JEC Macroeconomic Conference

RETURN TO PROSPERITY: CREATING THE

STRONGEST ECONOMY OF THE 21ST CENTURY

Presentation of

Stephen J. Entin

Institute for Research on the Economics of Taxation

February 23, 2010

IRET • 1710 Rhode Island Ave., NW, 11th floor, Washington, DC 20036

(202) 463-1400 • www.iret.org

Policy Targets And Policy Tools Two Policy Targets: Stable Prices And A Sound Dollar Vibrant Economy -- High Real Output, Income, Employment Two Policy Weapons: Monetary Policy (Federal Reserve) – Best Used To Keep Prices Stable Fiscal Policy -- Taxes & Govt. Spending (Congress, Mainly) – Can Facilitate Growth If Used Properly Reversing The Roles Leads To Trouble Two Strategies:  Shoot The Right Weapon At The Right Target And You Might Hit Both.  Shoot The Shotgun At The Elephant And The Elephant Gun At The Quail And You Will Get Gored And Go Hungry.

Policy Assignments: 

Nixon/Ford/Carter Years:  Set Monetary Policy To Promote Real Growth And Reduce Unemployment With Easy Money While ... Congress Spent Like Crazy And Let Inflation Raise Taxes, Growing The Public Sector And Restricting The Private Sector. Result: Stagflation. Kennedy/Reagan/Clinton(Gingrich) Years:  Set Monetary Policy To Promote Stable Prices While ... Congress Restrained Spending To Shrink The Public Sector And Cut Taxes In A Pro-Growth Manner. Result: Strong Private Sector Growth Without Inflation.

0

2

4

6

8

10

12

Pe

rc

en

t

1965 1970 1975 1980 1985

GNP Price Deflator *(Percent Change from Year Earlier)

3.0

5.7

4.1

10.8

5.7

10.0

3.6

2.1

3.7

1988

0

2

4

6

8

10

12

Pe

rc

en

t

1965 1970 1975 1980 1985

Civilian Unemployment Rate **

3.4

4.6

9.0

5.7

10.8

5.3

1988

0

2

4

6

8

10

12

14

16

18

Pe

rc

en

t

1965 1970 1975 1980 1985

3-Month Treasury Bill Rate **

3.5

7.9

3.2

8.8

4.4

15.5

7.0

16.3

7.1

10.5

5.2

8.1

1988

Inflation, Unemployment, And Interest Rates, 1965 - 1988

Does Fiscal Policy Have Demand Effects?   The Keynesian Focus On Managing Demand Is Misguided According To Friedman. Tax Cuts And Govt Spending Do Not Stimulate Demand, Because The Govt Must Fund Them Through Borrowing OrOffsetting Taxes/Spending Cuts.  With Rare Exceptions, Govt Spending Takes Resources From The Private Sector And Shrinks Real Output By Putting Them To Inferior Uses.

Tax Cuts Don't Work By Giving People Money To Spend (Raising "Disposable Income" Or "Aggregate Demand"). Unless Matched By Spending Cuts, The Tax Cuts Are Borrowed Back By The Treasury.

If The Federal Reserve Buys The Added Debt With New Money, Demand Will Rise, But The Likely Effect Is Higher Prices, Not Higher Output.

Or Must We Rely On Incentives To Supply?  Tax Cuts Can Boost Output By Creating Incentives To Produce; Only Those Tax Cuts That Affect These Incentives Have A Pro-Growth Effect.

Tax Cuts That Simply Redistribute Income Do Not Increase Work, Saving, Or Investment; They Do Not Increase Employment, Productivity, Output, Or Income. They Probably Reduce Them By Rewarding Non-Work.  Tax Cuts That Improve After-Tax Rewards At The Margin For Additional Work, Saving, Investment, Production, Raise Output, Employment, Income.  There Are No "First Order Income Effects" From A Tax Cut. A Tax Cut Raises Income Only As It Encourages Supply. As Supply Increases, People Get Paid For Their Productive Services, And Only Then Does Demand Rise. (Says' Law, Not Keynes' Claptrap).

Imposition Of A Tax

Quantity

Pri

ce

Supply(No Tax)

Demand

Tax

Q0

P0

Q1

Supply(With Tax)

Reduction in Value ofEconomic Output =

Loss to Consumer

+

Loss to Producer

Pp

Pc

Resources Redirected to other Activities

E1

E0

Laffer Curve

Tax Rate

Tax

Rev

enu

e

0% 100%

Government revenue maximized, but tax rate too high because it's

hurting growth.

Tax rate much too high. It's

hurting growth and lowering

government revenue.

Optimum tax rate: value of government services equals revenue and growth costs that taxes impose on society. Normal

Range ProhibitiveRange

A C

B

Tax Rate

Do

llars

Tax Increases Reduce Economic ActivityLong Before They Reduce Tax Revenues

Economic Output

Govt Revenues

0% 100%

A

B

Optimal Tax Rate

Revenue Maximizing Tax Rate

Hours Worked

Wag

eEffect of Tax On Labor

Labor Supply

Net Wage

Gross Wage Marginal Product of Labor

(Demand)Tax

Dropin

Labor

L1

MPL would rise if labor had more

capital to work with, and fall if

capital formation

lagged.L0

Desired Amount of Capital

Ret

urn

to

Cap

ital

Effect of Tax On Desired Capital Stock

Net Return

Gross Return

Required Return to Capital (Supply)

Tax

Drop in Capital

K1

Marginal Product of Capital (Demand)

K0

Employment

Wag

e

Labor Supply

MPL (K0)

W0

N1

MPL (K1)

W1

N0

A Smaller Stock Of Capital Reduces Wages

Taxing Capital Hurts Labor  Labor Bears The Economic Burden When Taxes Drive Capital Offshore Or Discourage It From Existing At All.  Taxing Income Used For Consumption Instead Of “Haig-Simons Income” Would Raise After-Tax Wages And GDP.  A 10% Rise In GDP And Wages Would Benefit Workers And Families More Than Misc. Tax Credits And Govt Jobs.

Marginal Vs. Average Tax Rates Income = $50 K. Desired Tax Take = $10 K. System 1: Tax All $50 K @ 20%.Tax = $10 K. Average Tax Rate = 20%.Marginal Tax Rate = 20%.Earn $100 More, Keep $80. System 2: Exempt $25 K. Tax $25 K @ 40%.Tax = $10 K;Average Rate 20%Marginal Rate 40%.Earn $100 More, Keep $60 Under Which System Will People BeMore Eager To Earn Additional Income?

Weighted Marginal Individual Income Tax Rate

25.3%

26.1%

26.8%

27.6%

28.5%

29.5%

30.5%

32.0%

33.2%

30.1%

28.1%

27.7%27.8%

28.5%

25.2%

23.3%23.4%23.3%23.2%23.2%

24.2%24.3%24.7%

25.1%25.4%

25.6%

26.1%

26.5%

25.6%

24.7%

22.3%

22.9%23.2%

20%

22%

24%

26%

28%

30%

32%

34%

72 73 74 75 76 77 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Year

Per

cen

t

Data Source: Internal Revenue Service, Statistics of Income, Individual Income Tax Returns, various issues; Internal Revenue Service, Statistics of Income Bulletin, various issues. (Data not published for 1978)

-20%

-10%

0%

10%

20%

30%

40%

50%

12,000 16,000 20,000 24,000 28,000 32,000 36,000 40,000

Earned Income

Mar

gin

al T

ax R

ate

Cumulative Marginal Tax Rate For A SingleTaxpayer Earning $12,000 to $40,000 With 2 Children

Child Tax Credit (-15%)

EITC Phase-Out (21.06%)

Payroll Tax (7.65%)

Federal Income Tax (10%, 15%)

State Income Tax (3%)

Cumulative Marginal Tax Rate

46.71%

25.65%

41.71%

26.71%16.71%

-4.35%

0%

10%

20%

30%

40%

50%

60%

70%

13,000 23,000 33,000 43,000Adjusted Gross Income (AGI)

Eff

ecti

ve M

arg

inal

Tax

Rat

eThe Phase-Out Of The Health Exchange SubsidyWould Create A Huge Marginal Tax Rate Spike

Single Individual

Sources: CBO for estimates of Health Exchange Subsidy; and calculations by author, based on Federal Income Tax, State Income Tax, Federal Payroll Tax, and Phase-Out of Health Exchange Subsidy. See text for more details.

Current Law (2009)

With Subsidy Phase-Out

Tax Base Vs. Tax Rates

 

The Tax Base -- What We Tax --

Is At Least As Important As

The Tax Rates We Impose.

 

The Income Tax Is Seriously Biased

Against Saving And Investment.

 

All Tax Reforms Worthy Of The Name

Reduce Or Eliminate These Tax Biases.

 

A Good Tax System Is

Saving/Consumption Neutral.

Multiple Taxation of SavingOne Tax on Consumption, Four Taxes on Saving

Layer 1– Tax on Earnings

Income is taxed when earned. If it is used for consumption, there is usually no further federal tax.

Layer 2 – Personal Income Tax on Returns

If the income is saved, the returns are taxed as interest, dividends, capital gains, or non-corporate business profits.

Layer 3 – Corporate Income Tax

If the saving is in corporate stock, the corporate tax hits the income before it is either paid out to shareholders or reinvested to boost future earnings.

Layer 4 – Transfer (Estate and Gift) Tax

Another tax on already taxed assets.

(Similar taxes at the state and local levels increase the multiple taxation.)

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

20 25 30 35 40 45 50 55 60 65 70Age

Saving from age 20 onward, under tax-deferred system and ordinary "double taxation"(7.2% interest rate, 20% tax rate).

TaxDeferred

Ordinary (Biased)

Tax Treatment

Advantage Of Tax Deferred SavingOver Ordinary (Biased) Tax Treatment:

Build-up Of $1,000 Saved per Year

Ass

ets

(th

ou

san

ds

of

$)

Multiple Taxation of Corporate Income

(a) Retained Earnings,

Pre-2003 Act

(b) Dividend Payout,

Pre-2001 Act

(c) Retained Earnings and

Dividends, 2003 Act

1) Corporate Income $1.00 $1.00 $1.00

2) Corporate tax at top rate $0.35 $0.35 $0.35

3) After-tax corporate income:

Either retained, raising stock price (columns (a), (c)), or paid as dividend (col. (b), (c))

$0.65 $0.65 $0.65

4) Individual income tax at top rate (dividends as ordinary income, retained earnings as capital gain)*

$0.13

(tax rate 20%)

$0.2574

(tax rate 39.6%)

$0.0975

(tax rate 15%)

5) Total tax $0.48 $0.6074 $0.4475

6) Total tax rate 48% 60.74% 44.75%

7) Income left to shareholder $0.52 $0.3926 $0.5525

* Top corporate rate excludes corporate surtaxes, and top individual rate ignores phase-outs of exemptions and deductions and taxation of Social Security, which may push effective top tax rates higher than statutory rates. Retained earnings are assumed to trigger a long-term capital gain with a maximum rate of 20% or 15%. Short-term gains are taxed at ordinary tax rates.

-194

-1,029

-94

-489

-2,549

-237

-3,000

-2,500

-2,000

-1,500

-1,000

-500

0GDP

CapitalStock

PrivateSectorWages GDP

CapitalStock

PrivateSectorWages

Changes In GDP, Wages, and Capital If Capital Gains and Dividends Tax Rates Increase

Changes in Billions of Dollars

Tax Rates Rise to 20% Tax Rates Rise to 28%

-1.4%

-3.8%

-1.4%

-3.4%

-9.5%

-3.5%

-10%

-8%

-6%

-4%

-2%

0%GDP

CapitalStock

PrivateSectorWages GDP

CapitalStock

PrivateSectorWages

Changes In GDP, Wages, and Capital If Capital Gains and Dividends Tax Rates Increase

Changes in Percent

Tax Rates Rise to 20% Tax Rates Rise to 28%

30.7

-28.3-19.9 -17.4

77.5

-73.5

-50.0 -46.0

-100

-80

-60

-40

-20

0

20

40

60

80

100

StaticGain

IncomeTax

Loss

OtherBudgetEffects

NetFederalBudgetImpact

StaticGain

IncomeTax

Loss

OtherBudgetEffects

NetFederalBudgetImpact

Static Versus Dynamic Federal Budget EffectsOf Capital Gains And Dividend Tax Changes

In Billions

Tax Rates Rise to 20% Tax Rates Rise to 28%

Present Value of Current Law Capital Consumption Allowances per Dollar of Investment Compared to Expensing (First-Year Write-Off)

Asset lives:3Yrs

5yrs

7yrs

10yrs

15yrs

20yrs

27.5 yrs

39yrs

Present value of first-year write-off of $1 of investment:

$1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00

Present value of current law write-off of $1 if inflation rate is:

0% $0.96 $0.94 $0.91 $0.88 $0.80 $0.74 $0.65 $0.55

3% $0.94 $0.89 $0.85 $0.79 $0.67 $0.59 $0.47 $0.37

5% $0.92 $0.86 $0.81 $0.74 $0.60 $0.52 $0.39 $0.30

Assumes a 3.5 percent real discount rate, 3-20 year assets placed in service in first quarter of the year, 27.5 - 39 year assets placed in service in January.

Expensing Versus Depreciation: Depreciation Overstates Taxable Income and Depresses Return on Capital

Expensing (Full Cost Recovery) Depreciation

Revenues from machine, present value

$115Revenues from machine,

present value$115

Full cost of machine $100 Full cost of machine $100

Actual profit $15 Actual profit $15

Full cost write-offfor tax purposes

(expensing)$100

Allowable depreciation write-off, present value

$85

Taxable profit =

Actual profit$15

Taxable profit exceeds actual profit

$30

Tax $5 Tax $10

Actual after-tax income $10 Actual after-tax income $5

Rate of return 10% Rate of return 5%

Marginal Tax Rates On Estates And Income Contributed To Estates, 2009

81%85%

70%

45%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Estate Tax Estate Tax andGeneration

Skipping Trust

Tax on a Dollarof Interest

Left in an Estate

Tax on a Dollarof Wages (self-employed)

Left in an Estate

Ma

rgin

al

Ta

x R

ate

State Income Tax

Estate Tax

Estate Tax

Estate Tax

Estate Tax

Payroll Tax

Federal Income

Tax

Federal Income

Tax

State Income Tax

GST

GST

GST

* 45% Estate Tax Rate became effective in 2007.Assumes married couple in 33% tax bracket, who are self-employed, with a 6% state income tax. Computed prior to Estate Tax Repeal, which is now scheduled for 2010.

*

-200

-150

-100

-50

0

50

100

150

Pre-2001 Law 35% Top Rate;$5 MillionExemption

15% Top Rate;$5 MillionExemption

Repeal EstateTax

Bill

ion

s o

f $

GDPLabor Income

Effect Of Estate Tax Alternatives OnGross Domestic Product And Labor income

Calculations by Author

-20

-15

-10

-5

0

5

10

15

20

25

30

35% Top Rate; $5Million Exemption

15% Top Rate; $5Million Exemption

Repeal Estate Tax

Bill

ion

s o

f $

Revenue Effect: Static Analysis

Revenue Effect: Dynamic Analysis

Revenue Effects Of Estate Tax Reform:Static Versus Dynamic Revenue Estimates

Calculations by Author

STEPS TOWARD NEUTRALITY:

ALL SAVING GETS DEFERRALOR RETURNS EXEMPT EQUIVALENT;

EXPENSING OF INVESTMENT;

NO DOUBLE TAX OF CORPORATE INCOME;

NO ESTATE AND GIFT TAX.

TAX BASES OF FOUR NEUTRAL TAXES & POINTS OF COLLECTION

NRST -- INCOME LESS SAVING = CONSUMPTION(NOT IMPOSED ON INVESTMENT GOODS).TAXED AT POINT OF SALE.

VAT -- INCOME LESS SAVING = CONSUMPTION(INVESTMENT EXPENSED). CAPITAL AND LABORINCOME TAXED AT BUSINESSES, IN STAGES.

CASH FLOW TAX -- INCOME LESS SAVING = CONSUMPTION. TAXED ON INDIVIDUAL TAX FORM.

FLAT TAX -- INCOME LESS INVESTMENT = CONSUMPTION. CAPITAL INCOME ON BUSINESS OR PROPRIETOR TAX FORM (INVESTMENT EXPENSED); WAGES ON INDIVIDUAL TAX FORM.

The Kennedy and Reagan Tax Cuts

The Kennedy rate cuts were roughly the same percentage rate reductions

across the board, but rewards rose most where rates were highest:

Top tax rate cut from 91% to 70%.

After-tax reward rose from 9% to 30%, up 230%.

Bottom tax rate cut from 20% to 14%.

After-tax reward rose from 80% to 86%, up 7.5%.

Similarly for the Reagan Tax cuts:

Top tax rate cut from 70% to 50%.

After-tax reward rose from 30% to 50%, up 67%.

Bottom tax rate cut from 14% to 11%.

After-tax reward rose from 86% to 89%, up 3.5%.

In both cases, a greater response by upper-income taxpayers raised the total share of taxes they paid.

The Kennedy and Reagan Tax Cuts, cont.

Kennedy also cut the corporate tax rate, introduced the ITC, and

accelerated depreciation.

Reagan (1981) also accelerated depreciation, increased the ITC, and

enhanced saving incentives.

Both altered business taxes as well as individual tax rates.

20.3%

7.4%

20.2%

24.2%

12.9%

17.9%17.5%

10.7%

39.9%

15.5%

10.7%

3.0%

0%

10%

20%

30%

40%

50%

Bottom50%

50% - 75% 75% - 90% 90% - 95% 95% - 99% Top 1%

Taxpayers in AGI Range

Inc

om

e T

ax

Sh

are

(%

)

1981 2006

While Marginal Tax Rates Have Fallen,High Earners' Income Tax Shares Have Risen

Marginal Individual Income Tax Rates Under Old Law

And 2001 / 2003 Tax Acts

1986 Tax

Reform Act*

1990 Tax

Act

1993 Tax

Act2001 / 2003 Tax Acts

If Congress

Lets Tax

Cuts Sunset

1988 - 1990 1991 - 1992 1993 - 2000 2001 2002 2003 - 2010‡ 2011 -

--- --- --- 10%† 10% 10% ---

15% 15% 15% 15% 15% 15% 15%

28% 28% 28% 27.5% 27% 25% 28%

33%** 31% 31% 30.5% 30% 28% 31%

28% --- 36% 35.5% 35% 33% 36%

--- --- 39.6% 39.1% 38.6% 35% 39.6%

* 1986 Tax Reform Act had transition rate for 1987, fully effective in 1988.** The 5% surtax recaptured the "benefit" of the initial 15% rate, creating the 33% "bubble"; marginal rate returned to 28% after

taxpayer had lost all "benefit" from the 15% rate.† Rebate in 2001 equivalent to 10% rate.‡ 2001 / 2003 Tax Acts sunset at end of 2010. Old rates return in 2011 in the absence of further legislation.

* 1986 Tax Reform Act had transition rate for 1987, fully effective in 1988.

Other 2001-2003 Tax Changes That Affect Growth  Enhanced Saving Incentives (2001)

Phase-Out Of Estate Tax (2001-2010)

Reduction Of Tax Rates On Dividends And Capital Gains (2003)

800

850

900

950

1,000

1,050

1,100

2000 2001 2002 2003 2004 2005Quarter

Bil

lio

ns

of

Do

lla

rs (

20

00

$)

200

220

240

260

280

300

320

340

Bil

lio

ns

of

Do

lla

rs (

20

00

$)

Data Source: BEA, National Income and Product Accounts, Table 5.3.6, accessed via www.bea.gov.

Real Private InvestmentAnd 2001, 2002, and 2003 Tax Cuts

2002 Tax Cut

2001TaxCut

2003 Tax Cut

Equipment and Software<-- Left Axis

Nonresdidential StructuresRight Axis -->

9,000

9,500

10,000

10,500

11,000

J F M A M J J A S O N D J F M A M J J A S O

Bil

lio

ns

of

Do

llar

sRebates Did Not Boost Consumption

2007 2008

Disposable Personal Income

Personal Consumption Expenditures

Data Source: U.S. Bureau of Economic Analysis <http://www.bea.gov>. Based on John B. Taylor, "Why Permanent Tax Cuts Are the Best Stimulus,' Wall Street Journal, Nov. 25, 2008.

Interim Steps --What Works And What Doesn't

  Pro-Growth Tax Provisions: End/Reduce Death Tax Augment Expensing (At The Margin) Lower Cap Gains, Dividend Tax Rates Lower Corporate Tax Rate Expand IRAs, Pensions (At The Margin) Lower Marginal Personal Tax Rates (Especially In Top Brackets)  Social Tax Cuts: They Have Their Role, But Do Not Create Jobs Or Boost Investment, Wages, Or Output. E.g. Child Credits, Personal Exemptions, Standard Deductions.

Don't Meddle, Don't Distort  Distorting Provisions Hurt: Targeted Credits/Taxes That Favor Or Penalize One Activity Over Another Grow One Area But Shrink Another, And Reduce Total Output And Welfare. e.g., Green Credits, Excises, Housing Breaks.  You Can't Raise GDP, Income, And The National Welfare By Making People Do Things The Hard Way. e.g., Locking Up Cheap Energy And Favoring Sources That Cost More And Deliver Less.

Recovery Assignments:Who Does What?

  Never Rely On The Federal Reserve To Create Real Growth With Easy Money.  The Best The Fed Can Do For Growth Is Focus On Price Stability, Because Inflation Raises Taxes On Investment And Kills Growth Of Jobs And Output.  It Is The Job Of Congress To Aid The Growth Of The Real Economy. That Is Best Done By Curbing Government, Leaving Productive Resources For Private Sector Uses.  Tax Rates And Regulations That Drive Up Costs Are Barriers To Production And Hiring That Must Be Kept Under Control.

Final Thoughts   People who do not learn from history are condemned to repeat it.  When governments do not learn from history, the people are condemned to repeat it.  Economics is not the dismal science, if you have a morbid sense of humor.

Final Thoughts, cont.  There is hope: we have in the past, and we can again, adopt policies that set the people free to flourish and prosper.  We even know what those policies are.  They do not require sacrifice by the people.  They require sacrifice by Washington.