Economic Growth and International Competitiveness

1
Economic Growth and International Competitiveness

• Presentation to the Presidents Advisory Panel on
  Federal Tax Reform
• Alan J. Auerbach
• March 31, 2005

2
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

3
The Tax System, Growth and Competitiveness

• Competitiveness many definitions
• Cost relative to foreign goods?
• depends on exchange rate
• comparative advantage cant 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?

4
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

5
Tax Policy and Intangible Capital

• Technological progress involves positive
  spillovers from individual advances
• Societal returns may be higher than individual
  returns may justify subsidy
• RE 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.

6
Tax Policy and Intangible Capital

• Summary Technological spillovers may justify an
  RD subsidy, but
• a subsidy exists even without the RE credit
• policy to spur productivity growth depends on
  more than the tax system

7
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

8
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

9
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

10
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

11
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

12
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

13
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

14
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

15
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)

16
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

17
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

18
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

19
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 systems incentives may be worst (e.g.,
  borrowing to invest in tax-preferred assets)

20
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. 574-595 (transition provisions)
2. Auerbach, Alan J., The Future of Fundamental Tax
   Reform, American Economic Review 87(2), May
   1997, pp. 143-146 (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. 141-170 (investment incentives and
   stabilization)