TAX POLICY AND CAPITAL FORMATION UNDER THE EMU:
PERSPECTIVES ON GERMAN ECONOMIC POLICY
12
Robert S. Chirinko
1
Department of Economics, Emory University, Atlanta, GA 30322, USA
2
CESifo, Munich, 81679, Germany
Forthcoming in Heinz Herrmann and Reiner Koenig (eds.),
Investing Today For The World Of Tomorrow:
Proceedings Of The Second Annual German Bundesbank Spring Policy Conference
(Berlin: Springer-Verlag).
A paper copy of the entire manuscript is available from the author, rchirin@emory.edu.
OVERVIEW
I beg the reader not to discard this somewhat utopian scheme with the sterile objection
of "utterly impracticable." Let its practicability be tested not by prospects for speedy
enactment but by the contribution it has to make to orderly thinking about the basic
issues of budget policy.
Richard Musgrave, 1959: vii
In fact, one of the most useful roles an economist can perform is to remind
policymakers that the economy is complex, that we must be keenly aware of the
unintended consequences of our actions, and that choices must be made among
competing objectives. We politicians don't always want to hear these things, but it is
important that we do.
Lee Hamilton, 1992: 61.
This paper offers a framework for considering capital formation and how it can be affected by
tax policy. The economics literature is particularly useful in isolating the major channels through which
tax policy affects capital formation and focusing attention on the key empirical magnitudes that largely
determine outcomes. The purpose of this framework is not to develop a "blueprint" for policy action
but rather, as noted by Musgrave, to contribute "...to orderly thinking about the basic issues of budget
policy."
Section 2 begins by examining an essential question facing policymakers: is there too little
capital? One set of well established theories and evidence suggests that capital formation is excessive;
another set that it is deficient. While the debate remains unsettled, we nonetheless adopt the operating
assumption that raising capital formation is an intermediate policy goal.
The three key channels translating tax policy into real outcomes are presented in Section 3 and
Figure 5 (attached). Central to any discussion is the "price" of capital. The rental price (or user cost)
of capital is an enormously helpful concept converting the complicated dynamics associated with
capital formation into a relatively simple and measurable variable. The user cost channel translates
changes in tax policy into changes in the price of capital. The extent to which these altered price
incentives affect capital formation is captured by the substitution channel. Quantifying this channel has
led to much controversy in the economics literature, and that debate is reviewed briefly. Finally, capital
formation's ultimate effect on the output of goods and services is through the production function.
Exogenous and endogenous growth theories have substantially different implications for the size of the
production channel. The goal of this section is to highlight the key economic magnitudes that
determine the ultimate impact of tax policy on real outcomes and to provide an overview of the
empirical debate.
Policy lessons relevant to Germany are discussed in Section 4. The effects of the EMU in
attenuating and amplifying the potency of tax policy are reviewed. This section then uses the threechannel framework to discuss four current German policy initiatives: business income tax cuts, capital
gains forgiveness, energy tax increases, and labor market reforms. Tensions and tradeoffs between
competing policy goals are highlighted.
In 1947, Dr. Edwin Nourse (the first chairman of the U.S. Council of Economic Advisers) was
discussing economic policy issues with President Harry Truman and his assistant, John Steelman, and
remarked "On the one hand...but then on the other hand..." After Dr. Nourse left the office, a
somewhat frustrated Truman supposedly asked "John, do you think you could find me a one-armed
economist?"
Regrettably, President Truman and perhaps some readers will remain disappointed. We are not
in a position to provide definitive answers to the issues surrounding tax policy and capital formation.
Nonetheless, the economic literature offers important insights that can address the following questions
facing policymakers:
1)
Should The Capital Stock Be Increased?
2)
How Is Tax Policy Translated Into Economic Incentives?
3)
What Are The Key Magnitudes Affecting The Impact of Tax Policy?
4)
How Does The EMU Affect These Channels?
5)
Are Current Policy Initiatives Likely To Succeed?
Figure
5
A Framework For Tax Policy Analysis
Tax Policy
User Cost
Channel
Economic Incentives
Substitution
Channel
Capital Formation
Production
Channel
Output