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Research Memorandum
January 1995 No. 3


A Tax Code For The Future: The Growth Experiment Revisited

Sound economic ideas are noted for their universality: they apply across borders and over time. Unfortunately, we've been through a drought in terms of fresh economic ideas for the past several years. One reason, clearly, has been a political environment that's been hostile to ideas in general and to sound ideas in particular. The recent elections warrant some hope that things may change, and that issues like tax reform will once again be put on the table. We might, in short, have another chance to get it right.

The rush to judgment on the Reagan era's "Supply-Side Revolution" was chiefly a journalistic undertaking, with the few analytical studies produced brushed aside in an avalanche of punditry. There was one book, however, written by a trained economist and published through a respected publishing house, which subjected the economic evidence of the 1980s to a rigorous examination: Lawrence Lindsey's The Growth Experiment. Appearing at the high point of the Bush interregnum, it generated little excitement in official Washington, even less in academic circles or the national media. However, a handful of individuals did study it—including at least one elected politician—who wrote at the time:

The Growth Experiment shows conclusively why the tax cuts of the 1980s were essential to America's resurgence of economic growth and, perhaps more importantly, lays out a model for reform that can be applied across all borders. Larry Lindsey has produced a "how to" formula for economic progress that ought to be central to the debates of the 1990s.

--Congressman Newt Gingrich

In the turbulent years since Lindsey's book appeared, America—and more particularly the rest of the developed world—has learned the peril of taking economic growth and meaningful job creation for granted.

Lindsey's careful yet lucid analysis, and the policy recommendations which flow from it, are every bit as relevant today as in 1990. In fact, the perspective offered by the last five years only serves to boost The Growth Experiment's relevance as a policymaking guide.

What follows is the first in a series of extracts taken from The Growth Experiment outlining key elements for policyrnakers to consider in designing a tax code for the future. This report, along with the next four, will be distributed to members of Congress and the press over the coming weeks. They are taken from the second half of the book, titled "Applying the Lessons." (The first half of the book contains the analytical chapters and a description of the model used by Lindsey in testing the effectiveness of changes in the tax code.) To receive a copy of the book, please contact the Manhattan Institute (see below).

--William Hammett President

About the Author

Mr.. Lindsey holds a Ph.D. in Economics from Harvard University. At the time he wrote The Growth Experiment he was a member of the economics faculty there, as well as a Research Fellow at the National Bureau for Economic Research and a Senior Fellow at the Manhattan Institute (which commissioned the book in 1987 and subsequently sponsored it). He served as a staff economist specializing in tax policy for the Council of Economic Advisors during the early Reagan years, and as an unofficial advisor to Prime Minister Thatcher's government in the mid-Eighties. In 1990 he was named a Special Assistant for Economic Affairs to President Bush, who in 1991 appointed him to the Board of Governors of the Federal Reserve System, a position he holds today.

Saving for the Future

The key to economic growth and a rising standard of living is capital investment in new technology, equipment, and processes. But a society cannot invest more than it saves except by borrowing from abroad. America's savings rate is the lowest in the industrialized world and our tax system, though vastly improved since the late 1970s, is still biased against savings. But with only a very modest loss of tax revenue, the tax system can be reformed to substantially encourage the savings we need to sustain our investment in a more productive economy.

Such a reform is particularly urgent because of the changing demographic characteristics of the population. In another thirty years, baby boomers will retire. Only a higher national savings rate will build a capital intensive, "working smarter" economy capable of supporting them in their old age. Nor will baby boomers be able to rely on Social Security for as large a portion of their retirement income as today's retirees. Unless they have large nest eggs of their own, many will retire into relative poverty.

The following reforms would eliminate the current bias of the tax system against savings in favor of borrowing and significantly increase our national savings rate:

 The IRA program should be turned into an Individual Savings Account program and the current ceiling on deductible contributions raised to $5,000 per worker to encourage contributors to save for a home, education, retirement, medical expenses, or temporary disability.

 Only that portion of interest income that exceeds the rate of inflation (the real interest rate) should be taxed.

 Only the real interest rate paid on home mortgages or home equity loans should be deductible. In addition, limiting the maximum deduction for real mortgage interest to $10,000 would blunt the urge to finance consumer spending with mortgage debt.

Individual Savings Accounts

Individual Retirement Accounts (IRAs) were designed to encourage longterm savings by allowing workers to contribute taxfree funds to an account that can accumulate interest, dividends, and capital gains, also taxfree. But the program has many defects. The major difficulty with promoting savings through the IRA program is that contributors may not withdraw their funds until age fiftynine and a half without substantial penalty. Yet retirement is only one motivation for saving. People also save for down payments on a home and for college tuition. Most families only focus on saving for retirement after their children are out of college. Because of this, government data confirm that the existing IIIA primarily attracts taxpayers in their fifties and sixties.

The government should turn the IRA program into an Individual Savings Account program to encourage people to save for a home, for education, for retirement, or for medical expenses or temporary disability. The ceiling on deductible contributions should be raised to $5,000 per worker.

In practice, it would probably be impossible to monitor the use of ISA funds after withdrawal. But the government should do what it could to ensure that the funds were used to save for worthwhile longerterm goals. For example, it could require that funds be kept in the ISA account for at least three to five years before they could be withdrawn without penalty. This liberal policy regarding withdrawals would greatly enhance the attractiveness of saving for younger families.

To discourage welltodo Americans from simply rolling existing assets into the program, a floor could be placed on the deductibility of contributions based on the taxpayer's capital income. People without much capital income by definition do not have much in the way of financial assets to roll over. For example, the floor on deductibility could be equal to half the capital income of the taxpayer. A twoearner married couple with $3,000 in interest and dividend income could contribute up to $10,000 to their ISA, but only the contribution in excess of $1,500 would be deductible.

A Revenue Neutral Savings Plan

It is not true that such a dramatic tax favor for a savings plan would cost too much in tax revenue in the long run. The ISA program would cost the government revenue as contributions are made, but most of that revenue would be recouped in the future when the funds were withdrawn by the taxpayer. The only cost to the government of shifting tax receipts through time via an ISA is the forgone taxes on the accruing interest, an amount far less than usually claimed as the revenue cost of an ISA program.

Moreover, since individuals as a rule would be able to earn a higher return on the ISA than the rate at which government must borrow, the present value of tax revenues may actually be increased by an ISA program. For example, if the government must borrow at 8 percent to fund the forgone taxes on the ISA, but the individual earns 10 percent in the ISA account, then both the government and the individual will be better off in the end.

In addition, the upcoming fiscal imbalances in the Social Security system make it imperative to shift current government revenue into the future. The present annual surpluses in the Social Security system are forecast to increase substantially during the 1990s and continue through the first quarter of the twentyfirst century. But by the 2030's, as baby boomers retire and the number of workers per retiree shrinks, the system is expected to start running substantial deficits, and by midcentury all of the accumulated surplus will have been consumed. The ISAs reduce government revenue only during the 1990s and early 2000s, coincident with large surpluses in the Social Security accounts. The ISAs would increase revenue when the contributions are withdrawn at midcentury, exactly when government would need extra funds to help finance Social Security payments.

Eliminating the Tax Code Bias Against Savings

Our current tax system virtually assures that money put into savings will have little more, or even less, purchasing power when it is withdrawn. During the late 1970s inflation and taxes reduced the real return on interest income from most conventional sources to well below zero. Even today, many savings vehicles produce a negative return. If savers were taxed only on the interest they earned above the inflation rate, they would at least be guaranteed a positive return and, all else being equal, a significantly higher return than they get today.

Moreover, the current system also encourages people to borrow. Although the tax reform enacted in 1986 eliminated the deduction of interest payments except for home financing, this change appears to have had little practical effect beyond encouraging people to use home equity loans to finance consumer purchases. In addition, the home mortgage deduction bids up the prices of existing houses, severely distorting the housing market in favor of highincome taxpayers for whom the deduction is valuable enough to justify buying a home with a higher price tag.

The solution is to make the tax system as neutral as possible with regard to borrowing and lending. Since under our reform only the real interest rate received by lenders would be subject to tax, only the real rate on home mortgages or home equity loans should be deductible. In addition, limiting the maximum deduction for real mortgage interest to $10,000 would blunt the urge to finance consumer spending with mortgage debt as well as substantially solve the problem of tax subsidies raising housing prices.

Conclusion

The main reasons to implement an ISA program are to encourage Americans to save for their own needs, to wean the United States from its addiction to credit, and to build capital for investment. The time to begin this process is now, when we have an unusual demographic opportunity in the babyboom generation reaching middle age and working harder than ever. But unless we encourage savings now, their hard work may go for nought as they become the first generation in American history to retire less comfortably than the previous generation. A little frankness about the future, and a program to encourage savings now, could change that future before it is too late.

 


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SUMMARY:
Sound economic ideas are noted for their universality: they apply across borders and over time. Unfortunately, we've been through a drought in terms of fresh economic ideas for the past several years.

 


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