ax Title ofTestimony of Alan J. Auerbach, Robert D. Burch
Professor of Economics and Law Director, Burch Center for Tax Policy and
Public Finance, University of California, Berkeley, Before the House
Ways and Means Commitee: Tax Reform, Growth and International
June 9, 2005
Tax Reform, Growth and International Competitiveness
Testimony before the Committee on
Ways and Means
House of Representatives
Alan J. Auerbach
Robert D. Burch Professor of Economics and Law
for Tax Policy and Public Finance
June 8, 2005
Mr. Chairman and Members of the Committee:
I am pleased to have this opportunity to offer my views on the effects
of the tax system on economic growth and international competitiveness
and the role that tax reform can play in promoting both. Today, I will
discuss the design of effective tax incentives and how the current tax
system measures up. I will also highlight one potential goal that tax
policy cannot achieve. Finally, I will draw some conclusions
regarding the design of fundamental tax reform and how potential reform
plans should be evaluated.
WHAT IS COMPETITIVENESS?
has experienced massive trade deficits in recent years, with net imports
in the first quarter of 2005 approaching 6 percent of GDP. This has led
to concerns that
producers may be losing their ability to compete in the global
marketplace. But how should one define competitiveness?
The simplest definition of competitiveness, perhaps, involves a
comparison of domestic and foreign costs of production;
producers are "competitive" if their costs of production are
lower. But this measure of competitiveness suffers from two logical
problems. First, the costs of foreign producers, measured in U.S.
dollars, depend on the exchange rates between the dollar and the
respective foreign currencies. A low enough dollar would make all U.S
producers competitive according to this definition, even with no changes
in domestic or foreign production techniques or local labor costs. Thus,
producers could be competitive even in our weakest industries or, at a
different configuration of exchange rates, not competitive even in our
strongest. Second, the most fundamental economic concept of
international trade - Ricardo's principle of comparative advantage
- dictates that a country will export the goods and services in which it
is relatively competitive, and import the goods and services in
which it is not - even if it is extremely efficient at producing goods
and services in the latter category. By definition, a country cannot
have a comparative advantage in producing everything, and thus it cannot
have a uniform cost advantage. Thus, a comparison of domestic and
foreign costs, though perhaps intuitively appealing, is not a useful
measure of competitiveness.
A better approach to measuring competitiveness relies on a comparison of
productivity, the amount of goods and services produced per worker hour.
Higher productivity means a higher attainable standard of living, for
over the long term a society cannot consume more than it produces. Our
objective, as a society, should be a high and rising standard of living.
International trade is only a means to achieving this ultimate
objective; strong exports or a trade surplus are not ends in themselves.
THE DETERMINANTS OF PRODUCTIVITY
Productivity per worker hour depends on a range of factors, many of
which are influenced by taxation. We should consider the impact of
taxation on human capital, tangible capital, and intangible capital -
the three types of capital that increase productivity by augmenting
basic, unskilled labor. All three types of capital are important
determinants of productivity and policies to foster capital accumulation
should be designed with all three types in mind (not just tangible
capital). Our present tax system does not treat the different types of
capital uniformly, thereby creating uneven incentives for capital
Tax Policy and Human Capital
The costs of accumulating human capital through education, on-the-job
training and workplace experience receive relatively favorable treatment
under current law. A primary cost of education and training is forgone
earnings - the earnings given up by staying in school or by accepting a
lower current salary in order to gain valuable job experience - and this
cost is effectively tax-deductible, because income and payroll taxes are
avoided when earnings are forgone. The progressivity of the tax rate
schedule offsets the benefit of being able to expense costs immediately,
for those who accumulate human capital will have higher future incomes
and thus face higher marginal tax rates. But there is another aspect of
the "success" tax that is often ignored, that a progressive
rate structure also provides insurance against income uncertainty.
Success may be the result of education and hard work, but it also
depends on luck: by choosing the right field of study, working for a
successful employer, or avoiding debilitating illness. Indeed, recent
research suggests that moving to a less progressive rate structure might
be undesirable, if one takes the reduction in this insurance function
into account. 1
The marginal tax rate reductions of recent legislation, then, have
offsetting effects on incentives for human capital accumulation,
increasing after-tax investment returns, but also increasing the
uncertainty of these returns. However, there is another important aspect
of recent policy that discourages human capital investment - the fact
that we are on an unsustainable fiscal path. That is, there is a
significant risk of large future tax increases. The decision to invest
in human capital relies on a very long time horizon, since the returns
to education and training may be realized only after several years. The
prospect of higher future taxes and the uncertainty regarding the
form and level of these taxes each discourage human capital investment.
A tax system's instability, in itself, discourages human capital
investment (and indeed, other types of investment as well), and it is
difficult to maintain a stable tax system when there is a large and
growing imbalance between taxes and spending.
Tax Policy and Intangible Capital
Intangible capital investments generally face more favorable tax
incentives than do investments in human capital. Not only can investors
write off such investments immediately, but qualifying investments are
eligible for the Research and Experimentation credit. Because the
immediate write-off, by itself, effectively eliminates the tax on new
investments, the combination of immediate write-off and the R&E
credit delivers an outright subsidy to investments in intangible
capital. Does such favorable treatment have any justification? The
answer is yes, because many intangible investments have the capacity to
convey positive "spillovers" to others in society. Put another
way, if investors cannot capture all the benefits of their investments,
they need some sort of compensation from the rest of society - those who
also gain from these investments - and a tax subsidy is therefore fair.
The right level and scope of the subsidy are difficult to determine,
however, for it is hard to identify the social payoffs to different
types of investments in intangible capital.
It should also be remembered that intangible capital depends on more
than research and development investment, and is influenced
substantially by government policy beyond the realm of taxation. Our
ability to achieve high levels of production relies on the clarity and
force of our legal system, the rationality of our regulations, the
flexibility of our employment relationships, and so forth. We should
view tax policy toward intangible capital as but one component of a
portfolio of policy tools.
Tax Policy and Tangible Capital
Incentives to invest in tangible capital, primarily plant and equipment,
are affected by myriad tax provisions. In thinking about the nature of
the provisions, it is useful to distinguish four dimensions in which tax
provisions may vary:
Are they broad or targeted?
Are they temporary or permanent?
Are they aimed at savers - those who supply the funds for investment -
or at the companies that actually spend the funds?
How do they apply to capital assets already in place, as opposed to
Broad versus Targeted
One of the key principles of tax design is that taxes should have as
broad a base as possible, so as to permit the lowest possible tax rate
for a given revenue requirement. A broad-based, low-rate system promotes
efficiency by limiting the distortions of economic decisions, and may
also be simpler and easier to administer than alternative systems.
Why deviate from this appealing norm? For example, why implement an
investment tax credit for investment in equipment, as we did prior to
1986? One argument is that the favored investment provides significant
social spillovers, basically the same rationale as for the favorable
treatment of investments in intangible capital. But there is no
convincing empirical support for the argument that certain types of
equipment investment generate such positive spillovers, so this argument
is weak. A second defense of targeted provisions is that they offset
existing benefits available to other investments. For example, prior to
the changes introduced by the Tax Reform Act of 1986, some argued that
real estate investment enjoyed a variety of tax benefits, so that the
investment credit simply leveled the playing field. While such an
argument may have had merit, at least before 1986, it is extremely
difficult to get such offsets right, as the tax provisions one must
weigh in seeking balance are typically quite different.
Temporary versus Permanent
No tax provision is truly permanent, because each year brings the
possibility of new tax legislation. But some provisions are explicitly
temporary. The bonus depreciation provisions introduced in 2002 and
enhanced and slightly extended in 2003 had this characteristic; indeed,
bonus depreciation has now expired.
Why adopt temporary provisions? The strongest potential justification is
as a stabilization device, to dampen swings in the economy. For example,
bonus depreciation was introduced while the economy was still recovering
from the 2001 recession, which had been characterized by a steep drop in
equipment investment. Historically, adjustments of the investment tax
credit were often motivated by similar concerns. There is plenty of
evidence that fluctuations in investment incentives altered the path of
investment, but no evidence that such effects served the purpose of
Very short-lived provisions, such as the bonus depreciation scheme, are
especially tricky to implement because they provide more powerful
incentives for longer-lived assets, allowing investors to lock in
"cheap" capital for a long time. The variations in incentives
across assets depend on how temporary the provisions are, making the
tailoring of provisions to provide uniform incentives extremely
difficult in a dynamic tax environment.
Saving versus Investment
With the existence of international capital flows, saving and investment
can occur in different countries. That is, savers in the
can supply funds for foreign investment, and businesses in the
can attract funds for their investment from abroad. If
capital accumulation is our goal, is it
investment we should be encouraging?
The argument for encouraging
saving is straightforward, for increasing saving expands national
wealth, whether this wealth is invested abroad or at home. An increase
in U.S. saving would also contribute to a reduction in our trade and
current account imbalances, for, as discussed further below, the share
of our domestic production not claimed by domestic investment or
government and private consumption is available for export.
The argument for encouraging U.S investment, as opposed to
saving, is less obvious, unless one subscribes to the view that such
investment generates large social spillovers, a view that I have already
dismissed. In the end, though, there is less distinction than there may
appear to be between policies that encourage saving and policies that
encourage investment, because investment and saving tend to move
Thus, policies that encourage saving encourage investment, and policies
that encourage investment encourage saving.
New Capital versus Old Capital
Some people seem to believe that provisions that benefit capital
necessarily benefit investment, but capital and investment are distinct.
Provisions may reduce the tax burden on existing capital more or less
than they reduce the tax burden on new investment. If stimulating
investment is our aim, then we should seek to reduce the tax burden on
investment. Although reducing the tax burden on existing capital at the
same time may be unavoidable, doing so may actually discourage
saving and investment, for example, by increasing asset values and
stimulating the consumption of goods and services.
Historically, proposals and actual policies have varied considerably in
their relative treatment of old and new capital. The following diagram
illustrates this variation, with provisions favoring old capital more
toward the left, and those favoring new capital more toward the right.
A reduction in the corporate tax rate lowers the tax burden on both new
and old capital, though it may help old capital more to the extent that
depreciation deductions are more favorable for new assets and shield
more of their income from taxation. An investment tax credit, on the
other hand, provides no benefit at all to existing capital. Moving in
the other direction, a reduction in the capital gains tax rate favors
old capital substantially more than new capital. A cut in the capital
gains tax rate reduces the tax burden not only on future income from
existing assets but also on these assets' past income - gains that have
already accrued but have yet to be realized.
Focusing tax provisions on new capital makes the provisions more
efficient at achieving their goal, but there are limits to the
feasibility of doing this. For example, an incremental investment tax
credit, applicable to investment in excess of some base level, would be
an even more cost-effective way of encouraging investment. But though
the incremental ITC has occasionally been proposed, the determination of
its base investment level is complex and involves potentially perverse
side effects of the type that have plagued the R&E credit over the
The way a tax provision is implemented also affects the extent to which
it favors old or new capital. For example, phasing in a reduction in the
corporate tax rate rather than adopting the reduction immediately
concentrates more of the overall benefit on new capital. Because
investment decisions are forward looking, a prospective corporate tax
cut may be almost as effective at stimulating investment as an immediate
one. But the phase-in procedure will save revenue and limit windfalls to
capital already in place, the source of current income. By this logic,
the dividend and capital gains tax reductions of 2003 get things almost
exactly backward. If investors believe that the scheduled sunset after
2008 will occur, then the tax reductions will have almost no impact on
the incentive to invest while still providing substantial tax benefits
to the owners of existing assets.
Finally, it is important to look at substance rather than form in
estimating the extent to which a tax provision favors new or existing
capital. Provisions labeled "savings incentives" appear aimed
at the generation of new savings, and hence targeted at new capital. Any
provision that provided a tax benefit only for new saving would indeed
be an incentive to save. But many tax incentives for "saving"
are available to individuals who simply transfer existing assets into a
qualifying account. Such asset transfers do not constitute new saving,
and the associated tax benefits represent windfalls to existing assets.
Legislators should keep this caveat in mind when considering the
expansion of such schemes.
Measuring the "Bang for the Buck"
As just discussed, capital income tax provisions vary in the extent to
which they provide windfalls to existing capital rather than incentives
for new investment. For a given investment incentive, a provision that
limits windfalls will have a lower revenue cost and hence a higher
"bang for the buck" - a greater investment stimulus per dollar
of lost revenue. But comparing the revenue lost by different provisions
is tricky because the provisions may vary in their timing. Provisions
that provide "front-loaded" incentives may appear more costly
over a short revenue window than comparable provisions that are
"back-loaded." A familiar recent example is the comparison
between traditional IRAs and Roth IRAs. The two types of accounts offer
similar tax benefits to depositors when calculated over the long term,
but the tax benefits of the Roth IRAs are received by a depositor over
time (through the exemption of earnings from tax), while the traditional
IRA delivers its benefits through an immediate tax deduction. Thus, over
a short period, say a ten-year budget window, the Roth IRA will appear
less expensive and seem to have a bigger bang for the buck than the
traditional IRA even though this is not the case.
Another example comes from the Tax Reform Act of 1986, which reduced the
corporate tax rate while repealing the investment tax credit. As
discussed above, the investment tax credit is focused more on new
capital than is a corporate tax rate reduction, so trading in the ITC
for a tax rate cut seems like a move in the wrong direction, at least in
terms of potential bang for the buck. But the ITC is a front-loaded
incentive, which makes it appear more expensive over a short time period
than a corporate tax rate reduction with a similar impact on the
incentive to invest. As the 1986 reform aimed at short-term revenue
neutrality, the process was biased against the ITC. 4
WHAT TAX REFORM CANNOT DO
There are, of course, many things that tax reform cannot accomplish, but
there is one objective so closely tied to tax reform in the minds of
some that it deserves explicit attention, lest reform efforts be
misdirected. Tax reform cannot reduce the trade deficit, at least not
through the tax treatment of exports and imports.
The trade deficit, by definition, equals the amount by which domestic
investment spending plus non-investment purchases by government and
households exceed domestic production, i.e., GDP; we must import the
excess of what we spend over what we produce domestically. Unless we
reduce domestic investment spending - clearly not an objective of tax
reform - the only ways to reduce the trade deficit are to increase
domestic production or to reduce spending by government and households.
Either one of these changes - increasing production or reducing
non-investment spending - amounts to an increase in
national saving, so reducing the trade deficit (assuming we don't
sacrifice domestic investment) requires an increase in national saving.
Thus, tax reform must increase national saving in order to reduce the
Tax reform can increase national saving by expanding the economy's
productivity, and hence the size of potential GDP, as well as by
encouraging saving directly, encouraging households to spend less and
save more of their current income. (Other government policies, too, can
reduce the trade deficit, notably deficit reduction policies that reduce
government spending and, through tax increases that reduce household
disposable income, reduce household spending.) But tax reform cannot
increase national saving simply by its treatment of exports and imports.
Some consumption tax proposals, such a value added tax or a retail sales
tax, incorporate border adjustments - they are not imposed on exports,
but are imposed on imports. Other proposals do not include border
adjustments; they do not relieve the tax on exports and do not tax
imports. In comparing the approaches with and without border
adjustments, some have argued that inclusion of border adjustments would
reduce the trade deficit by making our exports cheaper abroad and our
imports more expensive at home. But, with no other differences in
economic fundamentals in the
or abroad, border adjustments will simply strengthen the dollar, putting
importers and exporters in the same competitive positions no matter
which approach is adopted. 5
Ironically, the stronger dollar that border adjustments would induce
would also provide windfalls to foreigners holding dollar-denominated
assets - the very ones who have financed our recent trade deficits.
In summary, tax reform can help the trade balance, but only indirectly,
through its impact on national saving. The decision whether to include
border adjustments as part of a tax reform package should hinge
primarily on other factors, such as simplicity, compliance costs and
ease of administration.
IMPLICATIONS FOR FUNDAMENTAL TAX REFORM
On the basis of the preceding discussion, I offer the following
guidelines for tax reform design.
In thinking about the sources of productivity, keep all forms of
capital, not just tangible capital, in mind.
With few exceptions, avoid narrowly targeted tax provisions. Such
measures may be justified in exceptional cases, but more often are a
source of complexity and distortion.
Focus on incentives. Provisions formally associated with
"capital" or "saving" do not necessarily encourage
capital accumulation very much. Providing windfalls to existing assets
does not stimulate investment or saving.
Take future revenue consequences into account. Proposals can be tailored
to minimize short-run revenue costs or maximize short-run revenue gains
with little impact on the proposals' economic effects or long-run
revenue consequences. The attractiveness of these proposals should not
hinge on such cosmetic alterations.
Pay close attention to the design of transition provisions. Phase-in
provisions can be an effective method of focusing tax benefits on
investment rather than on existing assets. But the piecemeal application
of tax incentives can also introduce opportunities for tax arbitrage,
where individuals receive tax benefits simply by transferring existing
assets to achieve tax-favored status.
Do not conceive of tax reform as providing simple solutions to the
Remember that the objectives of tax reform will be undercut if the
overall fiscal system is unstable. Tax reform and broader fiscal reform
Shinichi Nishiyama and Kent Smetters, "Consumption Taxes and
Economic Efficiency in a Stochastic OLG Economy," National Bureau
of Economic Research Working Paper No. 9492, February 2003.
Alan J. Auerbach and Kevin Hassett, "Tax Policy and Business Fixed
Investment in the United States," Journal of Public Economics
47(2), March 1992, pp. 141-170.
Martin Feldstein and Charles Horioka, "Domestic Saving and
International Capital Flows," The Economic Journal 90(358),
June 1980, pp. 314-329.
Indeed, the one-year revenue effects of these two tax provisions were
roughly offsetting. See Alan J. Auerbach and Joel Slemrod, "The
Economic Effects of the Tax Reform Act of 1986, Journal of Economic
Literature 35(2), June 1997, pp. 589-632."
5 See Alan J. Auerbach, "The Future of Fundamental Tax
Reform," American Economic Review 87(2), May 1997, pp.
Presented by Alvin Brown and Associates,
tax attorney, formerly with the Office of the Chief Counsel of the
Call us for all IRS tax issues, problems and emergencies
Protect yourself from IRS intimidation, errors, and penalties.
www.irstaxattorney.com- firstname.lastname@example.org -
712-7690 - (703) 425-1400