Economic Growth and Economic Growth and International CompetitivenessInternational Competitiveness

Presentation to the President’s Presentation to the President’s Advisory Panel on Federal Tax Advisory Panel on Federal Tax

ReformReform

Alan J. AuerbachAlan J. AuerbachMarch 31, 2005March 31, 2005

OverviewOverview

How the tax system can influence growth How the tax system can influence growth and international competitivenessand international competitiveness

Issues in the design of effective tax Issues in the design of effective tax incentivesincentives

How the tax system How the tax system cannotcannot influence influence growth and international competitivenessgrowth and international competitiveness

Implications for the design of fundamental Implications for the design of fundamental tax reformtax reform

The Tax System, Growth and The Tax System, Growth and CompetitivenessCompetitiveness

Competitiveness: many definitionsCompetitiveness: many definitionsCost relative to foreign goods?Cost relative to foreign goods?– depends on exchange ratedepends on exchange rate– comparative advantage: can’t be competitive comparative advantage: can’t be competitive

at everythingat everything

Productivity, typically measured per Productivity, typically measured per worker hourworker hour– depends on technology (intangible capital), depends on technology (intangible capital),

tangible capital, and human capitaltangible capital, and human capital– how are these affected by tax policy?how are these affected by tax policy?

Tax Policy and Human CapitalTax Policy and Human Capital

Since primary cost of education and Since primary cost of education and training is forgone earnings, already close training is forgone earnings, already close to the consumption tax modelto the consumption tax model– expenses are effectively deductible because expenses are effectively deductible because

taxes on earnings are avoidedtaxes on earnings are avoided

Major negative impact is through Major negative impact is through progressive rate structure: “success” taxprogressive rate structure: “success” taxBut progressive rates also provide But progressive rates also provide insurance, promoting risky human capital insurance, promoting risky human capital investment that benefits society at largeinvestment that benefits society at large

Tax Policy and Intangible CapitalTax Policy and Intangible Capital

Technological progress involves positive Technological progress involves positive “spillovers” from individual advances“spillovers” from individual advancesSocietal returns may be higher than Societal returns may be higher than individual returns; may justify subsidyindividual returns; may justify subsidyR&E credit a response to this argument; R&E credit a response to this argument; but such expenditures already tax-favoredbut such expenditures already tax-favored– immediate expensing rather than depreciationimmediate expensing rather than depreciation

Productivity reflects more than the level of Productivity reflects more than the level of technology; also degree of regulation, technology; also degree of regulation, flexibility of employment relationships, etc.flexibility of employment relationships, etc.

Tax Policy and Intangible CapitalTax Policy and Intangible Capital

Summary: Technological spillovers may Summary: Technological spillovers may justify an R&D subsidy, butjustify an R&D subsidy, but– a subsidy exists even without the R&E credita subsidy exists even without the R&E credit– policy to spur productivity growth depends on policy to spur productivity growth depends on

more than the tax systemmore than the tax system

Tax Policy and Tangible CapitalTax Policy and Tangible Capital

Affected by myriad tax provisions that Affected by myriad tax provisions that influence overall rate of capital income influence overall rate of capital income taxationtaxation

One should distinguish betweenOne should distinguish between– broad and targeted provisionsbroad and targeted provisions– temporary and permanent provisionstemporary and permanent provisions– saving and investmentsaving and investment– new and old capitalnew and old capital

Broad vs. TargetedBroad vs. Targeted

General principle: broad base, low tax rate General principle: broad base, low tax rate provides greatest economic efficiency, provides greatest economic efficiency, simplicity and ease of administrationsimplicity and ease of administration

Why deviate from this norm? (e.g., ITC)Why deviate from this norm? (e.g., ITC)– positive spillovers? no convincing evidencepositive spillovers? no convincing evidence– to offset other tax benefits? difficult to get rightto offset other tax benefits? difficult to get right– concern about effects if perceived to be concern about effects if perceived to be

temporarytemporary

Temporary vs. PermanentTemporary vs. Permanent

1960s: ITC; 2002-3: bonus depreciation1960s: ITC; 2002-3: bonus depreciation

Why? encourage investment; implemented Why? encourage investment; implemented when investment has been lowwhen investment has been low

But no evidence that these temporary But no evidence that these temporary provisions stabilize investment or GDPprovisions stabilize investment or GDP

Saving vs. InvestmentSaving vs. Investment

With international capital flows, saving and With international capital flows, saving and investment are distinctinvestment are distinct– U.S. capital can be invested abroadU.S. capital can be invested abroad– foreign capital can be invested hereforeign capital can be invested here

Encouraging saving aids GNPEncouraging saving aids GNP– most direct way to enhance wealth creationmost direct way to enhance wealth creation

Encouraging investment aids GDPEncouraging investment aids GDP– may aid in adoption of new technologymay aid in adoption of new technology

But saving and investment tend to move But saving and investment tend to move together, so differences in incentives mutedtogether, so differences in incentives muted

New vs. Old CapitalNew vs. Old Capital

Reducing burden on existing capital Reducing burden on existing capital discouragesdiscourages saving and investment saving and investment

Incentive provisions vary greatly with Incentive provisions vary greatly with respect to relative benefits provided to respect to relative benefits provided to new and old capitalnew and old capital

New vs. Old CapitalNew vs. Old Capital

Reducing burden on existing capital Reducing burden on existing capital discouragesdiscourages saving and investment saving and investment

Incentive provisions vary greatly with Incentive provisions vary greatly with respect to relative benefits provided to respect to relative benefits provided to new and old capitalnew and old capital

capital gains tax cut

OLD NEW

incremental ITC

corporate tax rate cut

investment tax credit

New vs. Old CapitalNew vs. Old Capital

Focusing on new capital more efficient but Focusing on new capital more efficient but also more difficultalso more difficult– timing issuestiming issues– base definitionbase definition

But phased-in provisions can also limit But phased-in provisions can also limit windfalls while providing incentiveswindfalls while providing incentives– example: scheduled corporate rate reductionexample: scheduled corporate rate reduction– sunsets get this exactly backwardsunsets get this exactly backward

New vs. Old CapitalNew vs. Old Capital

Substance vs. form: provisions that appear Substance vs. form: provisions that appear focused on new capital may not befocused on new capital may not be

Example: shifting existing assets from Example: shifting existing assets from taxed to sheltered form does not increase taxed to sheltered form does not increase saving – it reduces national savingsaving – it reduces national saving– references to “consumption tax treatment” are references to “consumption tax treatment” are

misleading because result is lump-sum misleading because result is lump-sum transfer, not a consumption taxtransfer, not a consumption tax

Incentives and DeficitsIncentives and Deficits

Measuring the “bang for the buck” is tricky, Measuring the “bang for the buck” is tricky, because provisions vary in their timingbecause provisions vary in their timing

““Frontloaded” provisions (e.g., traditional Frontloaded” provisions (e.g., traditional IRA) look more expensive than equivalent IRA) look more expensive than equivalent “backloaded” ones (e.g., Roth IRA)“backloaded” ones (e.g., Roth IRA)

This can make more efficient provisions This can make more efficient provisions look less effective (e.g., ITC vs. corporate look less effective (e.g., ITC vs. corporate rate cut)rate cut)

What Tax Reform Cannot DoWhat Tax Reform Cannot Do

The current account imbalance plus the The current account imbalance plus the capital account imbalance must sum to capital account imbalance must sum to zerozeroThe capital account imbalance equals the The capital account imbalance equals the difference between domestic investment difference between domestic investment and national savingand national savingThe current account imbalance The current account imbalance cannotcannot be be reduced unless national saving increases reduced unless national saving increases or domestic investment fallsor domestic investment falls

What Tax Reform Cannot DoWhat Tax Reform Cannot Do

Border adjustments (as under a VAT) do Border adjustments (as under a VAT) do not encourage saving or discourage not encourage saving or discourage investmentinvestment

After exchange rate adjustment, little After exchange rate adjustment, little impact on capital flows or trade balanceimpact on capital flows or trade balance

Logic different than for specific export Logic different than for specific export subsidies or import taxes, which would subsidies or import taxes, which would alter composition of exports and importsalter composition of exports and imports

What Tax Reform Cannot DoWhat Tax Reform Cannot Do

For the United States, border adjustments For the United States, border adjustments would actually would actually reducereduce revenues and revenues and hence national saving over time, because hence national saving over time, because we are in debt to the rest of the world and we are in debt to the rest of the world and will have to run trade surpluses in futurewill have to run trade surpluses in future– this would worsen the current account this would worsen the current account

balance, though not substantiallybalance, though not substantially

Summary: border adjustments not Summary: border adjustments not importantimportant

Implications for Tax ReformImplications for Tax Reform

With few exceptions, avoid targeted tax With few exceptions, avoid targeted tax incentivesincentivesTransition provisions matter a lotTransition provisions matter a lot– a consumption tax transition that fully protects a consumption tax transition that fully protects

existing capital can turn a winner into a loserexisting capital can turn a winner into a loser– phase-ins may helpphase-ins may help

Piecemeal approaches may go the wrong Piecemeal approaches may go the wrong way:way:– hybrid system’s incentives may be worst (e.g., hybrid system’s incentives may be worst (e.g.,

borrowing to invest in tax-preferred assets)borrowing to invest in tax-preferred assets)

Selected ReferencesSelected References

1.1. Altig, David, Alan J. Auerbach, Laurence J. Kotlikoff, Altig, David, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser “Simulating Kent A. Smetters, and Jan Walliser “Simulating Fundamental Tax Reform in the United States,” Fundamental Tax Reform in the United States,” American Economic ReviewAmerican Economic Review 91(3), June 2001, pp. 574- 91(3), June 2001, pp. 574-595 (transition provisions)595 (transition provisions)

2.2. Auerbach, Alan J., “The Future of Fundamental Tax Auerbach, Alan J., “The Future of Fundamental Tax Reform,” Reform,” American Economic ReviewAmerican Economic Review 87(2), May 1997, 87(2), May 1997, pp. 143-146 (border adjustments)pp. 143-146 (border adjustments)

3.3. Auerbach, Alan J., and Kevin Hassett, “Tax Policy and Auerbach, Alan J., and Kevin Hassett, “Tax Policy and Business Fixed Investment in the United States,” Business Fixed Investment in the United States,” Journal of Public EconomicsJournal of Public Economics 47(2), March 1992, pp. 47(2), March 1992, pp. 141-170 (investment incentives and stabilization)141-170 (investment incentives and stabilization)