he 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
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
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
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
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
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
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
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
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
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
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
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 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
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
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
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.