# Presentation: 079131

## 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; 2002-3: 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

## 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

- 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. 574-595 (transition provisions)
- Auerbach, Alan J., “The Future of Fundamental Tax Reform,” _American Economic Review_ 87(2), May 1997, pp. 143-146 (border adjustments)
- 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. 141-170 (investment incentives and stabilization)