How Would Tax Reform Affect Financial Markets?

How Would Tax Reform Affect Financial Markets?

By John E. Golob

The U.S. Congress is evaluating several pro-posals to reform the federal income tax sys-tem. Proponents of tax reform want to

simplify tax preparation and stimulate economicgrowth by increasing the incentives for taxpayers towork, save, and invest.

While the primary objective of tax reform is amore productive economy, changing the tax lawswould also affect financial markets. Several of theproposals would change the way interest expensesare deducted and change the way income frominterest, dividends, and capital gains is taxed. Thesechanges would affect interest rates and the pricesof stocks.

This article analyzes the effects of income taxreform on U.S. financial markets. The first sectionof the article describes the general goals and fea-tures of tax reform. The second section analyzes inbroad terms how tax reforms would affect financialmarkets. The third section examines the specificproposals that Congress is evaluating and ranksthem according to their effects on interest rates andstock prices.

The article reaches three conclusions. First, mostproposals would reduce interest rates in credit mar-kets where interest income is currently taxable,including bank loans, Treasury securities, and cor-porate securities. Second, all proposals would in-crease interest rates in municipal credit marketswhere interest income is not currently taxable. Andthird, most proposals would increase stock prices.All three of these effects could be substantial.

AN OVERVIEW OF TAX REFORM

Tax reformers typically agree that the broad goalof reform is to improve the well-being of U.S.taxpayers. One way to accomplish this goal isthrough tax simplification. Few taxpayers findpleasure in filling out their tax forms, and mostwould welcome a simpler, less costly way of per-forming this irritating annual ritual.

Another way to improve the well-being of tax-payers is to spur economic growth. Reformerswould do so by minimizing the disincentives inher-ent in all tax systems. For example, economists havelong recognized that taxing wages discourageswork and taxing capital income discourages saving.Some tax systems distort economic decisions morethan others. Proponents of reform want to minimizesuch distortions.

John E. Golob is an economist at the Federal Reserve Bankof Kansas City. Stephen Monto, a research associate at thebank, helped prepare the article.

Goals of tax reform

Tax reformers want to simplify the tax system tolower the costs of tax compliance. Although all ofthe costs of complying with the tax laws cannot bemeasured, estimates of these costs are substantial.Compliance costs include the time taxpayers spendpreparing returns and the money they pay to taxpreparers. Taxpayers must also keep records, andthe IRS estimates that the record-keeping time ex-ceeds the preparation time for some tax forms. In astudy of 1985 tax returns commissioned by the IRS,Arthur D. Little, Inc. estimated that tax preparationand record-keeping costs were $50 billion for indi-viduals and $100 billion for businesses. Since then,both the number of taxpayers and the reportingrequirements have increased. Proponents of taxreform argue that a simpler tax system would elimi-nate most of the compliance costs.

In addition to reducing the explicit costs of taxcompliance, proponents contend that a simpler taxsystem would reduce taxpayer frustration. The taxsystem currently contains approximately 480 IRSforms, 280 IRS information pamphlets, and thou-sands of pages of supplementary documentation.Money magazine highlighted this complexity whenit asked 41 tax professionals to prepare the return ofa fictional family who owed $35,000 in taxes(Tritch). Even though all 41 preparers knew theirresults would be published in the national maga-zine, only two preparers calculated the tax within$500 of the correct amount, and 14 missed by over$5,000. As further evidence of the system’s com-plexity, up to a third of the callers to IRS taxpayerassistance lines receive incorrect answers (Simon).

More important than tax simplification, tax re-formers also want to reduce the disincentives in thetax system. Tax reform proposals would encourageindividuals to work and save more, and wouldencourage businesses to invest and export more. Inaddition, the proposals would discourage investorsfrom making unsound investments designed to

reduce tax liabilities. Finally, the proposals wouldreduce the incentives for individuals and busi-nesses to evade taxes by entering the “undergroundeconomy.”

The greatest concern of tax reformers is the lowU.S. savings rate. Reformers contend that the cur-rent income tax system encourages consumptionover savings and that the United States needs to savemore to keep its economy healthy. The U.S. savingsrate has been declining since the 1960s, and thesavings rate has been lower over the last ten yearsthan in any other ten-year period in U.S. history(Bernheim and Shoven). The savings rate is alsolower in the United States than in most other indus-trialized countries and is less than half the rate inJapan (OECD). Thus, all tax reform proposals in-clude features to encourage taxpayers to save moreof their income. Higher savings, in turn, wouldpromote more investment spending, higher produc-tivity growth, and ultimately, a higher standard ofliving.

The broad goals of tax reform are supported bymany legislators, economists, and political ana-lysts. Critics, however, are concerned about possi-ble side effects. For example, provisions thatencourage greater savings could also lead to a risein income inequality. Critics are also concerned thatcertain sectors of the economy would be hurt by taxreform. For example, homeowners and the housingindustry have benefited from the home mortgagededuction, and both are concerned about losing thisimplicit subsidy. Issues such as these will be impor-tant in the ongoing debate over tax reform and willneed to be addressed in conjunction with the finan-cial market effects addressed in this article.1

Features of tax reform

Tax reformers want to change several features ofthe tax code. To improve tax incentives, most pro-posals would reduce tax rates. But because lowerrates could lead to less revenue, the proposals would

20 FEDERAL RESERVE BANK OF KANSAS CITY

also eliminate many tax credits and deductions.Reformers also want to ensure that high-incomehouseholds continue to pay higher average tax ratesthan low-income households.

This section describes the general features of taxreform being evaluated by Congress. Some of thefeatures are common across multiple proposals,while others are unique to a single proposal. Thefeatures are broken into three categories. The firstcategory contains the proposed changes to the indi-vidual income tax, the second category contains theproposed changes to the business income tax, andthe final category describes the proposed directtaxes on consumption. Taxing consumption directlyhas been proposed as an alternative to taxing theincome of individuals and businesses.

Individual income tax. Reformers have proposedseven key changes to the individual income tax:2 (1)reduce marginal tax rates, (2) increase the incomeexempt from taxes, (3) reduce or eliminate deduc-tions, (4) eliminate taxes on income from invest-ments,3 (5) allow a deduction for savings, (6) taxindividuals for the interest income received frommunicipal securities, and (7) tax individuals on thevalue of their fringe benefits.

The first tax change for individuals would reducemarginal tax rates. The marginal tax rate is the ratetaxpayers pay on the last dollar of their income. Itis the rate economists consider most relevant foreconomic decisions (appendix). Marginal tax ratescurrently vary from 15 percent for low-incomehouseholds to 39.6 percent for households earningover $250,000. Proponents of lower marginal ratessay high marginal rates discourage work and encour-age taxpayers to spend resources avoiding taxes.

To reduce marginal rates as much as possiblesome tax reformers propose a flat tax. Under a flattax all income above a certain threshold would betaxed at a single rate. Proponents have proposed flatrates from 17 to 20 percent, depending on other

features of the proposals. Not all tax reformerswould flatten rates, however, and one proposal in-cludes a multiple-rate structure that would increasethe marginal rate for many taxpayers.

The second tax change for individuals wouldincrease the personal exemption, which is theamount of income that is exempt from taxes.Households with incomes less than the personalexemption pay no taxes. The current exemptiondepends on filing status and ranges from $3,800 forsingle taxpayers to $6,350 for married taxpayersfiling jointly.4 All income tax reform proposalswould raise this exemption. One proposal wouldraise the exemption to $13,100 for single taxpayersand $26,200 for married taxpayers filing jointly.

Tax reformers have two reasons for increasing thepersonal exemption. First, a high personal exemp-tion eliminates taxes for many low-income house-holds. Second, a high personal exemption ensuresthat the tax system is progressive, which means thathigh-income taxpayers pay a greater proportion oftheir income in taxes than low-income taxpayers.

The third tax change for individuals would reduceor eliminate many tax deductions. The three mostimportant deductions are mortgage interest ex-penses, state and local taxes, and charitable contri-butions. Tax reformers would reduce thesedeductions to increase taxable income, therebycompensating for the reforms that would reducerevenue. Some reformers offer a second reason foreliminating these deductions. They want to mini-mize the importance of taxes in economic deci-sions. For example, the home mortgage deductioncurrently encourages households to buy rather thanrent their residences. If this deduction were elimi-nated, households would no longer have to considertaxes when deciding whether to buy or rent.5

The fourth tax change for individuals would re-duce or eliminate taxes on income from savings,also known as capital or investment income. Capital

ECONOMIC REVIEW • FOURTH QUARTER 1995 21

income includes interest income, stock dividends,and capital gains from the sale of real or financialassets. Tax reformers contend that high taxes oncapital income encourage taxpayers to consumerather than save.

Many economists are especially critical of thetaxes on dividends and capital gains because thesetaxes are applied to income that has already beentaxed. Earnings from capital invested in a businessare taxed first as business income and second asdividends and capital gains. This double taxationcan imply effective marginal tax rates on capitalincome of up to 60 percent.6

In addition to affecting incentives, eliminatingtaxes on interest income would simplify the taxsystem. If taxes on interest income and deductionsfor interest expenses were eliminated, the IRS couldstop monitoring all interest payments. Currently,over a billion IRS 1099 forms must be filled outeach year to keep track of the interest transactionsin the U.S. economy.

The fifth tax change for individuals would allowa deduction for income saved. Under this proposedchange, taxpayers would pay taxes only on the partof their income they consumed. Tax reformers haveproposed the savings deduction as an alternative toeliminating taxes on investment income. Bothstrategies would increase the incentives to save.7

The sixth tax change for individuals would affecttaxpayers receiving interest income from municipalsecurities. Taxpayers currently do not pay taxes oninterest income from municipals, which includesecurities issued by both state and local govern-ments. One proposal would increase federal taxrevenue by taxing the income from municipals.

The final tax change for individuals would in-clude fringe benefits as taxable income. Becausefringe benefits are not currently taxed, many largecompanies have increased fringe benefits as a frac-

tion of employee compensation. Taxing these bene-fits would generate substantial revenue. Thischange would also treat employees more equitably,since employees with substantial fringe benefitscurrently pay lower effective tax rates on their totalcompensation.

Business income tax.8 Reformers have proposedsix key changes to the business income tax system:9

(1) reduce tax rates, (2) eliminate industry-specificdeductions and credits, (3) eliminate taxes on in-come from financial investments, (4) eliminatedeductions for interest paid, (5) allow immediatedeductions for capital investments, and (6) elimi-nate deductions for fringe benefits.

The first tax change for businesses would lowertax rates on business income. Proponents give threereasons for reducing these rates. First and mostimportant, taxing business income discouragesbusiness investment. That is, taxes on businessincome reduce the after-tax return on investment,which reduces the number of investments that areeconomically viable. Lowering these taxes wouldmake more investments viable and leave businesseswith more money to invest.10

A second reason tax reformers want to reduce thebusiness tax rate is to help the United States attractmore international business. Lower business taxeswould allow companies to increase their after-taxprofits by relocating to the United States from coun-tries with higher taxes.

A third reason flat-tax proponents want to reducethe business tax rate is to make business and indi-vidual rates similar. If businesses and individualspaid the same rates, lawyers and tax accountantswould be less able to avoid taxes by creativelymoving income and expenses between the two taxsystems. This flexibility caused federal revenuesto fall substantially below projections after the1986 Tax Reform Act (Poterba). Small businesseswere able to reduce their tax liability by filing as


Subchapter S corporations, which allowed them topay the tax rate for individuals rather than the highertax rate for businesses.

The second tax change for businesses wouldeliminate all industry-specific tax credits and de-ductions. Critics contend these tax subsidies cannotbe justified from a public policy perspective. Theyargue the tax code should not be used to conductindustrial policy because most “loopholes” growout of effective lobbying campaigns rather thanpublic need.

The third tax change for businesses would elimi-nate taxes on income from financial investments.Most of this income is from interest on liquid assets,but some businesses also have income from stockholdings. Proposals that would eliminate taxes onfinancial income for businesses are typically thesame proposals that do so for individuals. Propo-nents give the same reasons as those already dis-cussed, simplifying taxes and eliminating doubletaxation.

The fourth tax change for businesses would elimi-nate deductions for interest paid on debt. Currently,interest expenses are among the items businessesdeduct from their revenues when they calculatetaxable profits. Disallowing the interest deductionwould substantially increase tax revenues, whichwould partly compensate for the revenue lost byeliminating taxes on interest income.

The fifth tax change for businesses would allowan immediate deduction for capital investments,which include expenditures on buildings, furniture,vehicles, and equipment. Businesses currentlyspread these deductions over several years, corre-sponding to the useful life of each investment. Ineach year the deduction compensates the businessfor the amount that the investment wears out, ordepreciates, during the year. Allowing immediatedeductions for business investments would reducetheir taxable income and would encourage them to

invest more. Although this change would ulti-mately benefit all businesses, many could sufferduring a transition period. Some proposals wouldnot allow depreciation deductions for previous invest-ments, and these proposals would only benefit busi-nesses with investments larger than their depreciationdeductions.11

The final tax change for businesses would elimi-nate deductions for employee fringe benefits. Therationale for eliminating the deductions is that em-ployees do not currently pay taxes on these benefits.Eliminating business deductions for fringe benefitswould increase federal tax revenues without taxingemployees directly.

Consumption tax. Several tax reformers have pro-posed replacing the income tax with a direct tax onconsumption. Taxpayers would pay the consump-tion tax on retail purchases the same way they nowpay state and local sales taxes. Supporters of theconsumption tax estimate that a 17 percent federaltax rate could replace the revenue currently gener-ated by the income tax system. To rally support fora consumption tax, proponents promise to abolishthe IRS.

Tax reformers have proposed two alternative con-sumption taxes, a sales tax and a value-added tax.The two taxes would be indistinguishable to a tax-payer. In both cases, the retail price of goods andservices would increase by the amount of the tax.

The difference between a sales tax and a value-added tax emerges when viewed from the perspec-tive of a business. A sales tax is collected only byretailers. In contrast, a value-added tax is collectedby each business that adds value to a product.Consider a manufacturer that builds a car from rawmaterials and then sells the car to a dealer. A salestax would be collected only by the dealer. A value-added tax would be assessed on the supplier of rawmaterials, the manufacturer, and the dealer. Theprice the manufacturer pays for raw materials


would increase by the amount of the value-addedtaxes paid by the suppliers of the raw materials. Theprice the dealer pays would reflect the value-addedtaxes paid by both the raw materials supplier andthe manufacturer. Finally, the price the consumerpays would reflect the value-added taxes paid by allthree—supplier, manufacturer, and dealer.

A sales tax has both an advantage and a disadvan-tage relative to a value-added tax. Since a sales taxis collected entirely at the retail level, the tax iseasier to administer. The disadvantage of a sales taxis that assessing the entire tax at one point increasesthe incentive to evade it. For example, the entire taxcould be evaded by a black-market retailer. Thevalue-added tax is more difficult to evade becauseit is not levied at a single point.

A direct consumption tax would be administereddifferently than an income tax, but both tax systemswould have similar effects on financial markets.The effects would be similar because both tax pro-posals tend to put the tax burden on the part ofincome that is consumed. The similarity is ex-plained further in the next section.

FINANCIAL MARKET EFFECTS OFTAX REFORM

Tax reform would have direct and indirect effectson financial markets. The direct effects would stemfrom changes in taxes on capital income andchanges in the deductibility of interest expenses.The indirect effects would occur through changesin the economy. Reformers contend that changingthe tax system would increase savings, investment,and economic growth, thereby indirectly affectingfinancial markets. This section describes both thedirect and indirect effects of tax reform and explainswhy the direct effects are typically larger.

The analysis in this section assumes that taxreform would not affect the level of federal reve-nues or the federal budget deficit. 12 This assumption

is reasonable because the sponsors have tried todesign the proposals to be revenue-neutral. Never-theless, Congress has not yet produced any officialestimates of the revenue impact of tax reform.Previous tax reforms have shown that revenuechanges can be difficult to forecast, and revenueuncertainty must be recognized as a risk in anyreform proposal (Poterba).

Direct effects

The financial markets affected by tax reform canbe broken into three categories. The first categorycontains debt contracts whose interest income iscurrently taxable, including bank debt, Treasurysecurities, and corporate securities. The second cate-gory contains municipal securities whose interestincome is not currently taxable. The final categorycontains the stocks of publicly traded corporations.

Taxable interest rates. Two features of the pro-posed tax reforms would directly affect interestrates on securities that are currently taxable. First,many proposals would eliminate taxes on all inter-est income. Second, many proposals would eitherreduce or eliminate the deductibility of interestexpenses. These changes would reduce the demandfor credit and increase the supply, which wouldcause interest rates to decline.

Eliminating the deductibility of interest ex-penses would reduce the demand for credit. Busi-nesses currently deduct all of their interestexpenses. Individuals deduct the two largest com-ponents of their interest expenses, home mortgagesand debt incurred for financial investments.13 To theextent that interest deductions reduce a borrower’staxes, the effective after-tax costs of a borrower’sloan are less than the payments to the lender.Eliminating the interest deduction would makeborrowing less attractive, causing the demand forcredit to decline. On a graph with interest rates onthe vertical axis, the demand curve would shift tothe left (Figure 1).


Quantity

THE EFFECT OF TAX REFORM ON THE DEMAND FOR CREDITFigure 1

Interest rate

Demand under currenttax code

0

Quantity

THE EFFECT OF TAX REFORM ON THE SUPPLY OF CREDIT

Figure 2

Interest rate

Supply after eliminatingtaxes on interest

0

Supply under currenttax code


Just as interest deductibility affects credit de-mand, taxing interest income affects credit supply.If taxes were eliminated on interest income, lendingwould become more attractive, causing the supplyof credit to increase. An increase in the supply ofcredit implies that the credit supply curve wouldshift to the right (Figure 2).

The equilibrium interest rate occurs where thecredit demand and credit supply curves intersect.With the credit demand curve shifting to the left andthe credit supply curve shifting to the right, theequilibrium interest rate would decline (Figure 3).

How much would rates decline? The shift incredit supply and demand curves can be estimatedby considering how taxes affect borrowing andlending decisions. The analysis is based on theassumption that after-tax interest rates are the rele-vant rates when borrowers and lenders agree to debtcontracts. The importance of tax considerations canbe illustrated by comparing the interest rates ontaxable Treasury securities with the interest rates onnontaxable municipal securities (Chart 1). Eventhough Treasury securities are less risky than mu-nicipals, municipals consistently pay lower interestrates. Credit suppliers are willing to accept thelower interest rate on municipals because the after-tax return on municipals is generally higher than theafter-tax return on Treasuries.

The shift in the credit demand curve is related tothe tax rate of individuals and businesses that deductinterest expenses from their taxable income. Con-sider the credit demanded by a taxpayer paying a 25percent marginal tax rate. For this taxpayer, an 8percent tax-deductible interest rate is equivalent toa 6 percent nondeductible rate. That is, his taxeswould be reduced by one-fourth of the 8 percentinterest payment, causing his effective interest rateto be three-fourths of 8 percent, or 6 percent. Thistaxpayer would be indifferent if offered a choicebetween an 8 percent tax-deductible interest rateand a 6 percent nondeductible rate. If interest

deductibility were eliminated and nothing elsechanged, the taxpayer would demand the sameamount of credit at 6 percent as he had previouslydemanded at 8 percent. This quantifies the shift inthe taxpayer’s credit demand curve. On a graph withinterest rates on the vertical axis, the taxpayer’scredit demand curve would shift downward by afraction corresponding to the marginal tax rate.Returning to the numerical example, the newcredit demand curve would be 75 percent of theoriginal curve.

The analysis of tax effects on credit demand foran individual extends to the U.S. economy. Theanalysis is complicated, however, by the fact thatnot all taxpayers pay the same tax rate. Marginal taxrates for individuals and small businesses begin at15 percent and increase to 39.5 percent. Largebusinesses pay marginal rates according to a sepa-rate tax schedule, which taxes most corporate in-come at a 35 percent rate.

Because different taxpayers are taxed at differentrates, economists often use the marginal tax ratepaid by the “average” taxpayer when analyzing theeconomic effects of taxes (Barro and Sahasakul).This approach can be used to estimate the shift inthe credit demand curve. Since both individuals andbusinesses deduct interest expenses, both of theirtax rates are relevant. For individuals and smallbusinesses the average marginal rate is about 25percent. With a 35 percent tax rate for large busi-nesses, the effective tax rate for interest deductionsshould fall between 25 and 35 percent. Thus, elimi-nating interest deductibility would lower the creditdemand curve by 25 to 35 percent.

The shift in the credit supply curve is related tothe tax rate of taxpayers with interest income. Theanalysis follows the same logic as the shift in creditdemand. Consider a taxpayer with a 25 percentmarginal tax rate supplying credit at 8 percent.One-fourth of the interest income goes to taxes,making the taxpayer’s 8 percent interest rate before


taxes correspond to a 6 percent rate after taxes. Thistaxpayer would be indifferent to a choice between8 percent taxable interest income and 6 percentnontaxable interest income. If taxes on interest wereeliminated, the taxpayer would supply the sameamount of credit at 6 percent that he had previouslysupplied at 8 percent. That is, the taxpayer’s newcredit supply curve would be below the originalcurve by an amount corresponding to the fractionof interest income paid in taxes.

The effect of tax reform on the credit supply curvefor the U.S. economy would be similar to the effectfor an individual. The new credit supply curvewould be below the original curve by an amountcorresponding to the tax rate for the U.S. economy.Assuming the relevant tax rate is the same as for

the credit demand curve, the new credit supplycurve would be 25 to 35 percent below the origi-nal curve.

The lower credit demand and supply curves deter-mine a new credit market equilibrium. If the sametax rate applies to both curves, both would declineby the same fraction. Under this assumption theequilibrium quantity of credit would not change(Figure 3). The equilibrium interest rate would bereduced by a fraction corresponding to the relevanttax rate. With marginal tax rates in the 25 to 35percent range, tax reform would cause interest ratesto drop to between 65 and 75 percent of their valuebefore reform. An 8 percent interest rate before taxreform would drop to between 5.2 and 6.0 percentafter tax reform.

Equilibriuminterest rate(before reform)

THE EFFECT OF TAX REFORM ON THE SUPPLY AND DEMAND FOR CREDIT

Figure 3

Interest rate

0

Supply(with interestnontaxable)

Demand(without interest deductibility)

Supply(before reform)

Demand(before reform)

Quantity

Equilibriuminterest rate(after reform)

Equilibriumquantity


The analysis of credit supply and demand has thusfar assumed that all interest income is taxed and allinterest expenses are deducted. This assumption isonly an approximation, and some secondary factorsneed to be mentioned. Some interest income es-capes taxation because businesses are more diligentin reporting interest deductions than interest income(Hall and Rabushka). Since tax reform would notaffect the interest income that is already untaxed,this leakage suggests the credit supply curve wouldnot decline as much as previously suggested. Thedecline in the credit demand curve would also bereduced because some interest expenses are alreadynot deductible. For example, individuals currentlycannot deduct interest on nonmortgage consumerdebt.14

While the analysis illustrated in Figure 3 impliesa 25 to 35 percent decline in interest rates, theanalysis does not consider the secondary factorsdiscussed above. These factors are considered sec-ondary because most interest income is taxed andmost interest expenses are deducted. The exactimportance of the secondary factors is difficult toestimate. Nevertheless, these factors suggest theinterest rate decline would probably be closer to 25percent than to 35 percent.15

Interest rates on municipal securities. Under cur-rent tax laws, taxpayers do not pay taxes on theinterest income from municipal securities. One taxproposal would remove this exemption, causingmunicipal rates to rise to the levels paid by other

2

’72 ’74 ’76 ’78 ’80 ’82 ’84 ’86 ’92

16

12

10

8

1970

INTEREST RATES ON 1-YEAR MUNICIPALS AND 1-YEAR TREASURY BILLS

Chart 1

Percent

14

’90 ’94’88

Treasury bills

0

6

4 Municipals


taxable securities. Under the assumption that mu-nicipal securities would continue to be exempt fromstate and local income taxes, their interest rateswould be marginally lower than the rates on corpo-rate securities with comparable risk.

Most tax proposals would not change the taxexemption for municipals, but instead eliminatetaxes on all other interest income. These proposalswould also cause municipal interest rates to rise byeliminating the feature that attracts investors tomunicipals. Since some municipal investors wouldbe attracted to other credit markets, the supply ofcredit to the municipal market would decrease. Adecrease in the supply of credit implies that thecredit supply curve shifts to the left, which wouldlead to higher municipal interest rates (Figure 4).Note that the demand curve for municipal creditwould not change. The credit demand curve wouldshift if interest deductibility changed, but govern-ments do not pay taxes and thereby do not deductinterest expenses on municipal debt.

Analysts cannot reliably predict how much taxreform would increase interest rates on municipalsecurities. The size of the increase would depend ontwo primary factors, neither of which can be easilyestimated. First, the rate increase would depend onhow rapidly state and local governments reducedtheir demand for credit as interest rates rose (elas-ticity of credit demand). Second, the rate increasewould depend on the extent to which investorsfound substitutes for municipals in other creditmarkets (elasticity of substitution). Nevertheless, ifmunicipal and Treasury securities were taxed thesame, municipal interest rates would be higher thanTreasury interest rates because municipals are riskier.

Stock markets. Several elements of the current taxlaws affect stock prices. Because stocks represent aclaim on the expected future income of a corpora-tion, stock prices are affected by any change inshareholders’ claim on this income. Owners ofstocks pay taxes through both the individual and

business income tax systems. Any income earnedby a corporation is first taxed as business income.The remaining income is either distributed to share-holders as dividends or reinvested in the business.The dividends distributed to shareholders are taxedimmediately. The income reinvested should in-crease the value of the stock, which is ultimatelytaxed as a capital gain when the stock is sold. Thus,taxes on business income, dividends, and capitalgains all reduce the value of the corporation to theshareholder. Reducing these taxes would raise stockprices, and increasing these taxes would lower stockprices. Most tax reform proposals would reduce theeffective tax rate on corporate income paid to share-holders and in turn lead to higher stock prices.

Eliminating all three taxes on capital incomecould lead to substantially higher stock prices. Mar-ket observers are uncertain, however, about the sizeof the increase. Recall that double taxation in thepresent system can imply tax rates of up to 60percent on capital income. With such high rates, onemarket observer has suggested that stock pricescould double in response to tax reform (Forbes).Predictions of stock prices need to be viewed skep-tically, however, because economic models are no-tably unsuccessful in explaining past movements instock prices (Roll).

Tax reform proposals would have different priceeffects on different stocks. Eliminating deductionsand credits would tend to reduce the earnings andstock prices of companies that benefit most fromspecial provisions in current tax laws. For example,a depletion deduction benefits oil and mining com-panies, and a tax credit for manufacturing in U.S.territories benefits pharmaceutical and electronicscompanies.16 The stocks of companies not favoredunder current tax laws would respond more posi-tively to tax reform.

Another reason tax reform would have differentialeffects on stock prices is many taxpayers paydiff erent tax rates on dividends and capital gains.


Most capital gains taxes are paid on assets heldmore than one year, and the maximum tax rate onthese “long-term” gains is 28 percent. For divi-dends, tax rates can be as high as 39.6 percent. Thus,eliminating taxes on dividends and capital gainswould be more beneficial to stocks that pay highdividends than to stocks with income in the form ofcapital gains.

Changing the rules for deducting investmentexpenses could also have differential effectsamong different stocks. Allowing immediate de-ductions for all investment expenditures would beespecially beneficial to firms that make largeinvestments. For example, immediate deductionsfor investments would have contributed to a 75

percent reduction in Intel’s federal tax bill in 1993(Hall and Rabushka). Mature companies typicallyinvest less than growing companies, and disallow-ing depreciation deductions for previous invest-ments could lead to higher taxes for some maturecompanies.

Indirect effects

In addition to the direct effects of tax reform,financial markets would be affected indirectly bychanges in the economy. Tax reformers contend thatthe current tax code discourages economic activityand that economic activity would increase if thedisincentives were reduced. Reformers also con-tend that tax reform would reduce tax evasion.

Equilibriuminterest rate(before reform)

THE EFFECT OF TAX REFORM ON THE MUNICIPAL CREDIT MARKET

Figure 4

Interest rate

0

Supply(after reform)

Demand(before reform)

Quantity

Equilibriuminterest rate(after reform)

Equilibrium quantity(after reform)

Supply(before reform)

Equilibrium quantity(before reform)


The indirect effects of tax reform are even moredifficult to quantify than the direct effects. Theindirect effects are more uncertain becauseeconomists cannot reliably predict how the econ-omy will respond to changes in tax incentives.Some economists have estimated tax reform wouldincrease the level of economic output by 5 to 6percent (Hall and Rabushka). Others have sug-gested the economy would respond only marginallyto tax reform (Krugman). Without trying to resolvethe debate regarding the responsiveness of the econ-omy to tax incentives, this article will describe howfinancial markets would react if the economy re-sponds to the revised tax incentives.

Many of the tax reform proposals would reducethe tax rate on capital income. Tax reformers con-tend that doing so would increase savings and in-vestment, a view supported by the predictions ofeconomic models (Blanchard and Fischer).17 Ac-cording to this view, increases in savings and invest-ment would increase the capital stock, which in turnwould tend to reduce interest rates. This conclusionis based on the economic principle that an increasein one of the factors of production will lower thereturn to that factor. Thus, interest rates woulddecline because increases in the capital stock wouldreduce the return to capital.

Increases in the capital stock would also affect thestock market. As the capital stock increases, the econ-omy becomes more productive and economic outputrises. A stronger economy implies higher corporateincome, which would lead to higher stock prices.

In addition to the impact of higher domestic sav-ings, proponents contend that tax reform wouldattract more investment from abroad. This effectwould increase the capital stock even further, lead-ing to additional downward pressure on interestrates and upward pressure on stock prices.

Tax reformers maintain that lower marginal taxrates would increase the labor supply by providing

greater incentives to work. For example, researchershave found that lower marginal tax rates are espe-cially effective in attracting married women into thelabor force (Eissa). Increases in the labor forcewould lead to increases in both employment andeconomic output. Higher economic output wouldincrease the return to capital, which implies higherinterest rates (Dornbusch and Fischer). Since stockprices are positively correlated with economicoutput, stock prices would rise as employmentincreased.

On balance, the indirect effects of tax reform oninterest rates are ambiguous. Increases in the capitalstock would tend to lower interest rates, whileincreases in the labor force would tend to raise them.

Although the indirect effects of tax reform oninterest rates are uncertain, the effects would cer-tainly be smaller than the direct effects. Proponentsacknowledge that tax reform would take sevenyears to increase the level of GDP by only 2 to 4percent (Hall and Rabushka), and some economistshave suggested that even these moderate effects areoptimistic. The percentage change in interest ratesfrom the indirect effects would be similar to thepercentage change in GDP. Recall that the directeffects of tax reform are much larger, on the orderof 20 percent. The indirect effects would also takeseveral years to be fully realized, which furtherreduces their potential importance.

The indirect effects of tax reform on stock priceswould reinforce each other. Increases in domesticsavings and investment, the labor supply, andforeign investment would all cause stock pricesto rise. Predicting the size of the effect, however, ismore difficult than predicting the direction. Butagain, the size of the indirect effects would besmaller than the direct effects. Although corporateincome fluctuates over the business cycle, over thelong term it is a relatively stable fraction of GDP.Since stock prices are a claim on corporate earnings,the indirect effect of tax reform on stock prices


would be similar to the effect of tax reform on GDP.That is, stock prices might increase a few percent,which would be much less than the direct effects.Recall that the direct effects would be comparableto marginal tax rates, which can be as high as 60percent on capital income.

FINANCIAL MARKET EFFECTS OFSPECIFIC PROPOSALS

This section examines the financial market effectsof specific tax proposals. The proposals are diverseand their financial market effects could vary widely.

Congress is currently evaluating seven alternativetax proposals, which fall into three categories.Three of the proposals are in the flat tax categoryand have many common features (Table 1). The flattax was first proposed by Representative Armey andis now cosponsored by Senators Craig and Shelby.Two variations of the flat tax have also been pro-posed, one by Senator Spector and another by Rep-resentatives Solomon and Souder. In addition, twoincome tax proposals contain progressive marginalrates, which are substantially different both fromeach other and from the flat tax proposals (Table 2).The first of these proposals, the USA (UnlimitedSavings Allowance) tax, is jointly sponsored bySenators Nunn and Domenici. The second pro-posal, the 10 percent tax, is sponsored by Rep-resentative Gephardt. The final category containsdirect consumption taxes, which include both thesales tax and the value-added tax. Senator Lugar issponsoring a sales tax proposal and RepresentativeGibbons is sponsoring a value-added tax proposal(Table 3).18

The various tax reform proposals can be rankedaccording to their effect on interest rates and stockprices. The discussion begins with the proposal orproposals that would affect each market the mostand continues with those having progressivelysmaller effects. The analysis is based primarily onthe direct effects of tax reform.

Effects on taxable interest rates

Most of the specific tax reform proposals wouldcause interest rates to decline, but the size of thedecline would vary across the different proposals.The primary reasons for the decline are the directeffects of eliminating taxes on interest income andeliminating the deductibility of interest expenses.

Three proposals would have the maximum directeffect. The sales tax, the value-added tax, and theArmey flat tax would eliminate all taxes on interestincome and all tax deductions for interest expenses.As discussed earlier, these proposals would likelycause interest rates to decline to less than 80 percentof their current level.

The Spector and Solomon-Souder flat tax propos-als would reduce interest rates slightly less than theArmey proposal. Both of these alternative propos-als would allow deductions for some mortgageinterest, which implies somewhat less downwardpressure on interest rates. Nevertheless, both ofthese proposals would eliminate taxes on all interestincome and eliminate all interest deductions bybusinesses, so the interest rate declines would stillbe substantial.

The Nunn-Domenici proposal is next in theinterest rate ranking. This proposal would elimi-nate taxes on interest income and deductions forinterest expenses, but only on business returns.Thus, the Nunn-Domenici proposal would affectinterest rates less than the proposals that wouldchange how interest is taxed for both individualsand businesses.19

The Nunn-Domenici proposal has a unique fea-ture regarding the indirect incentive effects of taxreform. The proposal would allow a deduction forall income saved. This deduction would provide alarger incentive for taxpayers to save than proposalsto eliminate taxes on capital income. Eliminatingtaxes on capital income would reward taxpayers in


the future for current savings. The savings deduc-tion would reward savers immediately. Since theNunn-Domenici proposal would provide greaterincentives to save, it would have greater indirecteffects. This increase in savings would tend to lowerthe return to savings, which would imply lowerinterest rates.

The Gephardt proposal is last in the interest rateranking. The proposal would not change taxes oninterest income or the deductibility of interest ex-penses for either individuals or businesses. Also, theproposal contains no incentives for taxpayers tosave more. Thus, the proposal would affect interestrates only marginally. Since the proposal wouldreduce the marginal tax rates for some high-incometaxpayers, interest rates might decline a little. But,

these changes would be small relative to the typicalinterest rate moves over the business cycle.

Effects on municipal interest rates

All tax reform proposals would increase interestrates on municipals to some extent. The Gephardtproposal would have the largest effect on municipalinterest rates. This proposal eliminates the tax ex-emption for municipal securities, so municipal rateswould become comparable to other taxable interestrates. Municipal rates would be at least as high asthe rates on Treasury securities with comparablematurity. Municipal rates would exceed the interestrates on Treasuries by the appropriate risk premium,which would likely be in the vicinity of 30 to 50basis points for highly rated securities.

Table 1

SUMMARY OF THREE FLAT RATE INCOME TAX PROPOSALS

Common features Variations in specific flat tax proposals

• Personal exemption is increased

• Tax deductions and cred-its are reduced or elimi-nated

• Taxes are eliminated on interest income

• Taxes are eliminated ondividends and capitalgains

• Individuals and busi-nesses are taxed at sameflat rate

• Businesses are allowed immediate deductionsfor capital investments

1. Sponsored by Representative Armey, Senator Shelby, and SenatorCraig

• All deductions are eliminated, but a high personal exemption isallowed on individual returns

• Individuals and businesses are taxed at 20 percent tax rate fortwo-year transition, 17 percent rate afterward

2. Sponsored by Senator Spector

• Interest deductions are allowed on mortgage debt up to $100,000• Charitable contributions are deductible up to $2,500• Individuals and businesses are taxed at 20 percent rate

3. Sponsored by Representatives Solomon and Souder

• Interest deductions are allowed on mortgage debt up to $100,000• All charitable contributions are deductible• Individuals and businesses are taxed at 20 percent rate


Only the Gephardt proposal would change thetaxation of municipal interest income, but the otherproposals would still increase municipal interestrates. Other proposals would increase municipalinterest rates by providing investors with alternativetax-free securities.

All three flat tax proposals and both consumptiontax proposals would provide municipal investorsalternative tax-free securities. As investors shiftedto these other securities, municipal rates would riseuntil their rates exceeded the rates on Treasury

securities by the appropriate risk premium. Munici-pal rates would be marginally higher under theSpector and Solomon-Souder flat tax proposalsthan under the other flat tax and consumption taxproposals. Recall that nonmunicipal interest rateswould decline less with the Spector and Souderplans because both would allow interest deductionson mortgages up to $100,000.

The Nunn-Domenici proposal would affect mu-nicipal rates less than all of the other proposals.Municipals would retain their tax advantage for

Table 2

SUMMARY OF TWO INCOME TAX PROPOSALS WITH PROGRESSIVE RATES

1. The USA (Unlimited Savings Allowance) tax sponsored by Senators Nunn and Domenici

2. The 10 percent tax sponsored by Representative Gephardt

• All deductions are eliminated, except intereston home mortgages

• Interest income from municipal bonds is taxed

• Income from interest, dividends, and capitalgains continues to be taxed

• Employees are taxed on employer-providedfringe benefits

• Individuals are taxed at rates between 10 and 34percent

• 75 percent of taxpayers are taxed at a 10 per-cent rate

• Deductions are allowed for all income saved

• Deductions are allowed for higher education (college or vocational) up to $2,000 per person,with a maximum of $8,000 for a family

• Deductions are continued for mortgage inter-est, charitable contributions, and alimony

• A tax credit is given for social security taxes

• Individuals are initially taxed at rates from 19 to 40 percent, but rates are lowered to from 8to 40 percent over time

• Businesses are allowed immediate deductions for capital investments

• Businesses’ deductions for wages and fringe benefits are eliminated

• Businesses are not taxed on revenues from exports

• Businesses are taxed at an 11 percent rate


individual investors but would lose their tax advan-tage for businesses. Businesses would be encour-aged to shift to other securities, but individualswould not. Thus, municipal rates would not in-crease as much as under proposals that change theattractiveness of municipals for both individualsand businesses.20

Effects on stock markets

Three taxes currently reduce the income availableto a business’s shareholders—the business incometax, the individual income tax on dividends, and theindividual income tax on capital gains. Reducingany of these taxes would increase stock prices.

The proposals that would tax consumption di-rectly, the sales tax and the value-added tax, wouldhave the most positive impact on stock prices.These proposals would eliminate all three taxes oncapital income. With this approach, income fromcapital would not be taxed until it is ultimatelyconsumed.

The three flat tax proposals would eliminate taxeson dividends and capital gains but would continueto tax business income. By eliminating two of the

relevant taxes, these proposals would also increasestock prices. Since business income would continueto be taxed, however, stock prices would increaseless than under the consumption tax proposals.

The flat tax proposals contain another feature thatwould affect stock prices. While flat tax proposalswould reduce tax rates on business income, byeliminating business deductions the proposalswould increase the tax burden on businesses rela-tive to individuals. In 1993, for example, individu-als paid 81 percent of federal income tax revenuesand businesses paid the remaining 19 percent. Un-der a flat tax, individuals would have paid 58 per-cent of federal tax revenues and businesses wouldhave paid 42 percent (Hall and Rabushka).21 Thisincrease in business income taxes would dampenthe increase in stock prices.

The effects of the Nunn-Domenici and Gephardtproposals on stock prices are ambiguous. Both pro-posals would retain all three taxes on capital in-come. Both proposals would also reduce marginaltax rates for some taxpayers with dividends andcapital gains. Other taxpayers, however, would payhigher tax rates on capital gains. The net effect ofthese two changes is uncertain. Nevertheless, the

Table 3

SUMMARY OF PROPOSALS FOR DIRECT CONSUMPTION TAXES

1. Sales tax sponsored by Senator Lugar2. Value-added tax sponsored by Representative

Gibbons

• Assessed on retail purchases

• Collected by states

• 17 percent rate is required to provide samerevenue as current tax system

• Replaces personal and business incometaxes

• Assessed on value added at each stage of production

• Value added is revenue minus costs

• Revenue from exports and costs of imports arenot included in calculation of value-added

• Replaces personal and business income taxes


Nunn-Domenici and Gephardt proposals wouldcertainly have smaller effects on stock prices thanthe other proposals.

CONCLUSION

With the U.S. savings rate near a historic low andtaxpayers increasingly frustrated by the complexityof the income tax system, many economists andpolitical analysts are recommending tax reform. Byincreasing the savings rate and simplifying the taxsystem, tax reformers hope to make the economymore productive. Critics are concerned that encour-aging savings could lead to greater income inequal-ity. Also, groups and industries favored under thecurrent tax code are concerned about losing theirpreferential treatment. In addition to these issues,tax reform would have important effects on finan-cial markets.

This article has examined the potential financialmarket effects of proposals to reform the U.S. in-come tax system. Most proposals would reduceinterest rates in credit markets where interest in-come is currently taxable, which includes bankloans, Treasury securities, and corporate securities.Interest rates would decline because the supply ofcredit would increase and the demand for creditwould decrease. Lenders would supply more creditbecause they would no longer have to pay taxes on

their interest income. Borrowers would demandless credit because they could no longer deductinterest expenses from their taxes.

Tax reform would increase interest rates on mu-nicipal securities. One proposal would eliminate thetax exemption for interest on municipal securities.Under this proposal municipal interest rates wouldrise to levels similar to those on other taxable secu-rities. Municipal interest rates would also be af-fected by proposals that eliminate taxes on allinterest income. These proposals would lower thedemand for municipals by creating many nontax-able substitutes.

Finally, most tax reform proposals would increasestock prices. Three taxes currently reduce the frac-tion of a business’s income that is available to itsshareholders, the business income tax, the individ-ual tax on dividends, and the individual tax oncapital gains. Most proposals would reduce one ormore of these taxes, which would lead to higherstock prices.

Financial market effects vary widely among thevarious tax proposals, and in some cases the effectsare substantial. Anticipating these effects will beimportant both to Congress and to financial marketparticipants.


50

30

20

10

$91,850

Tax rate (percent)

40

Marginal rate

0

Average rate

$250,000$38,000 Taxable income$140,000

TAX SCHEDULE FOR 1994

Chart A-1

MARGINAL VS. AVERAGE TAX RATES

Economists consider the marginal tax rate tobe the important tax rate for economic deci-sions. The marginal tax rate is the rate appliedto the last dollar of income and is typicallyhigher than the average tax rate. For example,in 1994 the tax rate for married taxpayers filingjointly was 15 percent for income up to $38,000(Chart A-1). The rate increased to 28 percentfor income between $38,000 and $91,850. Forthose in higher income brackets, the lower taxrate still applies to the first $38,000 of their

income. Consider a married couple earning$76,000. The 15 percent rate would apply to thefirst $38,000, and the 28 percent rate wouldapply to the remaining $38,000. The averagetax rate for this couple would be the average of15 and 28 percent, which is 21.5 percent. But,if the couple increased their income by onedollar they would retain only 72 cents aftertaxes, so the 28 percent marginal rate is theimportant rate for economic decisions.

APPENDIX


ENDNOTES

1 The political implications of tax reform are discussed inseparate articles by Gray and Richman.

2 In addition to the seven changes discussed in the text, twoother features are worthy of mention. First, one proposalincludes a tax credit for social security taxes paid byindividuals. This change would reduce income taxes by theamount of taxes paid to the social security system. Taxpayerswhose tax payments to social security exceeded their incometax bill would receive a refund. The social security tax creditwould reduce or eliminate income taxes for manylow-income households.

Another proposed feature is a deduction for the cost ofhigher education. This deduction would subsidize the cost ofhigher education by providing tax relief for families withstudents in universities and vocational schools.

3 Unlike income from financial investments, income fromrental properties would be subject to business taxes.

4 The personal exemption increases with inflation, andspecific numbers given are for 1994 returns.

5 The interest deduction for home mortgages creates whateconomists refer to as an economic distortion. By encouraginghome ownership the deduction distorts the decision householdswould make in the absence of tax considerations.

6 After applying a 35 percent tax rate to business income, 65percent remains available to shareholders. If the income isdistributed to shareholders in the form of dividends themarginal tax rate can be as high as 39.5 percent, so thetaxpayer keeps 60.5 percent of the dividend. Thus, theshareholder ultimately receives 60.5 percent of 65 percent,which is 39.3 percent of the capital income. The effective taxrate is 60.7 percent.

Inflation can further increase the effective tax rate becausetaxes are applied to nominal rather real returns. Price inflationimplies that real returns are less than nominal returns, so taxesare a greater proportion of real returns than of nominalreturns.

7 Although both the savings deduction and the elimination oftaxes on investment income would encourage savings, thesestrategies have different consequences for some taxpayers.For example, consider a taxpayer living exclusively oninvestment income from assets that were either inherited orpurchased with previous savings. If taxes on investmentincome were eliminated, the taxpayer would pay no taxes.Under the savings deduction, however, the taxpayer would

pay taxes on the difference between income and savings. Thatis, the taxpayer would still be taxed on the amount consumed.

8 This article will follow the convention of other authors andrefer to the corporate income tax as the business income tax.In practice, many small businesses are taxed under theindividual income tax rather than the corporate income tax.

9 In addition to the changes discussed in the text, some taxreformers would like to reduce the U.S. current accountdeficit. These reformers have proposed encouraging exportsand discouraging imports by changing how taxable incomeis calculated. Export sales would not be included as taxablerevenue, and imports would not be included as costs whencalculating taxable income.

10 Reducing tax rates would not necessarily reduce taxes. Byeliminating deductions while reducing tax rates, flat taxproposals would increase income taxes for many businesses.

11 For example, in 1993 General Motors invested $6 billionand took $9 billion in depreciation deductions. Allowingdeductions for new investments while disallowingdepreciation deductions on previous investments would haveincreased General Motors’ taxable income by $3 billion in1993 (Hall and Rabushka).

12 Economists generally believe that increases in the federaldeficit would put upward pressure on interest rates.

13 Not all interest on debt for financial investments isdeductible. The deduction is only allowed if the investmentgenerates income, and the interest deduction cannot exceedthe amount of income that the investment generates.

14 Of course, tax reform would not change the deductibilityof interest on the national debt. In addition, IRAs and otherpension plans allow taxes on interest income to be deferred.To the extent that these accounts lower the effective tax rateon interest income, the interest rate decline from tax reformwould be reduced further.

15 Further evidence regarding the relevant marginal tax ratecan be found in the municipal securities market. Themunicipal interest rate should correspond to the after-taxinterest rate on similar securities. Assuming that municipalscontain a risk premium of 50 basis points, the one-yearmunicipal market over the last five years is consistent with amarginal tax rate of 30 percent.

16 The depletion deduction for oil and mineral companiestypically exceeds the costs of exploration and recovery.


Many pharmaceutical and electronics companies receive a taxcredit for manufacturing in Puerto Rico. Congress may eliminatethis tax credit before enacting a complete tax reform proposal.

17 To the extent that capital can flow between countries,domestic savings do not have to equal domestic investment.Nevertheless, researchers have found that capital is notperfectly mobile. Feldstein and Horioka authored a widelycited paper on this issue, and Frankel confirmed theirconclusion in more recent research.

18 Representative Archer, Chairman of the House Ways andMeans Committee, has endorsed the concept of a consumptiontax. His committee will hold hearings on alternative proposals.

19 The Nunn-Domenici proposal would also increasemarginal tax rates for many taxpayers, which would furtherdampen the interest rate decline.

20 Approximately half of the municipals are held bybusinesses. If substitution elasticities are comparable forbusinesses and individuals, the Nunn-Domenici proposalwould increase municipal rates by about half as much as theflat tax and consumption tax proposals.

21 Some income from small businesses would shift fromindividual to business returns under a flat tax, which accountsfor part of the calculated increase in the tax burden onbusinesses.

REFERENCES

Arthur D. Little, Inc. 1988. Development of Methodology forEstimating the Taxpayer Paperwork Burden. Washington,DC.: Internal Revenue Service, June.

Barro, Robert, and Chaipat Sahasakul. 1983. “Measuring theAverage Marginal Tax Rate from the Individual IncomeTax,” Journal of Business, October, pp. 419-52.

Bernheim, Douglas, and John Shoven. 1991. National Savingand Economic Performance. Chicago: University of Chi-cago Press.

Blanchard, Olivier, and Stanley Fischer. 1989. Lectures onMacroeconomics. Cambridge: MIT Press.

Dornbusch, Rudiger, and Stanley Fischer. 1987. Macro-economics. New York: McGraw-Hill, pp. 297-300.

Eissa, Nada. 1995. “Taxation and Labor Supply of MarriedWomen: The Tax Reform Act of 1986 as a Natural Experi-ment,” NBER Working Paper No. 5023.

Feldstein, Martin, and Charles Horioka. 1980. “DomesticSaving and International Capital Flows,” Economic Jour-nal, pp. 314-29.

Forbes, Malcolm. 1995. “What’s Stoking the Stock Market?”Forbes, July 31, p. 23.

Frankel, Jeffrey. 1991. “Quantifying International Capital

Mobility in the 1980s,” in B. Douglas Bernheim and JohnShoven, eds., National Saving and Economic Perform-ance. Chicago: University of Chicago Press.

Gray, Robert. 1995. “Blockbuster Tax Reform,” NationsBusiness, April, pp. 18-24.

Hall, Robert, and Alvin Rabushka. 1995. The Flat Tax. Stan-ford: Hoover Institution Press.

Krugman, Paul. 1994. Peddling Prosperity. New York: W.W.Norton & Co.

OECD. 1994. Taxation and Household Saving. Paris: OECD.Poterba, James. 1992. “Why Didn’t the Tax Reform Act of

1986 Raise Corporate Taxes?” Tax Policy and the Econ-omy, NBER. Cambridge: MIT Press.

Richman, Louis. 1995. “The Flat Tax,” Fortune, June 12, pp.36-46.

Roll, Richard. 1988. “R-squared,” Journal of Finance, July,pp. 541-66.

Simon, William. 1995. “Flat Tax Is Test of GOP’s Sincerity,”Wall Street Journal, May 24.

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How Would Tax Reform Affect Financial Markets?

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