U.S. Capital Formation: How the U.S. Tax Code Discourages Investment
by Margo Thorning, Ph.D on 01/31/2002
27 Pages
Certain means of taxation can directly affect saving and investment, which are keys to economic growth, better living standards and environmental safeguards. Of all developed countries, the United States places (by its tax code) one of the heaviest burdens on saving and investment of individuals and companies. Tax burdens on business investment, capital gains, interest and dividends cause the great part of income to be consumed, limiting the prospects for future economic growth.
Because of increases in investment taxation, the cost of capital investment has simply become too high. The cumbersome tax structure of today makes it hard for the United States to compete internationally and to implement better technology for better productivity.
Much of the current tax burden on investment stems from the 1986 Tax Reform Act (TRA ’86). As a result of this measure, the present value of capital cost recovery for both technological and environmental investments slipped dramatically, from 100 percent to 81 percent. TRA ’86 raised the effective tax rate on durable equipment from zero to 32 percent.
Taxing investment has a significant, negative effect on the overall output of the United States. U.S. domestic saving available for private investment has declined from an average of 9.7 percent of GDP over the 1960–1980 period to only 4.9 percent from 1991–2001. One study shows that if the United States had switched in 1991 to a consumption tax system (instead of taxing investment so heavily), real GDP would have been 5 percent higher by 2004. Business capital spending would be 35 percent higher.
Another obstacle to investment is the high capital gains taxes in the United States—some of the highest of all industrialized and developing countries:
• The U.S. taxes individual capital gains at a rate about 38 percent higher than the average capital gains tax of other countries.
• U.S. corporations face long-term capital gains tax rates about 80 percent higher than industrialized and developing countries.
• American businesses and individuals face higher tax penalties on interest and dividends than do investors of most countries.
Lower capital gains taxes lead to more investment. The Taxpayer Relief Act of 1997, which cut the capital gains tax from 28 percent to 20 percent, effectively reduced the net cost of capital for a new investment by about 3 percent. According to one study, the annual increase in business investment resulting from this tax cut continues at 1.5 percent per year.
Further cuts in capital gains taxes are necessary to encourage investment. Many scholars and policy makers agree that cutting capital gains taxes will result in substantial increases in real wages, stock prices and GDP.
Several recent analyses by academic scholars and government policy experts show a broad-based consumption tax to be the best alternative to the current federal income tax. One study predicts that under a consumption tax, real GDP would be 3.3 percent higher each year in the long run compared to 1.3 percent higher under a unified income tax. The Congressional Budget Office, analyzing the effect of switching from the federal income tax to a consumption-based tax, concludes that it would both increase national saving and raise the level of national output.
The findings of this paper show that fundamental tax reform would not only generate long-term economic growth, it would also secure a higher standard of living for households of every income level. One proposed consumption-based tax, projected to increase output by 7.5 percent, is more advantageous to the poor than the rich in the long run.
The United States economy has several challenges in the coming decades: a budget deficit pending the retirement of baby boomers, a global economy of competitors whose investments are less taxed, future threats that call for military preparedness, and environmental needs for advancing technology. Research shows the tremendous benefits of taxing consumption in order to encourage saving and investment. It may be the only way to raise enough capital to face the challenges of the twenty-first century.
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