Economic Growth and International Competitiveness Presentation to the President’s Advisory Panel on Federal Tax Reform Alan J. Auerbach March 31, 2005

Overview How the tax system can influence growth and international competitiveness Issues in the design of effective tax incentives How the tax system cannot influence growth and international competitiveness Implications for the design of fundamental tax reform

The Tax System, Growth and Competitiveness Competitiveness: many definitions Cost relative to foreign goods? –depends on exchange rate –comparative advantage: can’t be competitive at everything Productivity, typically measured per worker hour –depends on technology (intangible capital), tangible capital, and human capital –how are these affected by tax policy?

Tax Policy and Human Capital Since primary cost of education and training is forgone earnings, already close to the consumption tax model –expenses are effectively deductible because taxes on earnings are avoided Major negative impact is through progressive rate structure: “success” tax But progressive rates also provide insurance, promoting risky human capital investment that benefits society at large

Tax Policy and Intangible Capital Technological progress involves positive “spillovers” from individual advances Societal returns may be higher than individual returns; may justify subsidy R&E credit a response to this argument; but such expenditures already tax-favored –immediate expensing rather than depreciation Productivity reflects more than the level of technology; also degree of regulation, flexibility of employment relationships, etc.

Tax Policy and Intangible Capital Summary: Technological spillovers may justify an R&D subsidy, but –a subsidy exists even without the R&E credit –policy to spur productivity growth depends on more than the tax system

Tax Policy and Tangible Capital Affected by myriad tax provisions that influence overall rate of capital income taxation One should distinguish between –broad and targeted provisions –temporary and permanent provisions –saving and investment –new and old capital

Broad vs. Targeted General principle: broad base, low tax rate provides greatest economic efficiency, simplicity and ease of administration Why deviate from this norm? (e.g., ITC) –positive spillovers? no convincing evidence –to offset other tax benefits? difficult to get right –concern about effects if perceived to be temporary

Temporary vs. Permanent 1960s: ITC; : bonus depreciation Why? encourage investment; implemented when investment has been low But no evidence that these temporary provisions stabilize investment or GDP

Saving vs. Investment With international capital flows, saving and investment are distinct –U.S. capital can be invested abroad –foreign capital can be invested here Encouraging saving aids GNP –most direct way to enhance wealth creation Encouraging investment aids GDP –may aid in adoption of new technology But saving and investment tend to move together, so differences in incentives muted

New vs. Old Capital Reducing burden on existing capital discourages saving and investment Incentive provisions vary greatly with respect to relative benefits provided to new and old capital

New vs. Old Capital Reducing burden on existing capital discourages saving and investment Incentive provisions vary greatly with respect to relative benefits provided to new and old capital capital gains tax cut OLDNEW incremental ITC corporate tax rate cut investment tax credit

New vs. Old Capital Focusing on new capital more efficient but also more difficult –timing issues –base definition But phased-in provisions can also limit windfalls while providing incentives –example: scheduled corporate rate reduction –sunsets get this exactly backward

New vs. Old Capital Substance vs. form: provisions that appear focused on new capital may not be Example: shifting existing assets from taxed to sheltered form does not increase saving – it reduces national saving –references to “consumption tax treatment” are misleading because result is lump-sum transfer, not a consumption tax

Incentives and Deficits Measuring the “bang for the buck” is tricky, because provisions vary in their timing “Frontloaded” provisions (e.g., traditional IRA) look more expensive than equivalent “backloaded” ones (e.g., Roth IRA) This can make more efficient provisions look less effective (e.g., ITC vs. corporate rate cut)

What Tax Reform Cannot Do The current account imbalance plus the capital account imbalance must sum to zero The capital account imbalance equals the difference between domestic investment and national saving The current account imbalance cannot be reduced unless national saving increases or domestic investment falls

What Tax Reform Cannot Do Border adjustments (as under a VAT) do not encourage saving or discourage investment After exchange rate adjustment, little impact on capital flows or trade balance Logic different than for specific export subsidies or import taxes, which would alter composition of exports and imports

What Tax Reform Cannot Do For the United States, border adjustments would actually reduce revenues and hence national saving over time, because we are in debt to the rest of the world and will have to run trade surpluses in future –this would worsen the current account balance, though not substantially Summary: border adjustments not important

Implications for Tax Reform With few exceptions, avoid targeted tax incentives Transition provisions matter a lot –a consumption tax transition that fully protects existing capital can turn a winner into a loser –phase-ins may help Piecemeal approaches may go the wrong way: –hybrid system’s incentives may be worst (e.g., borrowing to invest in tax-preferred assets)

Selected References 1. Altig, David, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser “Simulating Fundamental Tax Reform in the United States,” American Economic Review 91(3), June 2001, pp (transition provisions) 2. Auerbach, Alan J., “The Future of Fundamental Tax Reform,” American Economic Review 87(2), May 1997, pp (border adjustments) 3. Auerbach, Alan J., and Kevin Hassett, “Tax Policy and Business Fixed Investment in the United States,” Journal of Public Economics 47(2), March 1992, pp (investment incentives and stabilization)