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March 1981

Getting Serious About Tax Reform

One way to improve America's economic situation is to increase our industrial capacity, which costs money that isn't available because Americans need every nickel to keep up with rising prices. But regular savings can be encouraged, argues one economist, by heavily taxing consumption, by reducing or eliminating state and local taxes...and more.

by Lester C. Thurow

The United States is in the middle of an economic disaster that is unfortunately not an economic crisis. If our current problems are allowed to persist for the next ten to twenty years, they will destroy our standard of living, threaten our international alliances, and jeopardize our domestic tranquillity. But no aspect of the present economic situation is calamitous enough to make us undertake the painful measures necessary to restore our economic health.

While America's productivity was rising 3 percent per year fifteen years ago, it is now falling. With falling productivity comes a decline in standard of living. We have, simply, less output to divide among Americans.

In contrast, German productivity is growing at a healthy 4 percent rate, and Japanese productivity is growing at an even healthier 7 percent rate. Each year, fewer American industries are competitive in world markets. Measured in terms of per capita GNP, the United States now ranks tenth among industrial countries. Every year it slips further.

Energy problems accelerate the decline in our standard of living. Every extra dollar for OPEC means one dollar less for Americans. At the beginning of the 1970s, OPEC took one percent of the American GNP; at the beginning of the 1980s, it took 4 percent; who knows what it will take at the beginning of the 1990s?

But the problems are more severe than a falling standard of living, as painful as that may be. Consider our military and political alliances. Will they be viable ten years from now if America continues to decline relative to Germany and Japan? Will poor Americans be able or willing to pick up the defense bills for rich Germans and Japanese? If not, what will happen?

Our newly rich allies would have difficulty assuming our present role. Both Germany and Japan are small geographically, and have the added disadvantage of proximity to the Soviet bloc. Germany also has a relatively small population. The Common Market is large in terms of population and economic muscle, but it lacks, and is unlikely to get, the political integration necessary to make speedy international political or military decisions. And the rest of our allies are unlikely to welcome dominant German and Japanese armies.

Energy problems compound the international difficulties. A cutoff from Persian Gulf oil would be painful for the United States, but not an economic disaster because we get relatively little oil from that region. Faced with a cutoff, we could quickly find enough domestic energy to keep essential activities going. But for Europe and Japan, Persian Gulf oil is essential.

Suppose the Persian Gulf were to be embroiled in war. Would the United States risk substantial military casualties to defend an area in which it does not have a direct interest? The Germans and Japanese do not have armies to send to the Middle East. How long would the American public be willing to see Americans, and only Americans, die to provide energy for Germany and Japan?

In the long run, this geo-economic difference will destroy the Western alliances unless we work together to end a dependency on Persian Gulf oil for the entire Western bloc. Realistically, this means the United States has to become not just energy self-sufficient but also a major exporter of energy.

If the energy problem were simply an economic problem it could be left to the marketplace. We allow rising prices to ration valuable land, and we could allow market prices to ration valuable energy. But the energy problem is not a function of scarce resources. It is a problem created by a cartel in control of a substantial portion of those resources.

Industrial economies can handle gradually rising energy prices, but they cannot handle abrupt cutoffs imposed for political reasons by cartel members. If we consider both foreign policy concerns and the economic costs of politically inspired supply disruptions, relief from this dependency becomes an absolute necessity.

At home, political frustration and social polarization can only intensify as standards of living fall. A look at the British shows what will happen. The right wing of the Tory party and the left wing of the Labour party devour the political middle. Middle-class altruism disappears. Programs designed to help the poor and to integrate minorities and women into the mainstream of economic life are abandoned. Social tensions pit group against group. Those pressures are already visible here and will grow worse in an environment of economic failure.

Something is fundamentally wrong, not only with our government but with all of our institutions. Never in our entire economic history has America achieved the productivity growth rates that the Japanese have gained. What used to be referred to as the "best managed corporation in America" (General Motors) has been brought to its knees by foreign competition.

We cannot compete when we have an educational system so poor that the New York Telephone company has to test fifteen individuals to find one literate enough to be a telephone operator. We cannot accelerate productivity when we have a legal system that allows anyone to create uncertainties and delays to the extent that major new industrial facilities, such as the North Dakota coal gasification plant, cannot be built. We cannot tolerate a set of corporate management incentives of such limited horizons that our firms cannot compete with farsighted foreigners. We cannot afford unions that resist technical change and enforce restrictive work rules. Our governmental system of checks and balances may have been right for the eighteenth century but it does not permit the quick decisions necessary for survival in the twenty-first century. That system will have to be changed.

Before we can advance on the reindustrialization and energy fronts, we will have to develop a consensus strategy that attempts to distribute equitably the necessary economic pain. We must not use these national goals as an excuse to widen existing inequalities in the distribution of income and wealth and to drive undesired institutions (unions), programs (affirmative action), or groups (blacks, Hispanics, women) out of the mainstream of society.

These dangers are apparent in several current proposals for altering the tax system. Consider the Reagan proposal to stimulate investment by means of lower capital gains taxes. If lower capital gains taxes were limited to plant and equipment investment in new, high-risk, venture capital situations, one could understand the proposal even if one did not agree with it. But the lower capital gains tax rates will also apply to antiques, paintings by Old Masters, land, first homes, second homes, and a wide variety of assets that have nothing to do with reindustrialization. For every dollar's worth of reindustrialization incentives offered, several dollars' worth of incentives will be provided for nonproductive investments. Since speculative investments usually pay off more quickly than productive investments, the net result of the tax cut may even be to increase the diversion of funds from productive to nonproductive investments.

I have a question to determine whether people are really serious about reindustrialization: Which of the many tax incentives for nonproductive investment are you willing to see eliminated? Anyone who says "none" is not really interested in a healthy American economy.

But suppose what we want is energy independence and enhanced productivity growth? Could we do what is necessary without further distorting the distribution of income and wealth? Or is trickle-down (immediate tax cuts for the rich that may lead to more jobs for the middle class and the poor) the only alternative? Fortunately we have still another choice.

If one were writing a history of the past twenty years of tax legislation, it would read like a history of trench warfare. Vast battles have been fought over the proper division of the tax burden between rich and poor, and over the equal treatment of those with equal spending power. But the advances or retreats have been measured in inches. This stalemate has to be replaced by a major structural overhaul.

If one of our national goals is to encourage energy production, then the recently enacted windfall profits tax should be eliminated. One can argue about the extent to which this tax discourages energy production, but more energy would surely be produced without it. The more profitable energy production is, the more energy will be produced. And since we cannot afford to give up any future energy production, no matter how small, we cannot afford the windfall profits tax.

Some individuals will undoubtedly become even more wealthy with the elimination of the windfall profits tax. But the personal income tax is the correct place to handle this problem. Other individuals (rock stars) are going to become fabulously wealthy from activities much less important to the national welfare. The rich should pay their fair share of the tax burden, but we needn't discriminate against the oil-rich.

What about the program to produce synthetic oil if no windfall profits tax is available to finance it? Although the production of synfuels requires government involvement, it does not require government investment. The problem arises because the price of imported oil is at least partly attributable to the machinations of a manmade cartel. Suppose imported oil were selling for $40 per barrel, and we were able to discover a process to make synthetic oil for $25 per barrel. Could we afford to go into production? If the $40 price represented the cost of producing imported oil, the answer would be a clear Yes. Given that billions of barrels of oil are consumed, billions of dollars are available to be made.

If the $40 price is set by a cartel, however, the decision to go into production is not so clear-cut. Large-scale investments would be necessary to make synthetic oil; but what would happen once we started producing oil? The cartel would be forced to cut its price to $24.99, and we would be left with a huge but worthless production facility. We would have done the world a favor--forced down the price of oil--but we would have lost our investment.

Private investors rarely do social favors that lead to capital losses. Since OPEC production costs (40 cents per barrel in Saudi Arabia is the current estimate) are far below selling prices, no private investor can compete with OPEC. Private investors do not want to risk their investments, and the plants do not get built. As a result, energy independence is not something that can be achieved by liberating free enterprise. Our government can, however, guarantee some minimum price for energy in the 1980s and 1990s. This would eliminate the basic uncertainty and at the same time allow competition between firms to produce alternative forms of energy most efficiently.

Since alternative energy supplies could not be available in the necessary amounts in less than ten years, however, the country also faces the problem of what to do between then and now. In recent months the French have increased their gasoline tax to $3.50 per gallon. Other countries are approaching this level. Yet we have no tax designed to discourage consumption.

The difference between the French and the American experience with gasoline taxation suggests two possibilities. Either the French and other industrial countries are stupid and we are smart, or the reverse. To ask the question in this manner is to answer it. Other countries levy those taxes because they know they can afford to pay the imported oil bill they would have to pay if they did not actively discourage consumption. But they are wealthier than we (with respect to per capita GNP), and have healthier economies generating larger productivity gains. If they can't afford their imported oil bills, we certainly can't afford ours.

We need the 4 percent of our GNP that goes for imported oil for other, more essential purposes such as defense and investment. Our imported oil bill deprives us of the resources necessary to right our domestic economy, and saps our long-run economic vigor.

Gasoline tax revenue raised by the federal government should be rebated to state and local governments dollar for dollar to the extent that they reduce their own taxes. A tax of $3 to $3.50 per gallon would permit the elimination of all state and local taxes. The resulting tax system would be fairer than what now exists in most states. A gasoline tax would be regressive (the tax burden would go down proportionately as incomes go up--but the current system of state and local taxation is even more regressive. The net effect would be a slight decrease in the tax burden of the poor. Such a shift in the structure of state and local taxation would require political courage and public persuasion, but the choice is survival, and eliminating all state and local taxes is not without its political attractions.

Reindustrialization will also require dramatic changes in the tax structure. To increase work effort and investment while lowering consumption, taxes will have to go up on consumption and down on both investment and work effort.

When productivity was growing at 3 percent per year, we were investing 9.5 percent of the GNP in plants and equipment. But investment rose to 10.3 percent of the GNP in the 1970s as productivity was falling.

In 1978, for example, Americans invested 10.4 percent of their GNP in plant and equipment. After correcting for inflation, the total quantity of plant and equipment available for production rose 3.4 percent. But hours of work rose 4.8 percent in the private economy and the amount of plant and equipment per worker fell 1.4 percent. A similar reduction occurred in 1979. It is not surprising that with less equipment per worker, productivity fell.

What happened? The answer is simple. Americans failed to live up to the promises made implicitly during the baby boom. The average American worker in the past twenty years has had $50,000 worth of plant and equipment at his or her disposal. Americans who had babies in 1960 were implicitly promising that they would save the $50,000 necessary to equip their children with the average amount of plant and equipment necessary to enter the labor force in 1980. Although Americans have fed and educated their children, they have failed to equip them for productive work.

The contrast with our competitors is frightening. The Japanese invest almost 20 percent of their GNP in plant and equipment with a labor force that is not growing. more than 10 percent of our GNP is required just to equip new workers. If American workers were to acquire new equipment as fast as the Japanese do, Americans would have to invest 30 percent of their GNP.

But raising investment from 10 to 30 percent of the GNP creates a problem. Until the new factories come into production--five to ten years from now--more investment means less consumption. Tax cuts that will stimulate investment are easy to implement. But the consumption tax increases that will be necessary to pay for them are more difficult.

On the investment side, the best solution is to eliminate the corporate income tax and to integrate corporate and personal taxation. No corporate income tax would be imposed, but each individual shareholder would be liable to pay personal taxes on all income (retained or paid out in dividends) earned by the corporation on his or her behalf. If the corporation declared no dividends but earned a profit, each shareholder would be liable for a tax on his share of that income, and the company would withhold a portion of those earnings in order to reduce the impact of an unexpected tax burden. At the end of the year, shareholders would get the equivalent of a W-2 form telling them how much corporate income to add to their other sources of income, and how much income tax had been withheld on their behalf.

Since corporate after-tax rates of return on investment in plant and equipment would approximately double with the elimination of the 46 percent corporate income tax, corporate managers would have a strong incentive to increase investment. At the same time, the fairness of the tax system would actually increase. Each shareholder, rich or poor, would pay taxes on corporate earnings at a rate commensurate with his own income position rather than at some common rate--e.g. the current maximum corporate tax rate of 46 percent. Those in a 30 percent personal income tax bracket would pay a 30 percent tax on their corporate earnings and those in a 50 percent bracket would pay a 50 percent tax.

At the same time, the maximum tax rates in the personal income tax--now 50 percent on earnings and 70 percent on capital income--should be equalized. Both work effort and investment are essential to economic progress. People with the same spending power should pay the same tax regardless of how they acquire their income.

While corporations are legal entities that write checks to governments, strictly speaking they do not pay taxes. They simply collect money from their shareholders, their customers, or their employees and transfer it to the government.

The corporate income tax has two sources of protection. The man on the street thinks it is a way to tax the rich. This is a mistaken perception. To the extent that it is a sales tax on consumers or a tax on employees, it is not a tax on the rich. And even if it is ultimately paid by the shareholder, it is not a very good tax on the rich. For most of the rich it is a tax shelter, since their personal tax rate is higher than the corporate income tax rate. If we want to tax the rich, the personal income tax is the right place to do it.

Corporate managers also support the corporate income tax, but on the grounds that it encourages firms to retain their earnings rather than to pay them out in dividends. No personal income taxes are paid if the funds are retained and the lower capital gains tax rates apply to the higher share prices flowing from the extra retained earnings and investment. From the individual manager's perception, this means more funds not subject to the competitive bidding of other managers in the financial markets. This perception is undoubtedly true, but shareholders should be encouraged to complain and demand their earnings when their managers are not earning a long-run rate of return competitive with other firms.

Other tax systems do not stimulate investment more than ours but they do act aggressively to hold consumption down. Why does the average American family save 5 percent of its income while the average German family saves 14 percent and the average Japanese family saves 20 percent? Don't foreigners like cars and cameras? Of course they do, but their governments have deliberately structured their tax systems and economies to discourage consumption.

Most of our industrial competitors impose a value added tax (VAT). (Sweden's is now close to 25 percent.) A VAT (a tax based on the "value" any producer adds to the cost of consumer goods) is essentially a national sales tax--a tax on consumption--which you do not have to pay if you don't consume. And if you insist on consuming, government takes a large fraction of your income away from you.

In addition to reducing consumption, the VAT has the advantage of taxing illegal underground activity. Those who earn their living in the underground economy may be able to escape the income tax, but they must pay VATs when they buy goods and services. The larger the underground economy, the more vital a VAT becomes.

The burden of the tax can also be allocated in whatever way one likes with a refundable income tax credit. Suppose a 10 percent VAT were imposed, along with a $1000 refundable credit. A family earning $10,000 and saving nothing would pay $1000 in VATs, but would get it back in the form of an income tax credit. Up the income scale, the $15,000 family would pay $500 ($1500 in taxes minus $1000 in an income tax credit) in net taxes, the $30,000 family $2000, and so on. With such a credit, the VAT can be made progressive (the fraction of income paid in taxes goes up as income goes up).

A 10 percent VAT--lower than that in most of the rest of the industrial world--would yield about $235 billion (10 percent of annual private production of goods and services) in revenue. This would be enough to replace the corporate income tax ($85 billion) and the Social Security tax (about $ 150 billion).

Both of these taxes should be replaced. The rationale for replacing the Social Security tax is like that for replacing the corporate income tax. If you want to encourage work effort and discourage consumption, you systematically reduce taxes on work and raise taxes on consumption. To lower taxes on savings and investment while raising taxes on work, as we will be doing under the current system for financing Social Security, is perverse. Work effort is probably even more important than investment.

When you shift from a Social Security tax that does not cover investment income, or even all of earnings, to a value added tax, and a progressive value added tax at that, you are making your tax system more, not less, progressive. The very rich who choose to save and invest can avoid taxes, but the big spenders get hit.

Higher personal income tax collections would yield an extra $50 billion in revenue. This should be put into the Social Security Trust Fund to build up a large surplus gradually. This is important for two reasons. A government surplus, coupled with the retirement of government debt, would contribute to the national goal of increasing savings. Governments cannot contribute to work effort, but they can and should contribute to savings.

The surplus would also alleviate the coming crunch in the Social Security system when the baby boom generation starts to retire. Between now and then--in the years after 2012--the savings in the trust fund will help make the economy more productive so that we can afford the pensions promised.

Very few people save because they are misers or because they want to die rich. Individuals save to consume. If they can consume without saving, that is precisely what they will do. Therefore, we must design an economic system that encourages individuals to save if they want to consume.

Basically, this means reducing consumer credit. Suppose you could not borrow to buy a car. This would do two things for plant and equipment investment. Someone else's savings would not need to be used to finance your car, and your car savings could be used for plant and equipment investment until you had accumulated enough to buy the car.

A sudden end to consumer credit for large durables would be too great a shock to the affected industries but the nation should start to move in this direction. We might, for example, announce that the maximum length of car loans would be systematically reduced over a specific period of time. Starting with forty-eight-month loans, the maximum loan would be reduced by twelve months each year over a four-year period. At the end of four years, no one could buy, cars on credit. Similarly, mortgage down payments should be systematically increased over time. Every year we might raise the minimum down payment 5 percentage points until we had replaced 20 percent down payments with 50 percent down payments.

No one knows whether these measures would be enough to turn 5 percent American savers into 20 percent American savers, but they would certainly move us in the right direction. If we cannot undertake painful measures, we cannot solve our problems. No-one has yet devised a painless way to induce Americans to save at a rate of more than 5 percent.

If we compare what needs to be done with what President Reagan is proposing, our economic problems seem certain to be as acute in 1984 as they were in 1980. The centerpiece--a 30 percent across-the-board personal income tax cut--is a triumph of packaging, but it is unlikely to make a substantial difference.

Americans now consume 95 percent of their income and save 5 percent. If their taxes are cut 30 percent, how much will they save? The most likely answer is that they will continue to save 5 percent and spend 95 percent. The net result will be a lot of extra consumption and only a little extra savings. But what we need is a lot of extra investment and no extra consumption.

If we think seriously about what America would have to do with its tax system or any other part of its economy to cure its problems, one obvious conclusion is that the solutions are "politically unfeasible." But to accept that conclusion is to accept the idea that America is through as a world economic power. We have to change.


Copyright © 1981 by Lester C. Thurow. All rights reserved.
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