National Taxation Association Luncheon Address

November 20, 2015

Capital Taxation Policy*


(PDF Version)

Thank you. I’m pleased to have this opportunity to talk with the members of the National Tax Association about a subject that interests me a great deal and has interested me for a long time. My subject is Capital Taxation Policy.

I will use this occasion to talk about my views on what can be done to increase capital formation and thereby increase our growth rate and our future standard of living. And while I won’t be commenting specifically about income distribution issues, I would simply note that as economists we all recognize that increasing capital formation will raise the productivity of labor and in so doing will raise labor compensation.

Before I turn to the tax issues specifically, let me begin with some general comments on the condition of the U.S. economy. I think that the US economy is doing well and will continue to do well in the future. That is certainly true relative to the other major industrial countries in Europe and Japan.

Of course we have problems that need to be fixed. High on my list are the large national debt that has doubled relative to GDP in the past decade, an education system for most K through 12 students that falls short of global standards, and a failure to provide useful education and training for many high school graduates.

But we also have great advantages that have raised our standard of living and will continue to do so in the future: an entrepreneurial spirit that generates new businesses and new products, a financial system that supports that entrepreneurship, great research universities that contribute to that process, and a labor market that does well at matching job seekers and jobs without the barriers of regulations, state owned enterprises, and labor unions that impede the labor markets in other countries.

But we could do better, especially relative to our recent performance. Looking ahead, the Congressional Budget Office predicts that the growth of output in the nonfarm business sector will slow from a growth rate of 3.5 percent during the past half century to just 2.5 percent in the next decade. The CBO attributes half of that decline to the slower growth of potential working hours (resulting from the aging of the population and the end of the surge of female labor force participation). The rest of the projected slowdown is attributed to lower capital accumulation and a slower increase of total factor productivity, perhaps a false distinction because greater capital accumulation would bring with it improvements in total factor productivity.

Before I focus on the subject of capital formation, I want to say more about the problem of measuring our rates of growth of real incomes and productivity.

As some of you may know (because I have been writing about it in the Wall Street Journal and other places), I think the official statistics understate the growth of real incomes and therefore of productivity.

The government statisticians have an impossibly difficult job. When I think about the growth of real incomes and of productivity, I think about the introduction of new products and new services and about increases in the quality of existing products and services. Consider for example the improvements in what health care can now achieve relative to what could be done just a few decades ago. Or more minor changes like the quality and variety of products in our supermarkets. I was recently surprised to learn that the official measure of GDP – a measure that is supposed to tell us the value of the goods and services produced in the United States – doesn’t include anything for the services of Google and Facebook or anything else that we receive but are not required to buy.

I don’t disagree with my friend Bob Gordon that much of the innovation of the past gave unrepeatably large boosts to our standard of living. Bob writes about indoor plumbing, electricity, and motor cars as providing these quantum leaps in real output. But those past improvements don’t mean that we won’t continue to have changes that raise our standard of living in the future.

The mismeasurement of the current real gains in output may mean that the official estimate that real per capita income is rising at 1.5 percent a year understates the gains that we are enjoying. The real rate of increase of real income may be more like a 3 percent a year rise, implying a doubling of real incomes in 25 years. And I believe we can improve on that by a variety of policies including policies to increase capital formation.

I turn therefore at last to the subject of capital formation.

The traditional textbook view of the role of capital formation is that increased capital per worker means more and better equipment, leading to higher productivity and therefore higher real wages and a higher standard of living. That continues to be true but it is only a small part of the story about the potential role of increased investment in businesses today.

The data teach us that investment in industrial equipment is just a small part of the investment that firms do today. Last year, total business investment, other than inventory investment, totaled $2.1 trillion. Only 10 percent of this investment was spending on industrial equipment ($209 billion). Firms spent 50 percent more on information processing equipment ($326 billion) and three times as much on software and other intellectual property products ($660 billion).

Companies need resources for all of this spending, and also for investing in upgrading the skills of production workers and of managers, a form of spending that is not counted as investment but that should be. But like other investment, it can only happen if firms have or can obtain the extra resources.

All of these forms of investment require savings. That is they require national output that is neither spent by consumers nor by governments. Some of this saving is done by the companies themselves in the form of retained after-tax profits. But much of it is done by the household sector that spends only part of its total income on consumption and lends the rest to businesses either directly or through financial intermediaries.

In short, the key to more investment in the economy is therefore more saving.

I hear a lot of talk in some quarters about the existence of a savings glut – i.e. a high level of saving that exceeds what firms want to invest and that therefore depresses overall demand and requires a lower than historically normal rate of interest to achieve full employment.

I am puzzled by this talk about a savings glut – talk about how high the rate of saving is.

It’s clearly not high in the household sector. Indeed, its much lower now than it was in the past. In the quarter century from 1960 to 1985, households saved an average of 9 percent of their after tax incomes. The annual saving rate in those 25 years ranged from a low of 7 percent to a high of 11 percent.

Now the official saving rate is just 4.6 percent. But even that number is misleading because the government statisticians changed the way we now measure the saving rate in the national income accounts. By the old definition, today’s saving rate would be only about 3 percent or one third of the average of the earlier quarter century.

So there is no evidence of any excess amount of household saving.

Corporate saving – that is the after tax profits not paid out in dividends – is now about 4 percent of GDP, not very different from where it has been traditionally. So there is no unusual excess saving from that source.

The Federal government has reduced its deficit in recent years as the economy recovered but at today’s level of 2.4 percent of GDP the government is a net borrower not a net saver.

That only leaves the rest of the world as a source of savings to be used in the United States. There is a view – or maybe I should say there was a view -- a textbook view -- of the global capital market in which the savings that take place in countries around the world flow to the places with the highest risk adjusted rates of return. There is, in that view, a single global capital market into which all savings flow and which then go to the best uses of those saving.

There is of course some element of this type of capital flow in short-term financial markets. But more generally we see that saving tends to stay in the country where it originates. Countries with high national saving rates also have high investment rates and countries with low national saving rates have low investment rates.

Domestic savers apparently like to keep their savings close to home. For temporary periods, spikes in domestic saving do lead to increased capital outflows and spikes in domestic investment attract funds from abroad. But these imbalances don’t last very long.

And those countries that had temporarily been big suppliers of capital to the United States no longer have the large current account surpluses with which to do so. China had a current account surplus that peaked at more than 10 percent of its GDP in 2008 but that has come down to less than 3 percent of its GDP now. The oil producers in OPEC have seen a sharp drop in their current account surpluses as the price of oil has declined.

The implication of this is that we have to increase the saving rate in the United States if we want to increase our rate of investment.

How can we increase the U.S. saving rate?

Let’s start with the Federal government. The government is now a dissaver at a rate of 2.4 percent of GDP. That rate of dissaving has come down in the past few years as the economic recovery has increased tax revenue and reduced unemployment related transfers. But the Congressional Budget Office warns that with current policies the deficit share of GDP will soon reverse and start to increase.

One important reason for the future deficit increase is the rise in the interest rates that will increase the cost of interest on the national debt, a debt that now exceeds 74 percent of GDP. The CBO estimates that the interest on the national debt will rise from 1.2 percent of GDP in 2015 to 2.8 percent in 2025, reducing national saving by 1.6 percentage points

A second important reason for the rising level of the budget deficit is the increased cost of the transfer payments to middle class seniors. These are not means tested programs for the poor but the much more expensive transfers in the Social Security and Medicare programs.

The CBO estimates that the cost of Social Security will rise from 4.9 percent of GDP now to 5.7 percent of GDP a decade from now and then to 6.2 percent of GDP by 2040. The rising cost reflects not only the increased number of retirees who will be receiving benefits but also the higher real level of the benefits per retiree. That projected increase in average real benefits means that slowing the growth of the average benefit can be consistent with a rising level of real benefits per retiree.

There are many ideas about how to reduce the growth rate of benefits. My own favorite would be to increase the age at which retirees receive the full level of benefits. That full benefit age is currently 67 years of age. That could be done at some time in the future while continuing to allow benefits to be received earlier with an actuarial reduction that keeps the real present value of those benefits unchanged.

That is what Congress did back in 1983 when it faced the risk that the Social Security tax revenue would not be enough to pay projected benefits. Congress raised the age for full benefits from 65 to 67, very gradually and with a delay, while also maintaining the option to receive actuarially reduced benefits at an earlier age.

In the three decades since 1983, life expectancy at age 67 has increased by three years. It makes sense to me to increase the age for full benefits gradually in the future to age 70 and then automatically adjust the age of full benefits to keep the remaining life expectancy with full benefits unchanged.

Another way to reduce the fiscal deficit and thus increase the national saving rate is to raise tax revenue. That can be done without raising marginal tax rates by limiting the so-called tax expenditures, the forms of government spending achieved by tax rules rather than explicit outlays.

For example, if I buy a Prius or other hybrid car, the government rewards me. It doesn’t do this by sending me a check but it gives me a reduction in my tax liabilities. Similarly, if I install a solar panel at my home, the government rewards me with a tax reduction.

There are a large number of these forms of spending built into the tax code. A pernicious feature of these tax expenditures is that, unlike traditional government expenditures, these features of the tax law do not have to go before Congress for annual review and reauthorization.

It would be desirable for the Congress to review all of these individual tax expenditures and decide which ones we can continue to afford in the current budget situation.

There are of course several much bigger tax expenditures including the deduction for state and local tax payments, the deduction for mortgage interest, and the exclusion of employer payments for health insurance. It would obviously be politically difficult to eliminate any of these popular tax expenditures. My preference is therefore to allow taxpayers to use all of them but to limit the total tax benefit that a taxpayer can achieve in this way.

I have studied a cap on the tax benefit from using these major tax expenditures equal to two percent of the individual’s adjusted gross income. Such a two percent cap would raise revenue equal to about one percent of GDP and would do so in a progressive way.

One of the reasons that I like the idea of a limit on tax expenditures as a way of raising revenue is that it should appeal to both Democrats and Republicans. Democrats insist that part of any deficit reduction plan must include increased tax revenue. Republicans want instead to reduce government spending. So limiting tax expenditures is a way of achieving both goals at the same time. I therefore work at explaining to my Republican friends that limiting tax expenditures is really a way to cut spending even though the effect of the deficit reduction shows up as an increase in revenue.

A third way to raise the national saving rate is to get households to save more. I think this will happen automatically if Congress slows the growth of future Social Security benefits since individuals will want to supplement these Social Security payments with more direct saving. But I also favor the creation of universal automatic enrollment personal retirement accounts, mandating that individuals enroll in such plans but also giving them the opportunity to withdraw their funds if they prefer not to participate. The experience in private firms that have established such automatic enrollment accounts is that employees do not take the option of withdrawing their funds and therefore do increase their rate of saving.

So those are the three ways that I think we could increase our national saving: reducing the fiscal deficit by slowing the growth of middle class entitlements, raising revenue by limiting tax expenditures, and encouraging increased individual saving by creating universal automatic enrollment accounts.

But how do we assure that this increased national saving will add to business investment in the various categories that I described earlier?

Experience shows us that a sustained increase in the national saving rate will indeed lead to an increased rate of national investment. Some of that may go into housing rather than corporate investment. Our tax law and lending arrangements already increase the flow of national saving into residential investment. Capping the tax deductibility of mortgage interest and of local property taxes will reduce this current bias in favor of owner-occupied housing.

But we can act directly to encourage investments in operating businesses. The tax rates on business income in the United States are the highest in the industrial world. There is strong bi-partisan support for lowering the 35 percent statutory corporate rate. Doing so would surely help to make business investment more attractive.

A bigger problem is giving an equal incentive for investments in unincorporated “pass-through” entities that are taxed at the personal level.

There is also a further problem. Some forms of business investment are immediately deducted – for example, investments in software development and employee training -- while investments in equipment and structures must be written off over time. It’s worth asking if that makes sense when both forms of business spending are creating capital assets. It would be better to allow full expensing of all forms of investment.

A unique and counterproductive feature of the US corporate tax system is the way we tax the profits earned by the foreign subsidiaries of American companies. When such a firm earns profits abroad, it pays the local foreign corporate tax on those profits. It can invest the after-tax profits in that foreign country or in other foreign countries without paying any additional tax. But if the company wants to bring those profits back to the United States, the company has to pay tax at a rate equal to the difference between the 35 percent US rate and the lower rate in the country where those profits were earned and taxed.

Not surprisingly, that induces US firms to establish subsidiaries in low tax countries like Ireland and Switzerland and then to leave the after tax profits abroad instead of bringing them back and subjecting them to the US corporate tax.

This tax rule also encourages some US companies to shift the location of their headquarters in order to be treated as a foreign company, the so-called corporate inversions. And this rule makes it attractive for foreign companies to buy US firms so that they are no longer subject to extra corporate taxation when they want to distribute overseas profits to their shareholders.

The United States is now just about the only country that uses that system of taxation. Others use what is known as the territorial method of taxation (sometimes called the dividend exclusion method) in which foreign profits that have been taxed abroad can be brought back with little or no extra taxation. Fortunately, there is a growing understanding of this issue and an increasing likelihood that corporate tax reform will involve not only lower rates but also a shift to a territorial system.

I recognize that what I have described is quite an agenda for new policies to increase saving and investment. But in pursuing that agenda we would be getting in line with what is being done in many other countries. And we would be rewarded with a higher rate of saving and investment and a more prosperous economy.

Thank you.

* These remarks were prepared for presentation at the annual smeeting of the National Tax Association, November 20, 2015, in Boston, Massachusetts. Martin Feldstein is professor of economics at Harvard University and President Emeritus of the National Bureau of Economic Research.