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286 August 26, 1983 HOW TO CURE AMERICA'S CAPITAL ANEMIA INTRODUCTION Capital is the life blood of economic growt h. Withoutaenough capital, investment lags, equipment ages, competition falters, and jobs disappear. Today, the United States is suffering from capital anemia. The U.S. savings rate remains the lowest among indus trialized countries and America's gross fi x ed investment, as a share of domestic output, is a third less than Japan's. Despite help from the Reagan tax cuts, which merely restored individual tax rates approximately to their 1978 levels, the savings rate fell in the first quarter of 1983 to 4 perce n t of after-tax income-the lowest since 1950 replace obsolete plant and equipment, the share of national income devoted to net nonresidential fixed investment fell more than half during the 1970s Adjusted for investment to Alarmed by this low level of savi ngs and capital investment many policymakers are rushing forward with quick-fix solutions.

Among the most hastily conceived and counterproductive are the industrial policy" initiatives. Such proposals are seductive.

Most industrial policy proponents talk of bolstering capital for mation and stimulating economic growth, often sounding remarkably like born-again supply-siders.

Unlike supply-siders, however, the supporters of a national industrial policy believe that the free marketplace cannot effi ciently raise and allocate the capital necessary to revamp U.S factories and spawn new technologies--especially with the huge federal deficits now looming over the capital markets. These economists and policymakers, therefore, recommend a broad range of new gover n ment powers, tariffs, and subsidies intended to channel funds to high growth "sunrise" industries while moderniz- ing declining "sunset1' industries 2 Another school of economists, however, believes that it is high taxes, especially on capital investment a nd savings, that are crippling the ability of the marketplace to provide new capital It is these taxes, not deficiencies in the market economy or the lack of a cohesive industrial policy, that are causing the nation's capital anemia reduce tax rates on Am e rican savings and investment Freed from the disincentives now imposed by the tax code, American business would regain its competitive vigor To cure it requires a huge dose of reform to Investment in the U.S. is taxed repeatedly. Corporate profits are taxe d at up to 46 percent and then taxed over again when dis tributed to shareholders as dividends and capital gains. Capital is also subject to state and local taxes, taxes on interest income and estate and gift taxes. As a result of inflation, total taxes on capital exceeded 70 percent by the late 1970s. This meant that although the real rate of return on corporate capital was 9.4 per cent before taxes in 1975-1978, it fell to only 2.8 percent after taxes. The tax wedge, in other words, took more than two-thi rds of corporate profits. This low after-tax return simply cannot prompt the capital investment necessary to replace aging plant and equipment and fuel vigorous growth.

High taxes substantially increase the cost of capital, crest ing enormous competitive d isadvantages for U.S. industry compared with its foreign competitions-particularly the Japanese. Example The cost of equity and debt to Japanese businesses to finance investments called the cost of capital services) is about one fourth that to U.S. indust r y its abundant and low-cost capital than to its much vaunted indus trial policy. The lower cost of capital allows Japanese firms to invest and to fund research which American businesses could not afford. Japan's tax collectors treat capital favorably in a number of ways 1) Japan does not tax capital gains 2) it provides special tax treatment to dividends; and (3) it encourages citizens to save. The U.S. should take a page from the Japanese success story and enact tax reforms to encourage greater capital fo rmation The Japanese economic miracle, in fact, owes much more to Government intervention in the marketplace through industrial policies fails to acknowledge America's dangerous c.apita1 shortfall.

The Reagan tax reforms are but a first step 1) replacing t he current income tax system with a consumption tax 2) abolishing the corporate income tax 3) abolishing capital gains and dividend taxes 4) taxing stockholders for corporate profits. As a first step, the tax bias against saving and investment must be red u ced by expanding Individual Retirement Accounts, exempting a share of net savings from personal income taxes, and granting businesses a more realistic depreciation deduction Now required are: 3 THE CAPITAL SHORTFALL Many studies conclude that the U.S. rat e, of capital invest ment and saving is insufficient for adequate economic growth job expansion, and a rising living standard.l Annual U.S. saving of gross domestic product (GDP) averaged 19.2 percent between 1960 and 19

80. By comparison, Japan saved 34.5 percent of GDP, and West Germany about 25.4 percent. Compared to other nations, the U.S. personal saving rate is also at rock bottom, averaging only 6.1 percent of after-tax income between 1960 and 1980--compared to 19.4 percent for the Japanese and 15.6 percent for the West Germans. While the Reagan personal income tax cuts seem to have boosted this low rate somewhat, a surge in consumer spending in the first quarter of 1983 reduced the rate to 3.9 percent, the lowest quarterly level since 19

50. Congres s must now couple the personal tax reductions--which, in fact, only restored tax rates to their 1978 levels--with further tax relief for savings and in vestment United States Japan Germany France United Kingdom Italy Canada TABLE 1 International Compariso n s of Saving Rates 1960-1980 Personal Saving Rate as a percent of after tax income 6.1 19.4 15.6 14.3 9.6 16.6 7.1 Total Gross Saving Rate as a Dercent of GDP 19.2 34.5 25.4 24.4 19.8 23.3 21.6 Calculated by Evans Economics, Inc., Washington, D.C These fig u res actually overstate the capital available for new investment, since a significant portion of savings is needed See Norman B. Ture and B. Kenneth Sanden, The Effects of Tax Policy on Capital Formation, prepared for the Financial Executives Research Foun dation 1977. 4 just to replace obsolete plants and equipment. The net saving rate, which measures savings for expansion, averaged 7.5 percent from 1966 to 1970, but declined to an average of 5.8 percent be tween 1976 and 19

80. In 1982 it fell dramatically to a pathetic 1.9 percent of GDP Countries with low saving rates predictably are plagued with low rates of capital investment and low productivity, as Table I1 demonstrates TABLE I1 Gross Fixed Investment Productivit9 as a percentage of GDP Manufacturing 1960-1980 1960-1973 1973-1980 United States 18.2 2.8 0.5 Japan 32.5 9 .o 4.7 Germany 34.9 4.7 2.9 France 22.7 5.7 3.2 United Kingdom 18.3 3.6 1.7 Italy 20.8 5.7 2.1 Canada 22.3 4.2 -0.2 Source: Organization for Economic Cooperation and Development, July 1 9 82 and December 1982 Real value added per person employed Among Western nations, the U.S. has been stymied at the bottom of the investment and productivity ladder for two decades. Japan meanwhile, devoted the greatest share of its GDP to gross invest ment among industrial nations and enjoyed a productivity rate nine times that of the U.S. from 1973 to 19

80. Other industrial nations generally follow this pattern U.S. investment has fallen dramatically since the 1960s (see Table 111 The share of gross natio nal product (GNP) devoted to net nonresidential fixed investment fell by more than half between the last half of the 1960s and the late 1970s. Net fixed invest ment averaged 4 percent from 1965 to 1969, but dropped sharply to 1.8 percent of GNP in the 197 5 to 1978 period. The rate of growth in nonresidential fixed capital also dropped. After expanding about 5.5 percent in the late 1960s, the rate of growth of fixed investment dropped in half to 2.4 percent in 1975 to 1978. 5 TABLE I11 Investment and the Re a l Net Return to Capital Growth in Investment as a capital Pre-tax Effective Post-tax percentage of GNP stock return tax rate return 1955-1959 2.5 3.5 11.1 69.7 3.4 1960-1964 2.3 3.3 11.6 62.2 4.5 1965-1969 4.0 5.5 13.3 59.5 5.5 1970-1975 3.0 3.9 9.8 72.2 2 .8 1975-1978 1.8 2.4 9.4 70.2 2.8 1955-1978 2.8 3.8 11.1 66.6 3.8 Source: Martin Feldstein, Inflation Tax Rules and Investment: Some Evidence National Bureau of Economic Research, July 1982 WHY SAVINGS AND INVESTMENT ARE LOW The principal reason for the c o llapse of investment has been the effect of higher taxes on capital. The combined capital taxes paid to federal, state, and local governments, from all sources increased from an average of 55 percent in 1965, immediately after the Kennedy tax cuts, to 90 percent in 1974 and remained at over 70 percent during the late 1970s.

Capital taxes surged mainly because of inflation. It increased corporate capital taxes in three principal ways: (1) depreciation allowances for capital equipment are based on historical cost rather than on replacement cost. This overstates business profits for tax purposes in times of inflation; this kind of historical depreciation raised corporate t.ax liability by $25 billion in 1979 alone 2) calculating inventory according to histori c al cost generates illusory business profits. This added another $30 billion to corporate tax liabilities in 1979 3) inflation in creases the taxable capital gain on sales of assets--giving the Treasury a further windfall of $10 billion in 1979.2 As Table I 11 shows, these inflation induced tax increases reduced the real rate of return on corporate capital from an Lawrence H. Summers Tax Policy and Corporate Investment I National Bureau of Economic Research, Working Paper No. 605, December 1980, p. 9. 6 aver age of 9.4 percent before taxes in 1975 to 1978 to just 2.8 wedge significantly reduces the incentive for risk taking.

Some economists measure the cost to the economy due to tax code distortions. They .call this "excess burden I' Capital taxes impose the greatest excess burden.

Michael Boskin, and Lawrence H. Summers, in separate studies, esti mate that capital taxes reduce output by more than 100 billion a year. Charles Ballard, John Shoven, and John Whalley, in another study, calculated that every additional dollar from capital taxes costs 49 cents in lost economic output. The entire tax system's distortions waste an estimated 13 cents to 22 cents per dollar of tax revenue raised.3 The tax system, in other words, imposes very heavy costs on the economy, in addition to removing resources directly percent after federal, state, and local taxes. This broad tax I Economists Martin Feld s tein THE COST OF CAP I TAL IN AMERICA AND JAPAN Capital taxes hamstring American business. George Hatsopoulos chairman of a Massachusetts high-tech company and a director of the Federal Reserve Bank of Boston, told the Joint Economic Com mittee of Congres s recently that U.S. firms face a real cost of capital of approximately 20 percent per year4 is about 75 percent below that level. This advantage decisively boosts Japan's international competitiveness-especially in high tech industries. The Hatsopoulos st u dy reveals, moreover, that the real cost of capital services in the U.S. increased in the 1970s from 15 percent between 1963 and 1973 to over 20 percent after 1973, where it remains today. While U.S. capital costs soared, Japan's declined from 7 percent t o 5 percent in 1981.5 Tax-Free Savinu In Japan this cost Japan's attractive tax environment is the major stimulus for its high rate of capital formation and low real cost of capital.6 The Japanese taxpayer can earn tax-exempt interest income on cer tain de p osits totaling 14.5 million yen 61,000 The tax code Charles L. Ballard, John B. Shoven, and John Whalley The Welfare Cost of Distortions in the United States Tax System Approach National Bureau of Economic Research, Working Paper No. 1043 December 1982, p . 23 and Abstract.

Dr. George N. Hatsopoulos High Cost of Capital: Handicap of American Industry American Business Conference, Inc. and Thermo Electron C6rpo ration, April 26, 1983 A General Equilibrium Ibid pp. 1-2.

Arthur Anderson Co Comparison of Indiv idual Taxation of Long and Short Term Capital Gains on Portfolion Stock Investments and Dividend and Interest Income in Eleven Countries prepared for the Securities Industries Associ ation, June 1983 7 for example, allows investors to earn tax-exempt inte r est on government bond investments up to 3 million yen 13,000 Savers can invest 3 million yen in savings deposits at banks.or at the post office and the interest income is tax free. And workers can use payroll deduction plans to earn tax-free interest on up to 5 million yen 21,000 Aside from these tax-exempt accounts, the Japanese worker's interest income from bonds and time deposits is taxed at only 35 percent. Washington, by comparison, taxes all interest income, at rates up to 50 percent.

Zero Capital G ains Tax more favorably than the U.S. The U.S. taxes long-term capital gains at a maximum rate of 20 percent and short-term capital gains held less than 1 year) at up to 50 percent. Japan, however exempts long- and short-term capital gains from taxes. Eve n with the Reagan tax cuts, only the stagnant United Kingdom (30 percent and economically troubled Sweden (22 percent) tax long-term capi tal gains at a higher rate than the U.S. Japan's refusal to tax capital gains encourages stock purchases, boosts small business entrepreneurship, and stimulates capital investment Japan treats corporate profits, capital gains, and dividends Low Taxes on Dividends Along with most U.S. trading competitors, Japan taxes divi dends at a lower rate than the U.S: Compared to the maximum rate of 50 percent in the U.S Japan typically taxes dividends at 35 percent. Distributed earnings of Japanese corporations capitalized at over 100 million yen 422,300) are taxed at'32 percent; re tained profits are taxed at 42 percent. This amelio r ates the double taxation of dividends, enhances the attractiveness of stock invest ment, and lowers the cost of corporate capital The Japanese worker can receive a lump sum retirement payment from his firm free of tax. In 1981, according to economist Davi d Henderson, a retired worker paid no tax on the first $45,000 of such retirement income.7 These corporate retirement funds are now a major source of investment capital in Japan. The U.S. only permits tax-deferred retirement savings through IRAs and Keoghs .

Impact on High Tech Thanks in large part to this tax treatment of capital, the Japanese paid just 5 percent for their capital services in 1981 while U.S. industry had to pay 19 percent. This means that a pro duct costing $10,000 in labor and capital in t he U.S. would cost the Japanese as little as $4,9

00. Lower labor costs are one reason for this, but lower capital costs account for.about 45 percent of the difference David R. Henderson The Myth of MITI," Fortune magazine, August 8, 1983 p. 113.

Hatsopo ulos, op. cit, p. 33. ,I High capital costs in the U.S. are especially destructive to the risky, long-term investments typical of high-tech projects It has been estimated that a U.S. investor would be willing to risk only 40 percent of what a Japanese inv e stor would on the research and development R&D) costs for a project requiring five years of development, given similar conditions. This is due to the disparities in the relative costs of ~apital This is why Hatsopoulos and others concerned about high-tech industrial development are so alarmed at the high cost of capital in the U.S. American high-tech firms, beset with heavy capital costs, often cannot compete with the Japanese. As the evidence shows, it is Japan's low cost of capital, not targeted industri a l policy, that makes funds available to expanding firms and is sus taining the Japanese economic miracle THE 1981 AND 1982 TAX LAWS Many economists maintain that the changes made in the 1981 Economic Recovery and Tax Act (ERTA followed in 1982 by the Tax E quity and Fiscal Responsibility Act (TEFRA have reduced suffi ciently the taxes on capital. They claim that any further cuts in capital taxes are unnecessary, and even would be counterpro ductive, since they would widen the deficit and push up interest ra tes. Some argue that substantial increases in business taxes and personal tax rates are needed to reduce deficits and stimulate investment by reducing interest rates.

The 1981 tax act, in truth, stopped well short of the reforms needed to eliminate the tax bias against saving. The Accelerated Cost Recovery System (ACRS which was the keystone of Reagan's 1981 capital enhancing initiative, only reduced.the cost of capital by about 1.2 percent and mostly benefited those industries having large fixed assets. T h e high-tech companies employing fewer fixed assets got much less benefit from ACRS.1 reversed some of these reforms, the 1981 Act has had a very posi- tive impact While the 1982 Act a) Accelerated Depreciation (Accelerated Cost Recovery System-ACRS ERTA i m proved depreciation for tax purposes, and so helped shield businesses from the high effective taxes on corporate capital caused by inflation under previous law. But because TEFRA eliminated about 70 percent of ERTA's capital incentives, major additional t ax initiatives are now needed to bolster capital investment ACRS also reduced some of the tax distortions Hatsopoulos, op. cit, p. 36.

Hatsopoulos, op. cit, p. 27. lo (b) Incentives for Personal Savinq The 25 percent personal tax-rate reductions reduced th e high marginal taxes on savings significantly. Lowering the top marginal tax rate on investment income from 70 percent to 50 per cent has encourdged capital formation. This has given a signi ficant boost to new equity offerings and to the bond and stock m arkets. Previously, high capital gains taxes had sharply diminished these important sources of business capital and had undermined seriously small business startups. Now the financial markets are flush with new funds, due, in part, to the capital tax cuts c) Indexing Tax Brackets for Inflation Indexing tax brackets for inflation will be a powerful stimulus ,to capital formation. Though indexing only affects the personal income tax brackets, dividends, interest, and capital gains are taxed through the perso n al income tax when they accrue to individuals. Mor,e important, three-quarters of all businesses are sole proprietorships, Subchapter S corporations, or partner ships which pay taxes through the personal tax code. These busi nesses tend to be the smaller, faster growing firms that contri bute disproportionately to job creation and innovation THE REMAINING TAX AGENDA Major Reforms The 1981 tax changes may be lifting the U.S. from last place among Western nations in productivity and capital formation, yet th e reforms did not go nearly far enough. U.S. tax code changes are needed to eliminate the tax bias against saving and invest ment.ll 'The most direct means of achieving this would be to switch to a consumption tax. Under this system, income would be taxed o nly when consumed, not when saved A consumption tax is neutral between present and future consumption, taxing each at.the same real rate. Currently, future consumption is taxed at a much higher rate than present consumption because extra taxes are applied to the earnings from savings already taxed. By increasing the after tax return to saving, a consumption tax would encourage saving and investment A number of reforms would construct a comprehensive consump tion tax l1 Ture and Sanden, op. cit. The followi n g closely follows the approach in this book 10 Tax either net savings or the net return to savings--not both the taxpayer simply computes income and deducts net savings. Interest income is taxed when consumed. This would eliminate the double taxation of s avings, a major barrier to capital formation To figure taxable income under the latter method Eliminate the corporate profits tax.

A'consumption tax would not tax corporate earnings until they are consumed. Retained earnings and other forms of net corporat e savings would be excluded from taxes. Shareholders would pay taxes on distributed business profits when they are spent. This treatment eliminates the double taxation of dividends, reduces the tax burden on capital, and equalizes the tax treat ment of di fferent kinds of investment.

Abolish business depreciation allowances and replace them with immediate expensinqll of all asset purchases.

The purchase of assets is a form of saving and should, therefore, be deductible from income. All pro ceeds from the s ale of assets including stocks and bonds would then be included in the taxable income in the year of the sale. Capital gains and losses would be entirely eliminated from the tax code. This tax treat ment eliminates the inflation induced distortions of his torical depreciation, creates tax neutrality among all classes of assets, and enhances incentives for capi tal investment.

Eliminate estate and gift taxes.

Inheritance taxes directly bear on capital investment and, therefore, shrink the pool of savings and dampen capital investment income Inheritances should be taxed only when spent.

Reduce Marginal Income Tax Rates.

Because high marginal tax rates magnify the bias against work, saving, and investment, the federal per sonal income tax should be lowered to a flat rate of 19 percent.

Limited Tax Revisions The chances of Congress enacting such changes in the tax structure are slim i'n the near term: But incremental changes could nudge the tax code in the direction of mitigating s ignifi cantly its anti-saving bias and thereby encourage capital forma- tion. Examples: 11 1) Corporate Income Tax-Rate Reductions The tax'on corporate profits, most experts agree, dis torts the relationship between the corporate and noncorporate sectors, dlscriminates unfairly against certain assets, and dis courages corporate investment. To correct this, the corporate income tax should be abolished and corporate earnings taxed only when consumed As a step toward this, Congress could reduce the tax rates o n corporate income. Complete elimination of the corporate income tax would have reduced the cost of capital by 3.5 percentage points in 1981 2) Corporate Deduction for Dividends or Shareholder Tax Credits The corporate profits tax discriminates against eq u ity financing while encouraging heavy indebtedness because interest expense is deductible from taxable income, but dividend payments to shareholders are not. The result: Dividends are subject to double taxation, once at the corporate level, and again at t he personal level.

One means of eliminating this distortion would be to allow corporations to deduct dividends from taxable income in the same manner as they deduct interest outlays. This would eliminate double taxation and give equal tax treatment to both equity and debt finance. The Hatsopoulos study calculates that this would reduce the cost of capital to profitable firms by 9 percentage points cutting.it from 19 percent to 10 percent. An equivalent method would be to give a credit to shareholders for t h e tax that corpora tions have already paid on distributed earnings 3) Capital Gains Tax Reform Thanks to inflation, capital gains taxes often become taxes on capital itself. The current tax system. makes no distinc tion between inflation induced gains and gains caused by real improvements in value The assessed value of capital investments therefore, should be adjusted for inflation, so that taxes are paid only on real gains The tax also should be reduced and, ulti mately, eliminated to enhance the environm e nt for capital formation The Treasury ironically may find itself collecting more revenues from a lower rate than it does now. In 1978, for example the tax was reduced from 40 percent to 28 percent enough additional investment to generate a net increase in revenues.12 This spurred I i I 4 l2 Me1 Colchamiro Revenue Estimmtes of an Elimination of the Capital Gains Holding Period Office of Economic Research, New York Stock Exchange July 19

83. See also "An Analysis of the Capital Gains Holding Period,"

Office of Economic Research, July 1982, pp. 9-10. 12 The holding period for capital gains should be eliminated bringing the U.S. tax treatment of capital gains more into line with the other industrialized countries. The extra tax that Washington imposes on gain s on investments held less than one year encourages investors to hold assets for longer than they otherwise would, thus restricting the mobility of capital and discourag ing investment in equities. Studies find that eliminating the capital gains holding pe r iod could generate more net revenues for the government by causing stockholders to sell off stocks more often and by stimulating equity investment.13 4) Expanding the IRA Deduction Individual Retirement Accounts (IRAs) have attracted an estimated 30-$50 b illion in funds in 19

82. These accounts encour age individuals to put aside funds for their retirement. While many savers may be shifting funds from existing accounts into IRAs, as existing savings accounts are drawn down, new saving will flood to IRAs in order to take advantage of the tax break.

Congress could accelerate this by eliminating the penalty for early withdrawal and increasing the ceiling for deductions.

Congress also could allow savers to deduct a share of their savings, say 50 percent, from taxable income, thereby cutting mar ginal tax rates on savings. The 1981 ERTA took a small step in this direction. One provision allows an exclusion of 15 percent of net interest income up to $3,000 6,000 on a joint account starting in 1985 5) Reductions in Marcfinal Income Tax Rates The bulk of the Reagan personal tax cuts have been eaten up by bracket creep and Social Security tax increases. Most Americans, in fact, will be no better off in 1988, from the point of view of'tax burden, than they were in 1 9

78. While only 3 per cent of taxpayers in 1960 faced marginal tax rates of 30 percent or above, 34 percent were in that tax bracket or higher in 1981.

The Reagan tax cuts will only restrain increases in those tax rates. Marginal tax rates should be cut further.

CONCLUSION Supporters of industrial policy have proposed Ita government industry partnership" to pick winners and bolster losers. What they overlook is that the U;S. already has a system to pick win ners and losers: the marketplace. In the marketplace, a c ompli cated network of financial institutions, individual entrepreneurs l3 Ibid 13 and investors decides which projects deserve funding. History proves that this is extraordinarily more successful than having Washington bureaucrats or politicians allocate resources industrial policy would insert the government into the heart of economic decision making An I Advocates of an industrial policy gaze longingly-and envi ously--at Japan as a model. This,is wise. But they seldom recognize what they are looking at. Japanese success stems not from an industrial policy,14 but from Tokyo's favorable, tax treat ment of capital. The result: Japanese businessmen can count on a high volume of capital at a far lower cost than their American counterparts.

The U.S. should emu late Japan, not by imitating an irrelevant industrial policy, but by copying its tax treatment of capital and investment. Like Japan, the U.S. should reduce taxes on capi tal gains, corporate income, dividends, and savings. Like Japan the U.S. should free up the market so that it can raise and allo cate capital efficiently. The ultimate goal should be replacement of the current U.S. tax system with a consumption tax. Such reforms would increase the capital available to.the American economy, thus triggering vigorous and sustained economic growth and millions of .new jobs I Thomas M. Humbert Walker Fellow in Economics l4 See also Katsuro Sakoh, Ph.D Industrial Policy: The Super Myth of Japan's Super Success Asian Studies Backgrounder No. 3, The Heritage Found ation, July 13, 1983.