains) received by savers, the tax makes
  it more expensive to save for future consumption,
  e.g. during retirement. But the amount of saving
  theoretically could decrease or increase in
  response to the tax (due to what economists call
  income and substitution effects working in
  opposite directions)
• Usually we think households will reduce the
  amount purchased of any good whose price goes up
• But, e.g. target savers would save more when
  the after-tax rate of return declined

14
The Effects Of Taxes On Saving

• The net effect of income taxes on saving is thus
  an empirical question
• While there are a range of opinions based on
  various types of evidence, the view of most
  economists is that saving is somewhat responsive
  to the rate of return
• Time series studies of aggregate consumption or
  saving for the U.S. show that for each 10
  increase in the rate of return (e.g. from 5 to
  5.5), saving increases between 1 and 5
• Evidence from the introduction or expansion of
  tax deferred saving vehicles (e.g. IRAs,
  401(k)s), which raise the rate of return to
  saving show substantial effects
• Every study of taxes and saving behavior, those
  that show larger, modest, small or virtually no
  effects, is subject to a variety of critiques

15
The Effects Of Taxes On Saving

• Even very modest (substitution) effects of
  capital income taxes imply very large costs to
  society from the tax distortions between
  consumption and saving (future consumption)
• Nobel laureate Professor Robert Lucas, in his
  research and 2002 Presidential address to the
  American Economic Association, concludes that
  removing the tax distortions to saving and
  investment are by far the most important avenue
  for improving economic well-being of any
  potential public policy reform

16
Five Tests for Tax Reform

1. Will tax reform improve the performance of the
   economy?
2. Will tax reform affect the size of government?
3. Will a new federal tax structure affect
   federalism?
4. Will a new tax structure likely endure?
5. Over time, will tax reform contribute to a
   prosperous, stable democracy?

17
Adam Smiths Four Canons Of Taxation

• Equality (Ability-to-pay) ought to contribute
  towards the support of the government, as nearly
  as possible, in proportion to their respective
  abilities that is, in proportion to the revenue
  (income) which they respectively enjoy under the
  protection of the state.
• Certainty The tax which each individual is
  bound to pay ought to be certain, and not
  arbitrary. The time of payment, the manner of
  payment, the quantity to be paid, ought all to be
  clear and plain to the contributor, and to every
  other person.
• Convenience in payment Every tax ought to be
  levied at the time, or in the manner, in which it
  is most likely to be convenient for the
  contributor to pay it.
• Economy in collection Every tax ought to be so
  contrived as both to take out and to keep out of
  the pockets of the people as little as possible,
  over and above what it brings into the public
  treasury of the state.

18
Key Decisions For Design Of Tax System

• Tax base(s) income, consumption, hybrid people
  or transactions
•  
• 2. Tax rate(s) flat, progressive, levels
•  
• Unit(s) of account family, individual,
  transactions
•  
• 4. Time period(s) of account transaction,
  annual, longer-horizon

19
Tax Reform

•  
• I.    Partial
•  
• Low rates
• Simplification
• Expanded tax deferred saving
• Corporate tax integration
•  
•  
• II.    Comprehensive
• National retail sales tax
• Value added tax
• Consumed income tax
• Flat tax

20
Alternative Ways To Tax Income And Consumption

• (1) Income Consumption Saving
•      or, Income Saving Consumption
• (deductible saving method)
•  
•  
• (2) Income Consumption Investment
• or, Labor Income Capital Income
  Consumption Investment
• or, Labor Income (Capital Income
  Investment) Consumption
• (business tax expensing method)
•  
•  
• (3) Excise, sales taxes

21
Consumption Taxes(arguments for)

• Equity
• People should be taxed on what they take out of
  the system, not what they contribute.
• Taxing life-cycle income (leaving aside bequests
  and inheritances) is equivalent to taxing
  consumption.
• Consumption may be a better measure of permanent
  income than is current income.
• A consumption-based tax can be progressive.
•  
• Efficiency
• Eliminate distortion of saving decision and hence
  discrimination against the patient vs. the
  impatient.
• Taxes all saving equivalently.
•  
• Simplicity
• A lot of the complexity of the tax code arises
  from capital income taxation and avoidance.

22
Consumption Taxes(arguments against)

• Equity
• Income better measure of ability-to-pay (at least
  in an annual tax with limited time horizons)
• Avoids differentiating capital and labor income
• Transactions based consumption taxes ineffective
  way of differentiating by ability
• Transition unfair to elderly
•  
• Efficiency
• Intertemporal distortion not so severe time
  horizons not so long 
• In practice, may wind up subsidizing saving,
  investment (e.g., debt finance and interest
  deductions unlikely to be limited in practice)
•  
• Simplicity
• Transition not simple
• Personal, business tax likely complex around
  saving, investment definition

23
Tax Reform And The Transition To A New Tax System

• Tax reforms gt capital gains and losses if the
  taxation of capital is involved
• We not only must compare the new tax or tax
  system to the old one, we also have to pay
  attention to transition issues
• Most major tax reforms involve transition rules
• a.   For a while, there are parallel tax
  systems
•          i. The old one, phasing out and
•          ii. The new one, phasing in
• b. Transitions impose costs, complexity
• 4. Important to evaluate actual tax systems
  before, after and during (transition), not just
  two theoretical systems

24
Conclusion

•  
• The U.S. saving rate is low and declining,
  although not nearly as much as the NIPA measures
•  
• The current tax system, on balance, is biased
  against saving
•  
• Redressing this imbalance is very important and
  should be a major component of tax reform
• This is especially so, given the closely related
  issues in the evolution of the public debt and
  social insurance transfers to the elderly
•  

25
Conclusion

• The two routes to reform
•  1.  Replace the current corporate and personal
  income taxes with an integrated consumed income
  tax, e.g. with personal rates of 10, 20 and
  30, a corporate rate of 30 phase out most
  deductions other than charity and mortgage
  interest include super-IRAs simplify,
  eliminate, combine other aspects of the code.
•  2.  Replace the income taxes with more
  fundamental reform, such as the Hall-Rabushka
  flat income tax or a national retail sales or
  value-added tax
•  
• The political economy of the sales and VAT taxes
  raise fundamental concerns of federalism and
  potential growth of government