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
OLD
capital gains
tax cut
NEW
corporate tax
rate cut
investment
tax credit
incremental
ITC
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
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. 574595 (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)