[House Report 109-726]
[From the U.S. Government Publishing Office]



109th Congress 
 2d Session             HOUSE OF REPRESENTATIVES                 Report
                                                                109-726
_______________________________________________________________________
 
                                                 Union Calendar No. 430

                        THE 2006 JOINT ECONOMIC

                                 REPORT

                               __________

                              R E P O R T

                                 of the

                        JOINT ECONOMIC COMMITTEE

                     CONGRESS OF THE UNITED STATES

                                 on the

                          2006 ECONOMIC REPORT

                            OF THE PRESIDENT

                             together with

                             MINORITY VIEWS
                                  and

                            ADDITIONAL VIEWS



                        JOINT ECONOMIC COMMITTEE

    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

HOUSE OF REPRESENTATIVES

                                     SENATE

JIM SAXTON, New Jersey, Chairman     ROBERT F. BENNETT, Utah, Vice 
PAUL RYAN, Wisconsin                     Chairman
PHIL ENGLISH, Pennsylvania           SAM BROWNBACK, Kansas
RON PAUL, Texas                      JOHN E. SUNUNU, New Hampshire
KEVIN BRADY, Texas                   JIM DeMINT, South Carolina
THADDEUS G. McCOTTER, Michigan       JEFF SESSIONS, Alabama
CAROLYN B. MALONEY, New York         JOHN CORNYN, Texas
MAURICE D. HINCHEY, New York         JACK REED, Rhode Island
LORETTA SANCHEZ, California          EDWARD M. KENNEDY, Massachusetts
ELIJAH E. CUMMINGS, Maryland         PAUL S. SARBANES, Maryland
                                     JEFF BINGAMAN, New Mexico
                 Christopher Frenze, Executive Director
                  Robert Keleher, Chief Macroeconomist
                 Chad Stone, Democratic Staff Director
                         Letter of Transmittal

                              ----------                              

                     Congress of the United States,
                                  Joint Economic Committee,
                                  Washington, DC, December 8, 2006.
Hon. J. Dennis Hastert,
Speaker of the House, House of Representatives,
Washington, DC.
    Dear Mr. Speaker: Pursuant to the requirements of the 
Employment Act of 1946, as amended, I hereby transmit the 2006 
Joint Economic Report. The analyses and conclusions of this 
Report are to assist the several Committees of the Congress and 
its Members as they deal with economic issues and legislation 
pertaining thereto.
            Sincerely,
                                                Jim Saxton,
                                                          Chairman.
                            C O N T E N T S

                              ----------                              
                                                                   Page
Overview of Current Macroeconomic Conditions.....................     1
Majority Staff Reports...........................................    10
    Reducing Tax Impediments to Capital Formation................    11
    Median Family Income and Inflation Mismeasurement............    26
    Costs and Consequences of the Federal Estate Tax.............    34
    Five Challenges that China Must Overcome to Sustain Economic 
      Growth.....................................................    77
Minority Views and Democratic Staff Reports......................   110
    Ranking Minority Member's Views and Links to Minority Reports   111
Additional Views of Vice Chairman Robert F. Bennett..............   119
    Overview of Current and Recent Macroeconomic Conditions......   120
                                                 Union Calender No. 430
109th Congress                                                   Report
                        HOUSE OF REPRESENTATIVES
 2d Session                                                     109-726

======================================================================




                     THE 2006 JOINT ECONOMIC REPORT

                                _______
                                

December 8, 2006.--Committed to the Committee of the Whole House on the 
              State of the Union and ordered to be printed

                                _______
                                

 Mr. Saxton, from the Joint Economic Committee, submitted the following

                              R E P O R T

                             together with

                             MINORITY VIEWS

                                  AND

                            ADDITIONAL VIEWS

 Report of the Joint Economic Committee on the 2006 Economic Report of 
                             the President

               Overview of U.S. Macroeconomic Performance


                      INTRODUCTION AND BACKGROUND

    This Report describes the macroeconomic performance of the 
U.S. economy since about 2003. Beginning at that time, the 
macroeconomy finally began to shake off the burdens of the 
adjustments required by the bursting stock market and 
investment bubbles. When an asset price (or stock market) 
bubble bursts, banks must contract their lending and 
consolidate their portfolios. Such adjustment is tantamount to 
a slowdown in investment: i.e., such a stock market adjustment 
is associated with a downward movement in investment. The stock 
market peak occurred in the spring of 2000. The Dow and Nasdaq 
stock price indices, for example, peaked in January and March 
2000, respectively. Overall, then, stock market prices began to 
fall sharply in the spring of 2000. Notably, most of the 
Nasdaq's large decline took place before January 2001, and 
consequently, had nothing to do with the new Administration's 
economic policy (See Figure 1). As stock prices fell, the 
financial cost of investment increased and various measures of 
investment growth declined: i.e., declines in investment lead 
to declines in economic activity. The investment sector, then, 
played a very important role in influencing recent cyclical 
economic activity. The seeds of this unsustainable stock market 
bubble, however, were sown in the period before the spring of 
2000, since the stock market bubble burst beginning in the 
first quarter of 2000. 


    Many economists have noted that the economic weakness of 
2000-2001 (or the ``Post Bubble'' or ``Adjustment Economy'') 
was inherited from earlier periods involving an asset-price 
contraction in the late 1990s. (See Figure 2). 


    Furthermore, it became increasingly obvious that the 
economic and financial strength in the late 1990s was 
unsustainable, with a good bit of that strength borrowed 
heavily from the late 1990s ``irrational exuberance'' of sharp 
stock market and rapid balance sheet gains.
    In sum, changes in the investment sector have been larger 
and more prominent than changes in most other sectors, 
including real GDP itself. The investment sector, for example, 
was significantly weaker than real GDP during downturns and 
significantly stronger than real GDP during recoveries. This 
relationship is depicted in figure 3. 


                             BRIEF OVERVIEW

    Recent macroeconomic activity indicates that the economy 
continues to expand with little sign of any major resurgence of 
inflation. In the third quarter of 2006, for example, the most 
recent data indicate that real GDP growth was up 3% on a year-
over-year basis. Notably, the advances in real GDP have 
continued for 20 consecutive quarters. Further, the economy 
remains on track to grow at a rate of about 3% in 2006, as 
forecast by the Federal Reserve as well as the Consensus Blue 
Chip forecast. The accompanying chart (figure 2), highlights 
some of these facts.
    The key components of real GDP support this analysis. Both 
consumer spending and non-residential fixed investment, for 
example, grew faster than GDP in the third quarter. Since they 
both grew faster than GDP, they made sizeable contributions to 
third quarter's growth. In addition, real non-residential fixed 
investment continues on track to register growth of about 8% 
for 2006. The equipment and software component of real non-
residential fixed investment has been growing at 8.1% over the 
last three quarters and, as mentioned above, grew faster in the 
third quarter than in the second quarter. Moreover, one of 
investment's leading indicators, corporate profits, has been 
expanding quite rapidly; consensus forecasts have corporate 
profits expanding at better than 18% for 2006. Another leading 
indicator, capital good orders, continues to trend upward. 
These signs, then, auger well for future investment.
    Another relevant consideration draws from the academic 
literature. In particular, that literature has thoroughly 
established that the volatility of U.S. GDP has fallen 
considerably for a number of years. This reduction of 
volatility means that the economy can not only grow faster than 
otherwise but that growth can be more stable than in the past. 
This phenomenon fosters a reduction in risk premiums and lowers 
long-term interest rates.
    Significant improvement can also be seen in other sectors. 
For example, 6.9 million jobs have been added to the existing 
payrolls since August of 2003. The U.S. has gained many more 
jobs than key European economies. Similarly, the unemployment 
rate, now at 4.4%, is historically low. In fact, over the past 
35 years, the unemployment rate has been below 4.4% fewer than 
30 months. Further, the U.S. unemployment rate is lower than 
the rates of most European and other industrialized countries.
    Over the last several years, the housing and real estate 
sectors have experienced ``bubble-like'' conditions. After 
increasing rapidly and persistently for a number of years, 
housing permits, starts, existing and new home sales, and other 
housing-related indicators breeched new record territory. Real 
estate prices increased dramatically.
    Many economists have predicted a ``bubble-like'' adjustment 
to this run-up in asset prices. Others point out that real-
estate ``bubbles'' are largely regional and not national in 
nature. Therefore, there is little the national government can 
or should do to rectify these problems, aside from maintaining 
the central bank's role as a lender of last resort. 
Additionally, financial firms can better manage risk than was 
earlier the case. And bank portfolios are in better shape than 
they were previously. These considerations, together with the 
fact that the current decline in real estate asset prices has 
not yet produced the many serious problems pessimists have 
predicted, has led others (including former Fed Chairman Alan 
Greenspan) to contend that our real estate problems are mostly 
behind us.
    In addition, optimists argue that there are a number of 
factors that will work to offset any weakness in real estate. 
Examples include healthy profits, declines in gasoline prices, 
(which will help consumers), declines in mortgage rates, and 
stock market advances.
    Another prominent current feature of the U.S. economy is 
the lower and more stable pace of inflation we have 
experienced. While most broad measures of inflation provide 
similar information, we nonetheless use the core PCE on a year-
over-year basis, depicted in the accompanying figure. (See 
Figure 4). The persistently lower rate of inflation depicted 
there has helped to calm financial markets, reduce risk 
premiums, and improve the credibility of the monetary 
authority. This persistently lower rate of inflation has in 
turn fostered lower expectations of future inflation and, 
consequently helped to lower interest rates. 


    Another distinctive characteristic of the recent period 
should be mentioned since it corroborates the view presented 
here. In particular, during this recent period, and unlike the 
past, a large and rapid increase in oil prices was not followed 
by or associated with increases in inflationary expectations 
and long-term interest rates. (See figure 5). This implies that 
the Federal Reserve was using broad price policy guides or 
informal inflation targets and not monetizing the oil price 
increases like it had done in the past. In short, long-term 
rates were not being driven by changes in oil prices as in the 
past. 


    In short, the U.S. macroeconomy has established a 
remarkably solid record with measures of aggregate economic 
activity registering not only relatively healthy and persistent 
rapid growth figures, but exceptionally stable non-inflationary 
growth. These surprisingly strong results occurred in the face 
of a literal barrage of supply side shocks (discussed below) 
that were readily absorbed by an exceptionally resilient 
economy.

                          POLICY CONTRIBUTION

    In light of this impressive record, particularly in the 
face of the many negative shocks absorbed by the economy: 
policymakers must ask, why has the economy performed so well? 
Put bluntly, the economy has advanced at a healthy, stable pace 
with little sign of meaningful inflation because of the 
economic policies that have been adopted. These policies will 
be briefly summarized.

Monetary policy

    Through the adoption of flexible, informal inflation 
targeting strategy, monetary policy contributes to minimizing 
inflation, reducing the volatility of inflation, and anchoring 
the price system. Over time, the credible implementation of 
this strategy works to calm and stabilize markets, such as the 
money, capital, and foreign exchange markets. Some argue that 
this strategy also works to reduce macroeconomic volatility. 
This more stable set of markets works to promote economic 
growth. Recent monetary policy, then, has likely contributed in 
a number of ways to the workings of the macro economy. In 
particular, the credible, implicit inflation targeting approach 
works to lower inflation, lower the volatility of inflation, 
lower the volatility of economic activity, and promote economic 
growth. (See Figure 6). 


                               TAX POLICY

    Tax policy can play a major role in promoting investment or 
capital formation and consequently, economic growth. 
Accordingly, the tax policy endorsed by the Administration is, 
for the most part, focused on a limited number of objectives 
that often relate to economic growth.
    In assessing initial economic conditions during the current 
expansion, it became obvious that investment and capital 
formation were weaker than desirable. The argument that with an 
entrenched income tax in place, saving, investment and capital 
formation were over-taxed and further, taxed multiple-times, 
was supported by the data. Accordingly, a tax program was 
proposed which lowered the tax rates on dividends and capital 
gains, and expanded expensing for business investment. More 
specifically, the ``Jobs and Growth Tax Relief Act of 2003'' 
was passed and contained a number of provisions, most notably, 
a reduction in both dividend and capital gains tax rates.\1\
---------------------------------------------------------------------------
    \1\ The highest capital gains rate of 20 percent was lowered to 15 
percent while the highest rate on dividend income was reduced from 35 
percent to 15 percent. See Alan Auerbach and Kevin Hassett, ``The 2003 
Dividend Tax Cuts and the Value of the Firm: An Event Study,'' NBER 
working paper 11449, June 2005, p. 1.
---------------------------------------------------------------------------
    There were a number of reasons to lower these tax rates on 
capital:
     Removing some of the bias toward the multiple 
taxation of capital and investment.
     Lowering tax rates so as to affect behavior and 
promote additional incentives to save and invest.
     Removing some of tax burden's dead-weight loss.
     Maintaining the U.S. as an attractive investment 
outlet for international investors.
     And, most importantly, fostering capital formation 
so as to promote economic growth.
    As the data in figure 2 suggest, these tax cuts are 
associated with higher trend growth in business investment 
spending and increases in the value of stock market. The NIPA 
data, for example, suggest that after the 2003 tax cuts, 
various categories of non-residential fixed investment began 
trending up at more rapid rates. Similarly, most common 
measures of stock market value (c.g., Dow Jones, Nasdaq, or 
S&P) began advancing at a faster pace. In addition, since the 
tax cuts were implemented, the country has experienced higher 
economic growth, increases in payroll employment, lower 
unemployment, higher real after tax income and more tax 
revenue. In short, the timing of investment and stock market 
activity appear to be consistent with the proponents of the tax 
cuts.
    Furthermore, a number of studies (and empirical evidence) 
support this contention.
    The findings of several studies tend to support the view 
that changes in the tax law have significant impacts on 
economic activity and economic growth.
    A review of the problems caused by high dividend taxes 
shows that the U.S. had the second highest dividend tax rate in 
the OECD. In light of this finding, lowering the dividend tax 
rate in the U.S. may be more potent than if undertaken 
elsewhere.
    Furthermore, Auerbach and Hassett (2005) find strong 
evidence that the 2003 change in the dividend tax law had a 
significant impact on U.S. equity markets. Thus, reducing those 
forms of taxation that work to tax capital in multiple ways may 
result in a more rational system.
    A similar view was outlined by Ben Bernanke (then CEA 
Chairman):

          . . . tax legislation passed in 2003 provided 
        incentives for businesses to expand their capital 
        investments and reduce the cost of capital by lowering 
        tax rates on dividends and capital gains . . . the 
        effects are evident in the investment and employment 
        data. From its trough in the first quarter of 2003, 
        business fixed investment has increased over 21 
        percent, with the biggest gains coming in equipment and 
        software.\2\

    \2\ Ben S. Bernanke, ``The Economic Outlook'', Chairman, 
President's Council of Economic Advisors, Testimony before the Joint 
Economic Committee, October 20, 2005, pp. 3-4.
---------------------------------------------------------------------------
    In sum, the macroeconomy has advanced sharply in recent 
years in part because of the contribution of a tax relief 
effort which lowered taxation on capital, promoted economic 
growth, and provided potent tax relief.

                               CONCLUSION

    Over the last several years, economic data indicate that 
the economy has been robust and has advanced at a healthy pace. 
Our economy has weathered a barrage of negative supply shocks 
(including a stock market bubble-bursting, a terrorist attack, 
a severe hurricane followed by a severe flood, two wars, 
corporate scandals, and a sharp increase in the price of oil). 
Given this array of significant hurdles, the economy's 
performance is remarkable. Part of the reason for this 
performance relates to the contributions made by monetary 
policy's focus on price stability. This focus leads to lower 
inflation; lower volatility of inflation; and more stable 
economic growth. Another reason for this remarkable performance 
is the pro-growth tax policy that has been embraced and allowed 
to lower the cost of capital. A further contribution relates to 
our flexible price system, which has enhanced the economic 
resiliency we enjoy.
    Consequently, the economic outlook remains positive. 
According to Federal Reserve and private economic forecasts, 
the economy is expected to grow at a healthy pace through 2006.
                                        Jim Saxton,
                                                  Chairman,
                                          Joint Economic Committee.

                                 Robert F. Bennett,
                                             Vice Chairman,
                                          Joint Economic Committee.

                         Majority Staff Reports
             Reducing Tax Impediments to Capital Formation


                        INTRODUCTION AND SUMMARY

    Recent tax reductions on income, dividends, and capital 
gains, together with expanded depreciation allowances, lowered 
taxation on savings and investment and hence on capital.\1\ 
These cuts improved the structure of capital taxation. 
Nonetheless, the existence of a mostly income-tax base 
continues to impose a bias against savings, investment, and 
hence capital formation. This anti-capital bias of income 
taxation has long been understood by prominent economists 
(including John Stuart Mill, Alfred Marshall, A.C. Pigou, 
Irving Fisher, and Nicholas Kaldor) who explicitly recognized 
that bias and preferred expenditure taxation.\2\ A host of more 
contemporary economists also recognize this bias and support an 
expenditure tax base.
---------------------------------------------------------------------------
    \1\ Most analysts or researchers refer to savings, investment, and 
capital accumulation in discussing analogous concepts. In this paper, 
we will refer to capital or rather capital accumulation as identifying 
savings and investment.
    \2\ See Appendix.
---------------------------------------------------------------------------
    Remedies for this bias in the form of wholesale 
restructuring of the tax code have been proposed in recent 
years: i.e., a flat tax, national sales tax, or consumed-income 
tax. All have advocates. But public choice theory suggests that 
there are important political obstacles to such sweeping 
reform. Consequently, instead of a one-time sweeping overhaul, 
an incremental approach to removing the tax bias against saving 
may prove to be more feasible politically. This paper 
delineates such an approach and examines the short-and long-run 
economic effects of reducing capital taxation. While the 
initial, short-term effects are straightforward and beneficial 
to capital, important secondary, longer-run effects, often 
overlooked and misunderstood are highlighted. In particular, 
several bodies of economic literature suggest that over time, 
important, substantial benefits of lower capital taxation are 
likely to accrue to labor and workers. In other words, over the 
long run, recent empirical evidence suggests that the benefit 
of reducing capital taxation may accrue to workers. 
Analogously, raising taxation of capital increases the burden 
on labor and, hence, hurts workers.
    Indeed, Lawrence Summers (1981) emphasized this point. He 
noted that:

          . . . shifting to consumption taxation would raise 
        the lifetime utility of the representative consumer by 
        the equivalent of about six year's income in the new 
        steady state. These estimates dwarf estimates of the 
        static welfare cost of taxation, and significantly 
        exceed even extreme previous estimates of the dynamic 
        loss.\3\

    \3\ Lawrence H. Summers ``Capital Taxation and Accumulation in a 
Life Cycle Growth Model,'' The American Economic Review, vol. 71, No. 4 
(September 1981), 533-544.

    This implies that important economic interests of labor and 
capital are harmonious, not antagonistic, as much present-day 
opinion suggests.

                       The Existing Tax Structure

    Currently, the taxation of capital in the U.S. takes many 
different forms, making it difficult to measure, analyze, or 
assess capital taxation in the aggregate or policies dealing 
with such an aggregate. For example, since federal taxation, 
for the most part, has an income base, a host of capital income 
sources are taxed, all of which add layers of taxation on 
capital. Federal taxation of dividend income, interest income, 
capital gains, corporate income, and gift and estate transfers 
serve as illustrations. The tax treatment of depreciation is 
also relevant. All of these different taxes are forms of 
taxation on savings, investment, and thus on capital. State and 
local governments also add property and state income taxes to 
the list.

                              IMPLICATIONS

    A key implication of the current hybrid tax structure is 
that the income tax base is necessarily biased against saving, 
investment, and hence, capital formation. An income tax that 
includes levies on various sources of capital income 
effectively taxes savings several times. In this structure, 
taxes are levied not only on current saving but also on the 
future returns to that saving. This structure, in effect, 
creates multiple layers of taxation on various forms of saving, 
whereas income consumed is only taxed once. As the late Norman 
Ture (1977) eloquently put it:

          The bias against saving in the present tax system 
        results from the fact that, with few exceptions, taxes 
        are imposed both on the amount of current saving and on 
        the future returns to such saving, whereas the tax 
        falls only once on income used for consumption. Since 
        the amount one saves today is the capitalized value of 
        income one will receive in the future, the same future 
        income stream is taxed at least twice. More 
        realistically, it is taxed over and over again: the tax 
        on capital gains, the corporation income tax, State and 
        local income taxes, property taxes, estate, gift and 
        inheritance taxes--all substantially add to the 
        aggregate tax burden on saving. Saving uses of income 
        are taxed far more heavily than anything else. The tax 
        system, thereby, greatly increases the cost of saving 
        and capital formation relative to the cost of 
        consumption.\4\

    \4\ Norman B. Ture and Kenneth Sanden, The Effects of Tax Policy on 
Capital Formation, Financial Executives Research Foundation, N.Y., 
1977, p.60.

    Recognition of this bias of income taxation suggests that 
the base for taxation should be changed to expenditure from 
income.

                       SOME HISTORICAL BACKGROUND

    The recognition that income taxation is necessarily biased 
against saving, investment, and capital formation and that 
taxation may be better based on consumption rather than income 
is not novel. This important observation has been recognized by 
generations of economists. Well known influential economists 
explicitly recognizing these points include John Stuart Mill, 
Alfred Marshall, A.C. Pigou, Irving Fisher, Nicholas Kaldor, 
and others. A brief summary and documentation of their thought 
along these lines is presented in the Appendix. This summary 
demonstrates that these influential economists explicitly 
recognized the bias of income taxation against saving, 
investment, and capital formation and that these arguments 
critical of income taxation have a remarkably respectable 
ancestry dating from at least the mid-1800s.
    Historical support for these ideas, however, runs much 
deeper than suggested by this brief summary or the 
documentation presented in the Appendix. Notably, the view 
outlined here is consistent with several important constructs 
of classical economic thought. First, for example, classical 
economists for the most part supported indirect rather than 
direct taxation.\5\ Indirect taxation, mostly tariffs and 
excise taxes, is largely consumption- or expenditure-based 
taxation that does not materially adversely impact savings, 
investment, or capital formation. Direct taxation, on the other 
hand, is made up largely of income or wage taxation, which 
adversely affects savings, investment, and economic growth. 
Thus, classical economists for the most part preferred 
expenditure rather than income taxation, analogous to the view 
spelled out above.
---------------------------------------------------------------------------
    \5\ See, for example, D.P. O'Brien, The Classical Economists, 
Clarendon Press, Oxford, 1975, pp. 245-259.
---------------------------------------------------------------------------
    Second, classical economists always emphasized economic 
growth and the primacy of aggregate supply and production as 
epitmomized in Say's Law, the cornerstone of classical economic 
thinking. The central theme of Say's Law is the primacy of 
aggregate supply: it is production and aggregate supply and not 
aggregate demand that creates wealth and economic growth. 
Capital formation was always seen as a critical factor in the 
growth process. These viewswere popularly summarized in phrases 
such as ``people produce in order to consume,'' or ``supply creates its 
own demand.''
    There are several relevant tax policy implications of Say's 
Law. The law, for example, implies that consumption is an 
effect and not a cause of production. Accordingly, while 
taxation of consumption doesn't materially affect production, 
taxation of production does adversely affect consumption. Thus, 
according to classical economists, expenditure taxation is 
preferable to taxes on production. Since Say's Law maintains 
that production and aggregate supply create wealth and economic 
growth rather than demand or expenditure, tax policies 
supportive of this view foster aggregate supply (rather than 
aggregate demand) and do not discourage production and capital 
formation by double taxation of savings. As Say himself argued:

          The encouragement of mere consumption is no benefit 
        to commerce; for the difficulty lies in supplying the 
        means, not in stimulating the desire of consumption; 
        and we have seen, that production alone, furnishes 
        those means. Thus it is the aim of good government to 
        stimulate production, of bad government to encourage 
        consumption. . . . It is impossible to deny the 
        conclusion, that the best taxes, or rather those that 
        are least bad, are . . . such as are least injurious to 
        reproduction.\6\

    \6\ Jean Baptiste Say, A Treatise on Political Economy, Book III, 
Wells and Lilly, Boston, 1824, pp. 92, 196 (emphasis added).

    Say's Law, then, is consistent with both the view expressed 
above, and the contention that taxes should tax people on the 
basis of ``what they take out of the common pool (consumption), 
rather than what they put into it (savings, investment, and 
capital formation).''

                 THE SUPPORT OF CONTEMPORARY ECONOMISTS

    In addition to these prominent, earlier economists, a 
number of contemporary economists have embraced the view that 
income-based taxation is inherently biased against saving and 
associated with multiple taxation of saving resulting in lower 
capital formation and slower growth than would otherwise be the 
case. These economists for the most part support tax reform 
involving various forms of consumption-based taxation. A 
partial, incomplete list of these supporters have included, for 
example, Norman Ture, David Bradford, Glen Hubbard, Michael 
Boskin, Martin Feldstein, flat tax advocates such as Alvin 
Rabushka, Robert Hall, as well as many others.
    These economists have supported and clarified the above-
mentioned arguments and have added insights of their own. One 
notes, for example, that income taxation ``skews relative 
prices in favor of consumption and against saving. and makes 
consumption more attractive than it should be and saving less 
attractive . . . (this) anti-saving bias (is) inherent in the 
use of income as a tax base.'' \7\
---------------------------------------------------------------------------
    \7\ Michael Schuyler, Consumption Taxes: Promises and Problems, 
Institute for Research on the Economics of Taxation, Washington, D.C., 
1984, pp. 7, 11, 38 (parenthesis added).
---------------------------------------------------------------------------
    Several of these economists analyzed the current 
``segregated'' corporate and individual tax systems and 
described several alternative ways these systems could be 
integrated, thereby eliminating forms of double (and multiple) 
taxation.\8\ Others developed tax reform proposals involving 
movement toward consumption-based from income-based taxation. 
In the process of developing such proposals, it was established 
that minimizing the economic distortion associated with 
multiple taxation of saving was a centerpiece of any such tax 
reform program.\9\
---------------------------------------------------------------------------
    \8\ See, for example, David Bradford, Untangling the Income Tax, 
Harvard University Press, London 1986; and U.S. Treasury Department, 
Integration of the Individual and Corporate Tax Systems, USGPO, 
Washington, D.C., 1992.
    \9\ See Steve Entin, ``Update from Washington on Fundamental Tax 
Restructuring,'' Institute for Research on the Economics of Taxation, 
July 18, 1995.
---------------------------------------------------------------------------
    Over the years, several of these alternative, sweeping, 
wholesale tax reform proposals have evolved or emerged and 
differentiated themselves from competing alternatives. Each 
alternative has positive elements supporting it. These 
proposals and their various pros and cons have been thoroughly 
assessed by a number of authors.\10\ Each of the key proposals 
has distinguished supporters as well as political sponsors. In 
general, the most popular alternatives are some variant of a 
flat tax, a national sales tax, and a consumed-income tax. Each 
of these tax systems would improve the performance of the 
economy so long as it replaced but was not added to the 
existing tax structure.\11\
---------------------------------------------------------------------------
    \10\ See, for example, Entin, ibid., and the National Commission on 
Economic Growth and Tax Reform, January 1996.
    \11\ See Entin, op.cit., p.5.
---------------------------------------------------------------------------
    While these sweeping reform proposals are commendable and 
would work to improve economic performance, wholesale tax 
reform rarely, if ever, occurs. There are several reasons why 
major tax reform is so unusual and the status quo is so well-
entrenched. Several of these explanations are provided by 
public choice analyses:
     The opposition of various special interest groups: 
Sweeping tax reform often involves the removal of special 
deductions, of exemptions, or of certain privileges (the 
product of years of lobbying efforts) that benefit important 
and well organized special interest groups. The costs of tax 
reform are often concentrated among special interests and the 
benefits often widely dispersed among the population. 
Accordingly, incentives are created that work to lower the 
probability of sweeping reform. In particular, special 
interests have incentives to organize, to lobby, to become 
well-informed, and generally to oppose sweeping reform: i.e., 
organized political opposition to reform is usually quite 
strong.\12\ On the other hand, benefits are often widely 
dispersed. Many groups and general interests who stand to 
benefit from lower taxes on capital and saving are unorganized 
and diffuse. Sometimes they don't realize they benefit because 
the benefits are neither obvious nor transparent. The general 
population often has little incentive to become well-informed, 
to lobby, to organize, and generally to muster support for tax 
reform. Thus, political support for tax reform is sometimes 
relatively weak. In short, support for tax reform is difficult 
to organize whereas opposition is easier to muster.
---------------------------------------------------------------------------
    \12\ Several flat tax proposals, for example, remove the mortgage 
deduction, which elicits strong opposition from the mortgage and real 
estate industries.
---------------------------------------------------------------------------
     The Absence of a Strong Consensus: In situations 
where majority control is less than overwhelming, consensus 
(and bipartisan support) may be essential for passage of 
sweeping tax reform legislation. Such consensus may be 
especially difficult to muster in situations as fractious as 
today's. Further, while trade-offs are inevitable when 
significantly altering the tax code, in practice tax changes to 
ensure popular support should have significantly more 
beneficiaries than losers. This requirement may be especially 
difficult to muster in situations where a sizable portion of 
the public pays no income tax.
     The System of Government in the U.S. is 
Institutionally ``Conservative'': Another factor explaining why 
sweeping tax reform is unlikely to occur is that 
institutionally, the form of government in the U.S. is 
resistant to change and prone to support the status quo; in 
this sense, the system is ``conservative''. The non-
parliamentary form of government, for example, is characterized 
by an elaborate system of checks and balances, two legislative 
houses, three branches of government, and decentralized powers, 
all of which serve as obstacles to rapid wholesale, dramatic 
change. Congress canbe a cumbersome institution and its 
organization often requires super-majorities or a strong consensus to 
complete legislation. Consequently, Congress often ends up supporting 
only piecemeal, incremental change.
    In sum, a number of reasons explain why sweeping tax reform 
is unlikely to occur. As a consequence, instead of one-time 
wholesale sweeping reform, an incremental approach to lowering 
taxation on capital may be more politically feasible and in 
practice more likely to be successful. As Conlan et al. 
remarked, ``incremental decisions are normally the path of 
least resistance where there is a pluralistic distribution of 
power.'' \13\
---------------------------------------------------------------------------
    \13\ Timothy J. Conlan, Margaret T. Wrightson, and David R. Beam, 
Taxing Choices: The Politics of Tax Reform, Congressional Quarterly 
Press, Washington, D.C., 1990, p. 231.
---------------------------------------------------------------------------

                        AN INCREMENTAL APPROACH

    Many economists and activists concur that an incremental 
approach to lowering taxation on capital would likely be more 
viable politically than any grand attempt at one-time sweeping, 
wholesale reform.\14\ An incremental approach, however, needs 
to have clear objectives so that continual movement toward 
these goals is maintained over time. An incremental approach, 
for example, should focus on minimizing the most egregious 
economic distortions of the existing tax structure. The 
greatest economic benefit is provided by lowering taxes in 
those areas where taxes are most distortive. Currently, this 
would involve lowering taxation on those activities that are 
taxed highest because of double--or multiple--taxation on 
capital: i.e., lowering taxes on those activities with the 
highest rates and the narrowest base. Economic activity, after 
all, should be taxed as evenly and equally as possible. Since 
saving, investment, and capital formation are often taxed 
multiple times, these tax-rates are generally higher than those 
on other economic activity such as consumption. Thus, saving, 
investment, and capital formation are prime candidates for 
further tax reduction.
---------------------------------------------------------------------------
    \14\ See, for example, Entin, op. cit., p. 3, where he suggests 
that an incremental approach could make significant gains by 
dismantling multiple layers of taxation on capital.
---------------------------------------------------------------------------
    More specifically, our system is hybrid in nature; some 
saving is taxed once, some twice, others three or four times. 
While the cost of capital may be low for some individual forms 
of capital, it is not low for the aggregate. Accordingly, an 
incremental approach to tax reduction would involve reducing or 
eliminating those forms of taxation comprising the multiple 
layers of taxation on saving, investment, and capital described 
above. Incrementally lowering taxation on capital would involve 
``peeling off'' those layers of multiple taxation on saving, 
investment, and capital, thereby lowering the aggregate cost of 
capital.
    Some incremental tax reduction, for example, might involve 
lowering taxation on any or all of the following: personal 
income, corporate income, interest income, dividend income, 
capital gains, gift and/or estate transfers. It might involve 
enhanced depreciation allowances and/or lower taxation on 
saving. It would, however, produce lower capital taxation in 
the aggregate. Given recent tax reduction on personal income, 
dividends, capital gains, depreciation allowances, together 
with the historic low saving rate in the U.S., direct tax 
relief for saving seems an especially appropriate choice at 
this time.
    Directly reducing taxation on saving can take a number of 
forms. Over the years, a number of tax-deferred saving vehicles 
have been established, including for example, IRAs, Roth IRAs, 
401k's, Keough accounts, as well as more specialized saving 
plans.\15\ These saving vehicles can be expanded in several 
ways. In addition to expanding allowable contributions, age and 
income eligibility limits can be liberalized as a way of 
lowering taxes on saving and capital.
---------------------------------------------------------------------------
    \15\ See, for example, James R. Storey, Paul J. Graney, 
``Retirement Plans with Individual Accounts: Federal Rules and 
Limits,'' Report for Congress, Congressional Research Service, Feb. 17, 
2003.
---------------------------------------------------------------------------
    In recent years, the administration has proposed an 
expansion of tax exempt savings vehicles.\16\ This proposal 
would consolidate, simplify, and expand the tax exempt 
treatment of saving, while encouraging saving. More 
specifically, the administration's proposal would replace the 
many current forms of tax exempt savings accounts with three 
types:
---------------------------------------------------------------------------
    \16\ See, for example, ``Principles of Tax Reform,'' testimony of 
Michael J. Boskin before the Joint Economic Committee of the U.S. 
Congress, November 5, 2003, pp. 15-6, for a discussion of the 
Administration's tax proposals.
---------------------------------------------------------------------------
          (1) Lifetime saving accounts (LSAs), (2) Retirement 
        savings accounts (RSAs), and (3) Employer Retirement 
        Savings Accounts (ERSAs). These newly consolidated 
        vehicles would operate like Roth IRAs: i.e., they would 
        be ``back loaded,'' so contributions would not be 
        deductible but distributions and earnings would be. 
        Interest and investment income would accumulate tax 
        free and withdrawals would be tax free. Contribution 
        limits for accounts would be increased substantially, 
        exempting sizable portions of savings from taxation for 
        most households. According to the original proposal, 
        for example, the new LSA would allow annual 
        contributions of $7,500 per person or $15,000 per 
        family. Income caps for eligibility would be 
        eliminated. The other new vehicles would allow for 
        similar contributions so that overall, incentives to 
        save would be bolstered considerably, while capital 
        taxation would be significantly reduced. Given ``the 
        new investor class'' whereby workers are savers and 
        investors, owning IRA's, stocks, and pension funds, 
        such tax reduction would to some extent directly 
        benefit labor.

                 EFFECTS OF REDUCED TAXATION ON CAPITAL

    Because taxation on saving, investment, and capital 
formation takes a number of different forms, it is often 
difficult to precisely quantify the aggregate macro effects of 
lower capital taxation. Analysis of the macro effects of 
lowering capital taxation often borrows from several related 
bodies of literature, including the tax incidence, optimal 
taxation, and the growth literature.

                            INITIAL EFFECTS

    Most popular analyses of tax cuts on capital tend to focus 
on the initial, first-round effects that benefit capital, 
after-tax returns to capital, and capital owners. Today, 
capital owners increasingly are workers with pensions, IRAs, 
and or stocks in their portfolios. That is, more and more 
middle-class households own stocks, bonds, real estate and 
other assets in their pension funds, IRAs, and mutual funds. It 
is estimated, for example, that more than 50 percent of U.S. 
households own equities.\17\ Many of these individuals are 
entrepreneurs or small business owners. In short, there is an 
emerging ``investor class'' that increasingly includes middle-
end and even some lower-income households.
---------------------------------------------------------------------------
    \17\ See, for example, Equity Ownership in America 2005, Investment 
Company Institute and the Securities Industry Association, pp. 1,7,8.
---------------------------------------------------------------------------
    Accordingly, ``labor'' and ``capital'' theoretically cannot 
be stereotypically categorized into distinct ``air tight'' 
compartments. Sharp distinctions between these categories is 
increasingly suspect. Instead, the categories are increasingly 
becoming ``blurred''; labor and capital are gradually merging 
into one entity. As a consequence, the effects of taxes on 
capital no longer are confined to wealthy or upper-income 
households. Rather, reductions of taxation on capital 
increasingly impact middle-class investors or the entire 
``investor class.''
    In spite of these observations, however, the distinction 
between capital and labor remains appropriate for analytical 
purposes as in studies of the effects of capital taxation.
    The initial effect of lower capital taxation, for example, 
is to increase the after-tax rate of return received by owners 
of capital. Higher rates of return on capital will improve 
incentives to save, invest, and accumulate capital. 
Conventional economic analysis maintains that lowering taxation 
on capital promotes capital formation, and helps both the stock 
market and owners of capital, some of whom may be wealthy. It 
is these initial effects that are highlighted and emphasized by 
the media and political pundits. Their analysis is often 
accompanied by assertions that the benefits of capital tax cuts 
go largely to a small sliver of the population, and come at the 
expense of labor and the working class. The interests of 
capital and labor are antagonistic in this view. Far from 
promoting growth, tax cuts on capital are often depicted as 
zero-sum in nature, allowing the rich to accumulate wealth 
relative to workers.\18\
---------------------------------------------------------------------------
    \18\ Proponents of this view contend that lowering Capital Taxation 
brings about shifts of funds out of taxable funds and into now lower-
taxed capital. No new capital is created, only shifts in distributions 
occur.
---------------------------------------------------------------------------

                        A MORE COMPLETE PICTURE

    These initial, first-round effects are partial and 
incomplete. They are misleading since they represent only part 
of the story and overlook important secondary effects. They are 
what the French political economist Bastiat referred to as 
``what is seen'' as opposed to ``what is not seen.'' As Bastiat 
argued, an acceptance of only these partial, first-round 
effects is a common error of economists.\19\
---------------------------------------------------------------------------
    \19\ Henry Hazlitt's paraphrasing of Bastiat is noteworthy:
    ``(A key fallacy) is the persistent tendency of men to see only the 
immediate effects of a given policy, or its effects only on a special 
group, and to neglect to inquire what the long-run effects of that 
policy will be not only on that special group but on all groups. It is 
the fallacy of overlooking secondary consequences.
    ``In this lies the whole difference between good economics and bad. 
The bad economist sees only what immediately strikes the eye; the good 
economist also looks beyond. The bad economist sees only the direct 
consequences of a proposed course; the good economist looks also at the 
longer and indirect consequences. The bad economist sees only what the 
effect of a given policy has been or will be on one particular group; 
the good economist inquires also what the effect of the policy will be 
on all groups.''--Henry Hazlitt, Economies in One Lesson, Arlington 
House, N.Y., 1979, pp. 15-6 (parenthesis added).
---------------------------------------------------------------------------
    A more complete, comprehensive assessment is more general, 
taking into account the ``not so obvious,'' indirect, secondary 
and longer-term effects impacting all groups. These effects 
were emphasized by classical economists but are often 
overlooked by recent analysis. The secondary effects of lower 
capital taxation can be very important, as they involve impacts 
on labor, productivity, wages, living standards, and economic 
growth.
    As mentioned above, initial effects of capital taxation 
cuts raise the rate of return to capital, benefiting capital 
and its owners. With higher rates of return on capital, 
incentives to save and invest improve, fostering more capital 
formation. These effects, however, are only the initial effects 
of cuts in capital taxation. In particular, the increased 
formation of capital eventually bolsters the earnings of labor, 
as labor becomes more productive when it is combined with a 
larger stock of capital.\20\
---------------------------------------------------------------------------
    \20\ See Richard E. Wagner, Federal Transfer Taxation: A Study in 
Social Cost, Institute for Research on the Economics of Taxation, 1993, 
pp. 10-11. The following paragraph follows the argument therein.
---------------------------------------------------------------------------
    The effects of changes in the capital stock on labor, 
productivity, and other factors are explained by a fundamental 
principle of economics: namely, the law of variable proportions 
(or the law of diminishing returns). This law maintains that 
the greater the amount of capital combined with a given amount 
of labor, the greater is the marginal product of that labor. 
Similarly, the larger the capital-labor ratio, the lower is the 
marginal product of capital. Some important insights are 
illustrated by this important principle. Increasing the 
capital-labor ratio, for example, results in an increased 
demand for now more productive labor. In an efficient market 
system, the increased demand for labor services results in 
increases in both employment and real wage rates: i.e., higher 
standards of living for labor. While other factors influence 
labor productivity, there is a strong consensus that one of the 
most important determinants of labor productivity over time is 
the size of the capital stock with which people work.
    So, in contrast to the analysts who focus exclusively on 
the initial effects of reductions in capital taxation and who 
contend that capital tax reduction benefits only the wealthy 
capital owners, more complete analysis suggests the benefits of 
reduction in capital taxation are more widespread. Cuts in 
taxation on capital can benefit labor in important ways. In 
particular, over time, a reduction in capital taxation 
fostering capital formation can importantly improve labor 
productivity, labor's wages, employment and thus labor income, 
living standards, and economic growth. Countries that are 
capital rich tend to have high living standards. More general 
analysis suggests that labor and capital are complements: that 
the economic interests of labor and capital are harmonious, not 
antagonistic, as suggested by the partial analysis described 
above. Policies that promote capital formation, therefore, 
likely will benefit labor. Indeed, even though workers may not 
own capital, they still can benefit (sometimes significantly) 
from its increase. In effect, benefits of reduced capital 
taxation shift over time from supplies of capital to supplies 
of labor.\21\
---------------------------------------------------------------------------
    \21\ See Gary Becker, ``The Dividend Tax Cut Will Get Better with 
Time,'' Business Week, February 10, 2003, p2 of 3.
---------------------------------------------------------------------------

                             CORROBORATION

    The above-described secondary effects which underscore the 
benefits of lower capital taxation accruing to labor are 
corroborated in several bodies of economic literature. This 
literature tends to support the view that the principal 
beneficiaries of tax reduction on capital are not only capital 
owners as maintained by much contemporary analysis.

                        TAX INCIDENCE LITERATURE

    Studies of tax incidence determine how the burden of a tax 
is allocated among consumers, workers, and other factors of 
production. In so doing, the tax incidence literature provides 
a number of illustrations of the benefits of lowered capital 
taxation shifting to labor. As Kotlikoff and Summers contend in 
their survey of the tax incidence literature:

          The distinctive contribution of economic analysis to 
        the study of tax incidence has been the recognition 
        that the burden of taxes is not necessarily borne by 
        those upon whom they are levied. . . . Economics is at 
        its best when it offers important insights that 
        contradict initial, casual impressions. The theory of 
        tax incidence provides a rich assortment of such 
        insights. Tax incidence's basis lesson that . . . taxes 
        on capital may be borne by workers. (is an 
        example).\22\
---------------------------------------------------------------------------
    \22\ Lawrence J. Kotlikoff and Lawrence H. Summers, ``Tax 
Incidence,'' Chapter 16, Handbook of Public Economics. Volume II, 
edited by Alan Auerbach and Martin Feldstein, North Holland, N.Y., 
1987, pp. 1043, 1088. (parenthesis added).

    Similarly, Fullerton and Metcalf show in their survey that 
tax incidence analysis ``begins with the very basic insight 
that the person who has the legal obligation to make a tax 
payment may not be the person whose welfare is reduced by the 
presence of the tax.'' \23\ In short, this literature 
demonstrates that economic incidence is distinctly different 
from statutory incidence because changes in behavior alter the 
tax burden.
---------------------------------------------------------------------------
    \23\ See Fullerton, Don and Gilbert E. Metcalf, ``Tax Incidence,'' 
National Bureau of Economic Research (NBER) Working Paper 8829, NBER, 
March 2002, p. 1.
---------------------------------------------------------------------------
    Further, this literature concedes that lower capital 
taxation may improve the welfare of labor. Indeed, this 
literature provides a number of examples of reduced capital 
taxation which is shifted so as to significantly benefit labor. 
These results are the product of a variety of methods, models, 
and differing assumptions or conditions. The results often 
depend, for example, on assumptions about factor elasticities, 
about economic openness, or about factor mobility. Similarly, 
the type of model employed (e.g., static, dynamic, general 
equilibrium, life-cycle, etc.) may significantly affect the 
results. \24\ In addition to this literature, surveyed 
professional economists indicated they supported the view that 
a significant portion of the tax burden of corporate income 
taxation is shifted away from capital.\25\
---------------------------------------------------------------------------
    \24\ See Kotlikoff and Summers, op. cit., pp. 1060, 1066, 1067, 
1073. See also Fullerton and Metcalf, op. cit. (e.g., See citations 
about Feldstein. (1974), Judd (1985a), and Mutti and Grubert ((1985).)
    \25\ See Fullerton and Metcalf, op. cit., p. 29 (footnote).
---------------------------------------------------------------------------

                            OTHER LITERATURE

    Additional economic literature corroborates the view that 
secondary effects of capital tax cuts are important and often 
largely accrue to labor. In particular, some authors 
contributing to the optimal taxation literature find that it is 
suboptimal for the economy to tax capital income in the long 
run.\26\ This suggests that capital taxation should be reduced 
in order to benefit the macroeconomy, economic growth, and 
labor in the long run. Other researchers, notably Feldstein, 
find large welfare costs and deadweight losses associated with 
capital taxation. For example, Feldstein calculates ``an 
enormous welfare cost associated with the taxation of capital 
income'' as well as ``a significant gain in welfare from a 
shift away from a capital income tax toward a wage tax.'' \27\ 
Generally, ``the more recent work on the welfare cost of 
capital income taxation carried out in the 1980s . . . tended 
to indicate that the welfare cost of capital income taxation 
was significant.'' \28\
---------------------------------------------------------------------------
    \26\ See, for example, Raymond G. Batina and Toshihiro Ihori, 
Consumption Tax Policy and the Taxation of Capital Income, Oxford 
University Press, Oxford, 2000, p. 23. See, for example, citations for 
Arrow and Kurz (1970), Judd (1985), Chamley (1986), and later Lucas 
(1990).
    \27\ See Batina and Ihori, op. cit., pp. 22, 53.
    \28\ See Batina, and Ihori op. cit., pp. 87, 105.
---------------------------------------------------------------------------
    Researchers, notably Lucas, showed that lowering the 
capital income tax rate could permanently raise the economy's 
growth rate.\29\
---------------------------------------------------------------------------
    \29\ See ibid, p.93. Eliminating capital income taxation would 
significantly boost the per capita capital stock according to Lucas 
(see Batina and Ihori, ibid, p.105).
---------------------------------------------------------------------------
    Growth literature shows that capital accumulation promotes 
growth and higher income per capita. It suggests that lowering 
the income tax rate on capital would not only boost growth, but 
also advance welfare, thereby ultimately benefiting workers. 
Some researchers also argue that capital taxation is suboptimal 
if capital is mobile internationally (and the economy 
open).\30\ In this case, lowering the tax on the more mobile 
factor (capital) works to relieve the accumulated burden on the 
more immobile factor (labor) and thus works to benefit labor. 
And the literature is peppered with models which suggest that 
the benefits from lowering interest income taxation may be 
shifted substantially to workers: that a lowered capital 
taxation will foster capital accumulation which, when combined 
with labor, raises the wages received by workers.\31\
---------------------------------------------------------------------------
    \30\ Ibid, p. 301.
    \31\ Ibid, p. 100.
---------------------------------------------------------------------------
    In sum, major categories of economic literature--the 
literature on tax incidence, on optimal taxation, and on 
economic growth--all strongly suggest that lowering taxation on 
capital may well have significant secondary effects that accrue 
to the benefit of labor or workers rather than exclusively to 
capital. Additionally, the movement toward reduced capital 
taxation can remain fully consistent with any desired degree of 
tax progressivity; adoption of consumption taxation does not in 
any way consign consumers to a more regressive tax system.\32\
---------------------------------------------------------------------------
    \32\ The tax rate structure determines the degree of progressivity.
---------------------------------------------------------------------------

                        Summary and Conclusions

    Recent tax reductions on income, dividends, and capital 
gains, together with expanded depreciation allowances, lowered 
taxation on capital. These cuts improved the current structure 
of capital taxation. Nonetheless, the existence of an income-
tax base continues to impose a bias against savings, 
investment, and hence capital formation. This anti-capital bias 
of income taxation has long been understood by prominent 
economists (including John Stuart Mill, Alfred Marshall, A.C. 
Pigou, Irving Fisher, and Nicholas Kaldor) who explicitly 
recognized that bias and preferred expenditure taxation. A host 
of more contemporary economists also recognize this bias and 
support an expenditure tax base.
    Remedies for this bias in the form of wholesale 
restructuring of the tax code have been proposed in recent 
years; e.g., a flat tax, national sales tax, or consumed-income 
taxation. All have advocates. But public choice theory suggests 
that there are well-known political obstacles to such sweeping 
reform. Consequently, instead of a one-time sweeping overhaul, 
an incremental approach to removing the tax bias against saving 
may prove to be more feasible politically. This paper 
delineates such an approach and examines the short- and long-
run economic effects of reducing capital taxation. While the 
initial, short-term effects are relatively straightforward and 
beneficial to capital, important secondary, longer-run effects, 
often ``unseen'' and misunderstood, are highlighted. In 
particular, several bodies of economic literature suggest that 
important, substantial benefits of lower capital taxation are 
likely to accrue to labor and workers. This implies that 
important interests of labor and capital are importantly 
harmonious, not antagonistic, as much present-day opinion 
suggests. These mutual benefits often go unrecognized. For all 
of the reasons highlighted in this paper, there is strong 
support for making permanent recent reductions in capital 
taxation.

                                Appendix

                            EARLIER WRITERS

    This appendix documents the historical recognition of the 
anti- saving bias of income taxation. The view that taxation 
should be based on an individual's expenditures or consumption 
rather than his income or earnings was voiced by Thomas 
Hobbes.\1\ The essential idea he supported was that ``an 
expenditure base would tax people according to the amount which 
they take out of the common pool, and not according to what 
they put into it.'' \2\
---------------------------------------------------------------------------
    \1\ Thomas Hobbes, Leviathan, chapter XXX. Cited in Nicholas 
Kaldor, An Expenditure Tax, Unwin University Books, London, 1965.
    \2\ Nicholas Kaldor, An Expenditure Tax, Unwin University Books, 
London, 1965, p.11.
---------------------------------------------------------------------------
    John Stuart Mill clearly spelled out important arguments 
against income-based taxation. He explicitly recognized that 
income taxation is biased against saving (and hence investment 
and capital formation) because of the multiple taxation of 
saving. Mill's support of consumption-based taxation was 
important because he and his principles were so influential. As 
Blaug emphasized:

          All through the second half of the 19th century 
        Mill's Principles of Political Economy was the 
        undisputed bible of economists . . . as late as 1900 
        Mill's work was still the basic textbook in elementary 
        courses in both British and American universities.\3\
---------------------------------------------------------------------------
    \3\ Mark Blaug, Economic Theory in Retrospect, R.D. Irwin, 
Homewood, Ill., 1968, p. 180.

    In making the case for consumption-based taxation in this 
book, Mill clearly spelled out the biased nature of income 
---------------------------------------------------------------------------
taxation:

          . . . the proper mode of assessing an income tax 
        would be to tax only the part of income devoted to 
        expenditure, exempting that which is saved. For when 
        saved and invested . . . it thenceforth pays income tax 
        on the interest or profit which it brings, 
        notwithstanding that it has already been taxed on the 
        principal. Unless, therefore, savings are exempted from 
        income tax, the contributors are twice taxed on what 
        they save, and only once on what they spend. . . .\4\ 
        The difference thus created to the disadvantage of 
        prudence and economy is not only impolitic but unjust. 
        To tax the sum invested, and afterwards to tax also the 
        proceeds of the investment, is to tax the same portion 
        of the contributors means twice over . . . No income 
        tax is really just from which savings are not exempted; 
        and no income tax ought to be voted without that 
        provision . . .
---------------------------------------------------------------------------
    \4\ John Stuart Mill, Principles of Political Economy, Augustus M. 
Kelley, Fairfield, 1909, p. 813.

          . . . all sums saved from income and invested, should 
        be exempt from the (income) tax.\5\
---------------------------------------------------------------------------
    \5\ Mill, ibid. pp. 814-15, 829 (parenthesis added).

    Alfred Marshall also supported consumption-based taxation 
and actually proposed a post-World War I expenditure tax.\6\ 
Another well-known economist, A.C. Pigou, contended that an 
income tax can be shown to be biased against saving and 
investment; accordingly, he argued that an expenditure tax is 
preferable to an income tax.\7\
---------------------------------------------------------------------------
    \6\ See Alfred Marshall, ``The Equitable Distribution of Taxation 
(1917),'' in Memorials of Alfred Marshall edited by A.C. Pigou, 
Augustus M. Kelley, N.Y., 1966, pp. 345-352.
    \7\ A.C. Pigou, A Study in Public Finance, London, MacMillen & Co., 
1947 (Third edition), chapter X.
---------------------------------------------------------------------------
    Irving Fisher was another prominent economist who 
recognized that income taxation is biased against saving, 
investment, and capital formation, since savings is taxed 
multiple times. Echoing the arguments presented by Hobbes, 
Mill, and Marshall, Fisher stated that saving should be exempt 
from income taxation and that expenditure-based taxation is 
preferred. Fisher (1942) explicitly took note of earlier 
economists supporting this view in his book's extensive 
bibliography.\8\
---------------------------------------------------------------------------
    \8\ Irving Fisher and Herbert Fisher, Constructive Income Taxation, 
Harper & Bros., New York, 1942.
---------------------------------------------------------------------------
    In making his argument, Fisher noted that income taxation 
is flawed in several ways:

          [income taxes] are unfair . . . because they impose 
        double taxation (by taxing savings and their fruits) . 
        . . they thus tax the producers of the nation's wealth 
        more heavily than those who merely spend, especially 
        the ``idle rich'' . . . By taxing the increase of 
        capital, they kill the most important geese which lay 
        the most important golden eggs . . . if a tax on the 
        savings is added to a tax on the fruit of the savings, 
        essentially the same thing is taxed twice.\9\
---------------------------------------------------------------------------
    \9\ Ibid, p.3, p.56. [brackets added].

    Fisher took note of several forms of multiple taxation on 
---------------------------------------------------------------------------
capital. For example, he stated:

          . . . to tax the corporation on the profits which it 
        distributes and, at the same time, to tax the 
        stockholders personally on their dividends is to tax 
        the same thing twice--it is double taxation.\10\
---------------------------------------------------------------------------
    \10\ Ibid, pp. 28-29.

    Fisher's book and his many other publications addressing 
this topic show the broadness and depth of his knowledge on 
this subject.\11\
---------------------------------------------------------------------------
    \11\ See his bibliography, ibid., pp. 249-260.
---------------------------------------------------------------------------
    Recognizing the biased nature of income taxation, Nicholas 
Kaldor also made the case for expenditure-based taxation in a 
study stemming from his work at the Royal Commission on the 
Taxation of Profits and Income in the early 1950s. His 
arguments included all the points outlined above, but also 
highlighted several additional ones. Kaldor emphasized, for 
example, that ``an expenditure base would tax people according 
to the amount which they take out of the common pool and not 
according to what they put into it.'' \12\ Kaldor also argued 
that income taxation is biased against risk bearing and, 
further, that:
---------------------------------------------------------------------------
    \12\ Kaldor, op.cit., p. 53.

          The primary economic objective of the financial 
        policy of the Government in a modern state . . . is . . 
        . the maintenance of . . . an adequate rate of capital 
        accumulation for steadily rising standards of 
        living.\13\
---------------------------------------------------------------------------
    \13\ Ibid., pp. 173-4.

    In sum, the idea that income taxation is biased against 
saving, investment, and capital formation is not novel, but 
rather, has a remarkably respectable ancestry dating from at 
least the mid-1800s.
           Median Family Income and Inflation Mismeasurement


                            I. INTRODUCTION

    It is widely recognized in the academic and research 
communities that the consumer price index (CPI) is a faulty 
measure of inflation and the cost-of-living. As a result, use 
of a flawed inflation measure appears to show real median 
family income dropping from 2000 to 2005, when in fact it has 
increased by between $2,200 and $3,000 (Figure 1). Since these 
are pre-tax data, calculations that take into account the 
effect of tax reductions since 2001 would show an even greater 
after-tax increase in family income. This paper is organized as 
follows. Section II briefly reviews the empirical evidence on 
the accuracy of the CPI and provides a range of estimates of 
the bias in the CPI. Section III presents real median family 
income using more accurate measures of inflation. Section IV 
summarizes the findings with a conclusion, followed by the 
Appendix with the methodology. 


                 II. MISMEASUREMENT AND BIAS IN THE CPI

    Perhaps the mostly widely followed measure of inflation in 
the United States is the consumer price index (CPI). The CPI 
attempts to gauge the overall price level by measuring changes 
in consumer-level prices for a basket of goods and services. 
The CPI was first introduced in 1919 by the U.S. Department of 
Labor's Bureau of Labor Statistics (BLS).\1\ The index 
underwent numerous methodological changes over its history, but 
by the early 1990s the index suffered from a number of 
persistent problems which caused the CPI to overstate the rate 
of change in the price level. A blue-ribbon panel, headed by 
economist Michael J. Boskin, issued a report in 1996 which 
identified the sources and magnitude of bias in the CPI.\2\
---------------------------------------------------------------------------
    \1\ U.S. Bureau of Labor Statistics, ``Chapter 17. The Consumer 
Price Index: History of the CPI, 1919 to 2003,'' in BLS Handbook of 
Methods, online at http://www.bls.gov/opub/hom/homch17_d.htm, updated 
4/10/2006.
    \2\ Michael J. Boskin, Ellen R. Dulberger, Robert J. Gordon, Zvi 
Griliches, and Dale Jorgenson, ``Toward a More Accurate Measure of the 
Cost of Living,'' Final Report of the Advisory Commission to Study the 
Consumer Price Index, Committee on Finance, U.S. Senate (December 4, 
1996).
---------------------------------------------------------------------------
    Since the Boskin report, BLS has implemented a number of 
changes in the methodology underlying the CPI, such as 
increased use of geometric means. Despite these changes, the 
CPI continues to significantly overstate the price level. As 
BLS's own economists have noted, ``these changes have not had 
an important quantitative effect on the [CPI] All Items 
index.'' \3\
---------------------------------------------------------------------------
    \3\ David S. Johnson, Stephen B. Reed and Kenneth J. Stewart, 
``Price Measurement in the United States: A Decade after the Boskin 
Report,'' Monthly Labor Review 129, no. 5 (May 2006): 17.
---------------------------------------------------------------------------
    The debate over the accuracy of the CPI is not just an 
academic one. Numerous indicators are converted from nominal 
terms to inflation-adjusted dollars using the CPI. One of the 
most closely watched measures of economic well-being in the 
U.S. is the Census Bureau's median income figures. In order to 
make meaningful comparisons over time the Bureau employs a 
variant of the CPI known as the CPI-U-RS. Because the CPI is 
used to adjust income data for inflation, the persistence of a 
bias in the index remains an important policy issue.
    Robert Gordon, one of the leading experts on the CPI, 
concluded in a May 2006 study that despite changes implemented 
by the BLS, the upward bias in the CPI remained quite large. 
Although BLS adopted some of the changes recommended by the 
Boskin report, the subsequent experience has led Gordon to re-
estimate the importance of some of the factors still affecting 
CPI bias. In particular, he found that upper-level substitution 
bias played a more important role than originally thought. On 
balance, Gordon estimated that ``today's bias is at least 1.0 
percent per year or perhaps even higher.'' \4\ After estimating 
the various causes of CPI bias, Gordon reported that the sum of 
the estimates yields a total bias of 1.10 percent per year.\5\
---------------------------------------------------------------------------
    \4\ Robert J. Gordon, ``The Boskin Commission Report: A 
Retrospective One Decade Later,'' National Bureau of Economic Research, 
Working Paper 12311 (June 2006).
    \5\ Ibid., 3.
---------------------------------------------------------------------------
    Boskin himself revisited the issue of CPI bias in a 2005 
article, reaching similar conclusions as Gordon. Boskin's 
article observed that inflation is inherently difficult to 
measure for a number of reasons. Not only are new goods and 
services introduced frequently, but relative prices change 
purchase patterns. Moreover, the sheer size of the economy is 
itself an obstacle to accuracy:

          There are literally hundreds of thousands of goods 
        and services available in rich industrialized modern 
        market economies. A single supermarket may contain 
        30,000 differently priced items, and a WalMart store 
        over 40,000, so measuring in a single index what 
        happened to prices in a single store can be quite 
        difficult. Doing so for the entire economy is vastly 
        more complex. As we have become richer, demand has 
        increasingly shifted to services away from goods, and 
        to characteristics of goods and services such as 
        enhanced quality, more variety, and greater 
        convenience.\6\
---------------------------------------------------------------------------
    \6\ Michael J. Boskin, ``Causes and Consequences of Bias in the 
Consumer Price Index as a Measure of the Cost of Living,'' Atlantic 
Economic Journal 33, no. 1 (March 2005): 5.

    As Boskin noted, the economy has become more service- 
oriented than in decades past, ``when a larger fraction of 
economic activity consisted of easier-to-measure items such as 
tons of steel and bushels of wheat.'' \7\ On balance, Boskin 
concluded that the current CPI bias remains significant, 
``likely being on the order of 80 or 90 basis points.'' \8\
---------------------------------------------------------------------------
    \7\ Ibid.
    \8\ Ibid.
---------------------------------------------------------------------------
    Other researchers have reported similar findings. In a 
comprehensive review of the issue published in the prestigious 
Journal of Economic Literature, David Lebow and Jeremy Rudd 
found a significant bias in the CPI. After accounting for 
changes made by BLS and applying new methodologies, the authors 
``conclude that the CPI is currently and prospectively 
overstating the true rate of change in the cost of living by 
about 0.9 percentage point per year.'' \9\ The authors also 
found ``the single largest source of bias to be the CPI's 
inadequate accounting for quality improvements and the 
introduction of new items.'' \10\
---------------------------------------------------------------------------
    \9\ David E. Lebow and Jeremy B. Rudd, ``Measurement Error in the 
Consumer Price Index: Where Do We Stand?'' Journal of Economic 
Literature 41, no. 1 (March 2003): 160.
    \10\ Ibid.
---------------------------------------------------------------------------
    Researchers generally identify four main sources of bias in 
the CPI. Lebow and Rudd identify and discuss a fifth source: 
weighting. A detailed treatment of all these sources, however, 
is beyond the scope of this paper.\11\ The following points 
briefly describe the different causes of bias.
---------------------------------------------------------------------------
    \11\ A more detailed discussion of sources of bias in the CPI can 
be found in Lebow and Rudd, 163-191.
---------------------------------------------------------------------------
     Upper-level substitution occurs when consumers 
shift from one product to a different product due to a change 
in relative prices. For example, if the price of apples 
increases, consumers may elect to buy more bananas in place of 
apples.
     Lower-level substitution occurs when consumers 
shift from one type of a product to different type of the same 
product due to a price change. For example, if the price of Red 
Delicious apples increases, consumers may start buying Granny 
Smith apples instead.
     Outlet substitution occurs when consumer change 
the place or vendor of purchase due to a price increase. For 
example, if the price of Levi jeans increases at Macy's, 
consumers could choose to buy the same jeans at WalMart or J.C. 
Penny's.
     New products and quality change can cause CPI to 
overstate inflation because a higher price does not reflect a 
new product or improved quality. For example, if the price for 
an MRI scan rises, the CPI might not take into account the fact 
that the new scanner provides more precise images. Although the 
cost of the scan may be higher, the higher price does not 
reflect the fact that the scan is more valuable.
     Weighting bias results from the way surveyed 
prices are weighted in the CPI formula. Weights are derived 
from a consumer survey which is subject to errors due to 
respondents' memory of purchases, accuracy of respondents' 
estimates, and problems inherent to household surveys (e.g., 
response rates, small sample size, etc.).
    Table 1 displays the magnitude of each source of bias as 
estimated by the researchers discussed above, as well as the 
overall size of the upward bias in the CPI. Although there are 
some differences in the estimated magnitude of individual 
sources of bias, there is remarkable consistency in the overall 
size of the bias. Thus, recent research by leading experts 
points to a bias in the CPI of between +0.80 to +1.1 percentage 
point per year. 


    Confirmation of the problems in the CPI comes from the 
Federal Reserve itself. During his tenure as Chairman, Alan 
Greenspan stopped using the CPI as its primary inflation 
indicator. Greenspan stated that the personal consumption 
expenditures (PCE) index was a superior measure of inflation. 
However, even the PCE has problems which, according to 
Greenspan, result in an upward bias in its measurement of 
inflation by 0.5 to 1.0 percentage point.\12\
---------------------------------------------------------------------------
    \12\ Alan Greenspan, ``The Economic Outlook,'' Testimony to the 
Joint Economic Committee, U.S. Congress, 11/3/05.
---------------------------------------------------------------------------

                     III. REAL MEDIAN FAMILY INCOME

    The U.S. Census Bureau publishes data each year on median 
income for a variety of family and household types.\13\ The 
present analysis focuses on median income for one particular 
unit: married- couple families with one or more children. In 
many ways, this is the prototypical middle-income American 
family. In 2005 there were an estimated 27.1 million married-
couple families with one or more children under the age of 18, 
consisting of 114 million persons.\14\ Close to two-fifths 
(38.5 percent) of U.S. residents lived in such families.\15\ 
These families also bear a significant portion of the federal 
income tax burden. Based on 2004 tax data (the most recent 
available), joint returns of married persons that have at least 
one dependent accounted for 39 percent of all income taxes, 
with the average taxable return paying $16,418 in federal 
income tax.\16\
---------------------------------------------------------------------------
    \13\ The median is generally considered the best measure of the 
typical or middle value in a group. In the present context, the median 
is that point which divides the number of families in half, with one-
half falling above the median and one-half below.
    \14\ U.S. Census Bureau, Table F-4, ``presence of Related Children 
Under 18 Years Old--Married Couple Families, by Total Money Income in 
2005,'' online at http://pubdb3.census.gov/macro/032006/faminc/
new04_001.htm.
    \15\ U.S. Census Bureau, Statistical Abstract of the United States: 
2006 (Washington, DC: Government Printing Office, 2006), 9.
    \16\ U.S. Department of the Treasury, Internal Revenue Service, 
Statistics of Income division, Individual Income Tax Returns 
Publication 1304 for 2004, ``Table 1.2: All Returns: Adjusted Gross 
Income, Exemptions, Deductions, and Tax Items,'' and ``Table 2.4: All 
Returns: Exemptions by Type and Number of Exemptions,'' available 
online at http://www.irs.gov/taxstats/indtaxstats/article/
0,,id=134951,00.html#_pt1.
---------------------------------------------------------------------------
    To allow comparisons between different years, the Census 
Bureau adjusts previous years' nominal estimates using a 
version of the CPI.\17\ Because the CPI overstates inflation, 
adjustments based on the CPI are likewise biased. Thus, the 
Census Bureau's estimates for real median family income lead to 
inaccurate conclusions. A correct comparison of income over 
time requires the use of a corrected CPI. When the CPI is 
corrected for its known bias, as estimated by the researchers 
in the previous section, a more accurate picture emerges of 
changes in median family income.
---------------------------------------------------------------------------
    \17\ The Census Bureau uses a version of the CPI known as the CPI-
U-RS. Although there are some differences between the CPI-U-RS and the 
more common CPI-U, the two series closely mirror each other. Between 
2000 and 2005, the CPI-U increased by a total of 13.41 percent, 
compared to a 13.36 percent increase for the CPI-U-RS. For more 
information on the CPI-U-RS, see: U.S. Department of Labor, Bureau of 
Labor Statistics, ``BLS Statement on the Use of the CPI-U-RS,'' online 
at http://www.bls.gov/epi/cpiurstx.htm.
---------------------------------------------------------------------------
    The present analysis attempts to correct for the recognized 
bias in the CPI by using the estimates of the bias reported by 
Gordon, Boskin, and Lebow and Rudd. For Gordon, the analysis 
uses his estimate of 1.1 percentage point, while for Lebow and 
Rudd it applies their estimate of 0.87 percentage point. Since 
Boskin provides a range of 0.80 to 0.90, this analysis uses the 
midpoint of his range, or 0.85 percentage point. For each of 
estimate, the analysis subtracts the researcher's estimate from 
the annual percentage change in the CPI-U-RS to arrive at a 
revised and corrected inflation index. The corrected index is 
then used to adjust nominal income amounts to 2005 real 
dollars.
    Table 2 presents calculations showing median family income 
in constant 2005 dollars, where the inflation adjustment was 
made using the uncorrected CPI-U-RS and three variations of a 
corrected CPI-U-RS. Each correction variation corresponds to 
one of the three studies discussed in Section II above. As can 
be seen, the results differ markedly in both magnitude and 
direction depending on whether a corrected CPI is used or not. 
When the CPI is used without correcting for the known bias, it 
appears that median income for married couple families with one 
or more children has fallen by $705, or -1.0 percent, between 
2000 and 2005. However, if the bias in the CPI is taken into 
account and corrected, median income clearly increases. Median 
family income for married couples with one or more children 
rose by between $2,212 (using Boskin's estimate of the CPI 
bias) to $3,052 (using Gordon's estimate). 


                             IV. CONCLUSION

    It is widely recognized that the CPI overstates the rate of 
inflation. This bias in the CPI was studied in depth by the 
1996 Boskin Commission. Ten years later, additional research 
has led to better estimates of the size and persistence of the 
bias. Recent research has yielded estimates of the current 
annual CPI bias that include 0.80 to 0.90 percentage point 
(Boskin), 0.87 percentage point (Lebow and Rudd), and 1.1 
percentage point (Gordon).
    When a corrected measure of inflation is used, median 
income displays solid growth. For married couple families with 
one or more children, the net gain in median income ranges from 
$2,212 to $3,052, or +3.2 percentage points to +4.5 percentage 
points (in 2005 dollars). These figures stand in stark 
opposition to the alleged decline in family income, a result 
only obtained by using a flawed measure of inflation. If the 
effect of recent tax reductions were included, the after-tax 
income gains would be even stronger.

                         Appendix: Methodology

    Incorporating adjustments to the CPI and calculating real 
values require several steps. Table 3 presents the data and 
calculations underlying the analysis in this paper.\1\ The 
first step is to start with nominal income amounts and an 
uncorrected CPI-U-RS index (or CPI for short).\2\ From the 
uncorrected CPI, one can calculate the annual percentage change 
in the base index as well as constant dollar amounts.
---------------------------------------------------------------------------
    \1\ One value that has been omitted from the table to simplify 
presentation is the uncorrected CPI value for 1999, which is 0.854. 
This value is necessary to calculate annual change in the CPI for 2000.
    \2\ These data can be obtained from the Census Bureau directly, as 
cited in note 14, and at: U.S. Census Bureau, ``Annual Average Consumer 
Price Index Research Series Using Current Methods (CPI-U-RS)--All 
Items: 1947 to 2005,'' online at http://www.census.gov/hhes/www/income/
income05/cpiurs.html.
---------------------------------------------------------------------------
    In order to incorporate an adjustment to the CPI for the 
estimated bias, there are essentially four steps to complete, 
illustrated here with the Boskin bias estimate. First, since 
the bias causes the CPI to overstate the rate of inflation, 
adjustments should lower the annual percent change in the 
index. Thus, 85 basis points are subtracted from the 
uncorrected CPI annual change each year (e.g., 3.34 - 85 = 
2.49). This step produces a revised series of annual percent 
change. Second, the 1999 CPI value of 0.854 is then ``grown'' 
each year by the revised percent change values, yielding a new, 
corrected index. Third, because the analysis seeks to put all 
dollar amounts in 2005 terms, the corrected index must be 
rebased to 2005 dollars. This is accomplished by dividing the 
corrected index through by the 2005 value. Finally, real income 
values can then be calculated using a CPI corrected by Boskin's 
estimate of the CPI bias. These steps are subsequently repeated 
for Lebow and Rudd's and Gordon's estimates of the CPI bias.


            Costs and Consequences of the Federal Estate Tax

                           EXECUTIVE SUMMARY

    This study examines the arguments for and against the 
federal estate tax, finding that benefits of the tax are often 
overstated, and in any case are far smaller than the documented 
costs. On balance, the analysis finds that the costs imposed by 
the estate tax outweigh any potential benefits that the tax 
might produce. In light of this finding, there is no compelling 
reason to keep the tax, and a number of reasons to reduce or 
abolish it.
Arguments for the estate tax
     Inequality: The paper draws on a large body of 
theoretical and empirical research showing the estate tax is an 
ineffective tool for fighting wealth and income inequality. As 
one noted liberal economist has said, ``The reformer eyeing the 
estate tax as a means to reduce inequality had best look 
elsewhere.''
     Charitable Giving: Recent research indicates that 
the charitable deduction exerts only a modest, if any, 
stimulative effect. In fact, the estate tax may actually be a 
significant barrier to charitable giving, as estate taxes crowd 
out charitable bequests.
     Tax Revenue: The estate tax clearly results in 
some losses in the federal income tax, meaning that the true 
net revenue of the estate tax is less than the official, static 
measures of its revenue yield. Although the exact magnitude of 
the effect is not known, some research suggests that repeal of 
the estate tax will not result in a revenue loss for the 
federal government.
Costs of the estate tax
     Economic Growth: The estate tax exerts a negative 
effect on the economy by generating extremely high compliance 
costs, introducing economic inefficiencies, and by reducing the 
stock of capital in the economy. The present study estimates 
that the estate tax has reduced the stock of capital in the 
economy by approximately $847 billion.
     Small Business: The estate tax has a negative 
influence on entrepreneurial activity by hindering entry into 
self-employment and by breaking up family-run businesses. 
Family-run firms and farms particularly feel the pinch of the 
estate tax because they are less likely to have the liquid 
resources needed to meet their estate tax liabilities.
     Social Mobility: Because the estate tax disrupts 
the transmission of family wealth to succeeding generations, 
the estate tax hinders upward income mobility. One study 
estimates that the estate tax will consume 11 to 13 percent of 
African-American wealth over the next 50 years. With the number 
of minority-run businesses surging in recent years, the estate 
tax will come to affect more and more such firms.
     Fairness, Simplicity and Efficiency: The large 
number of tax avoidance options means that the tax burden is 
distributed unfairly among payers of the tax, is unnecessarily 
complicated, and will distort taxpayer behavior. As two liberal 
economists have noted, ``tax liabilities depend on the skill of 
the estate planner, rather than on capacity to pay.''
     Environment: A 2001 study found that approximately 
2.6 million acres of forest land must be harvested each year to 
pay for the estate tax. Another 1.3 million acres must be sold 
to raise funds to pay estate taxes, of which close to one-third 
(29 percent) is either developed or converted to other uses.

          Assessing the Federal Estate Tax: Costs and Benefits

                            I. INTRODUCTION

    Benjamin Franklin observed over 200 years ago that ``in 
this world nothing can be said to be certain, except death and 
taxes.'' \1\ Death and taxes may indeed be inevitable, but the 
simultaneous convergence of the two in the federal estate tax 
has produced one of the most contentious components of the 
federal tax code. Part of this debate is driven by the very 
nature of the estate tax itself. Many people simply find it 
objectionable as a matter of principle to tax the savings 
someone has accumulated over his or her lifetime, most of which 
have already been previously subjected to the income tax at 
least once. That the estate tax is imposed upon the death of a 
loved one only exacerbates the grief of loss.
---------------------------------------------------------------------------
    \1\ John Bartlett, Familiar Quotations, 16th ed. (Boston, MA: 
Little, Brown and Company, 1992), 310.
---------------------------------------------------------------------------
    This study examines the arguments for and against the 
federal estate tax to find that benefits of the tax are often 
overstated, and in any case are far smaller than the documented 
costs. Supporters of the tax defend it on the grounds that it 
reduces inequality, encourages charitable giving, and raises 
much needed tax revenue. However, this paper identifies a large 
body of theoretical and empirical research showing the estate 
tax is an ineffective tool for fighting wealth and income 
inequality. With respect to charitable giving, the available 
evidence does not support the contention that people are 
greatly motivated by tax incentives when making gifts from 
their estates. Even the $25 billion the tax raised in 2005 is 
overstated because it fails to take into account income tax 
losses that result from the multitude of estate tax avoidance 
strategies.
    The rather small potential benefits of the estate tax stand 
in sharp contrast to large and significant costs of the tax. 
The estate tax discourages savings and capital accumulation, 
thus impeding economic growth. Small businesses and innovation 
suffer as well, as the estate tax reduces funds available for 
investment and employment, and destabilizes the business at a 
vulnerable moment, the death of the founder or current leader 
of the enterprise. Since the owning of a small business is the 
key means for lower- and middle-income families to accumulate 
wealth, the estate tax also hinders economic mobility. Even the 
environment is harmed by the estate tax, since the enormous 
liquidity demands of the tax force owners to sell and develop 
environmentally-sensitive habitats in order to meet their 
estate tax obligations. On top of all these costs, the estate 
tax lacks the basic features of good tax policy due to its 
complexity and lack of equity.
    When the costs of the estate tax are paired with the 
benefits, the mismatch is easy to discern, with the costs far 
exceeding the benefits. On balance, then, this study finds that 
the costs imposed by the estate tax outweigh any benefits that 
the tax might produce. In light of this finding, there is no 
compelling reason to keep the tax, and a number of reasons to 
reduce or abolish it. To preview the results of the present 
analysis, consider the conclusion drawn by Henry Aaron and 
Alicia Munnell, two prominent liberal economists, in their 
study of the estate tax:

          In short, the estate and gift taxes in the United 
        States have failed to achieve their intended purposes. 
        They raise little revenue. They impose large excess 
        burdens. They are unfair.\2\
---------------------------------------------------------------------------
    \2\ The authors, however, favor reforming the estate tax, not 
repealing it. Henry J. Aaron and Alicia H. Munnell, ``Reassessing the 
Role for Wealth Transfer Taxes,'' National Tax Journal 45, no. 2 (June 
1992): 138.

    This paper updates and extends two previous Joint Economic 
Committee studies on the estate tax.\3\ The current report 
builds on the previous studies to reflect more recent data and 
legislation. Readers wishing additional information on the 
various arguments for and against estate taxation should 
consult the earlier studies.
---------------------------------------------------------------------------
    \3\ Dan Miller, The Economics of the Estate Tax, U.S. Congress, 
Joint Economic Committee (December 1998); and Dan Miller, The Economics 
of the Estate Tax: An Update, U.S. Congress, Joint Economic Committee 
(June 2003).
---------------------------------------------------------------------------

                 II. OVERVIEW OF THE FEDERAL ESTATE TAX

    The estate tax, also known as the death tax, is a tax 
imposed on transfers of savings made at the holder's death. 
Three times in this nation's history a federal death tax has 
been imposed only to be repealed shortly thereafter.\4\ In each 
instance, the tax was implemented to provide revenue on a 
short-term basis to finance military activities (1797-1802, 
1862-1870, and 1898-1902). With the advent of World War I, the 
federal estate tax was reintroduced for a fourth time in 1916 
and has existed ever since. Many states also impose their own 
death taxes.
---------------------------------------------------------------------------
    \4\ The term death refers to all taxes imposed at death. Estates 
taxes are levied on a deceased's estates, while inheritances taxes are 
paid by the recipients of transfers.
---------------------------------------------------------------------------
    The modern estate tax regime began in 1976, when 
legislation implemented a unified system of wealth transfer 
taxes. The unified system consists of three separate taxes: the 
estate tax, the gift tax, and the generation-skipping transfer 
(GST) tax.\5\ Estate and gift taxes are imposed on transfers 
made at death and during life, respectively. Tax liabilities 
are a function of taxable assets, less any deductions, above 
the exemption amount. The GST tax is generally imposed on asset 
transfers that skip a generation (e.g., from grandparents to 
grandchildren) above the exemption amount. Throughout this 
paper, estate tax is used to refer to this unified system of 
taxing intergenerational transfers.
---------------------------------------------------------------------------
    \5\ For additional information, see John R. Luckey, ``Federal 
Estate, Gift, and Generation-Skipping Taxes: A Description of Current 
Law,'' Congressional Research Service, Report 95-416A (updated January 
5, 2005).
---------------------------------------------------------------------------
    An important feature of the estate tax is the step-up in 
basis for transferred assets. The basis of an asset is used as 
its cost for the purpose of calculating capital gains. Under 
the unified wealth transfer tax system, when a decedent 
transfers an asset to an heir, the asset's basis is increased, 
or stepped-up, to its current market value. The effect of this 
step-up is to exempt from capital gains taxation the amount of 
the step-up.
    The 2001 Economic Growth and Tax Relief Reconciliation Act 
(EGTRRA) implemented, among other things, a gradual reduction 
in federal estate taxes, beginning in 2002 and culminating in 
full repeal in 2010 (Table 2).\6\ For the estate tax, the 
exemption amount is gradually increased to $3.5 million and the 
top estate tax rate is lowered to 45 percent between 2002 and 
2009. The GST tax exemption amount is eventually raised to $3.5 
million by 2009. For gifts, the annual exclusion amount 
continues to be adjusted for inflation ($12,000 in 2006), 
subject to a cap of $1 million in tax-free lifetime gift 
transfers. Also effective in 2010, gift taxes will be cut to 
equal the top applicable income tax rate, and the GST tax will 
be repealed. EGTRRA replaces the step-up in basis with a 
modified carryover basis in 2010, with taxable gains subject to 
an exemption of up to $4.3 million ($1.3 million for any heirs, 
plus an additional $3 million for transfers to spouses).\7\
---------------------------------------------------------------------------
    \6\ Public Law No: 107-16. Table 7 at the end of the paper presents 
the rate structure of the estate tax in greater detail. Nonna A. Noto, 
``Calculating Estate Tax Liability during the Estate Tax Phasedown 
Period 2001-2009,'' Congressional Research Service, Report RL31092 
(updated April 1, 2005).
    \7\ For additional detail, see Nonna A. Noto, ``Estate and Gift Tax 
Law: Changes under the Economic Growth and Tax Relief Reconciliation 
Act of 2001,'' Congressional Research Service, Report RL31061 (updated 
January 29, 2002). 


    The estate tax reduction and repeal set forth by EGTRRA, 
however, contains a sunset provision. Starting in 2011, the 
legislation repealing the estate tax expires and the estate tax 
system is restored to the pre-2001 law, with the exemption 
amount previously scheduled to increase to $1 million. Congress 
is currently considering a permanent repeal of the estate 
tax.\8\
---------------------------------------------------------------------------
    \8\ The U.S. House of Representatives passed H.R. 8, the Death Tax 
Repeal Permanency Act of 2005, on April 13, 2005 by a vote of 272 to 
162.
---------------------------------------------------------------------------

                   III. ARGUMENTS FOR ESTATE TAXATION

    Advocates of the estate tax generally rely on three 
different arguments to support the tax. First, supporters claim 
the estate tax is necessary to reduce inequality. Second, 
estate tax advocates contend that the deduction for charitable 
bequests induces substantial giving to nonprofit organizations. 
Finally, supporters argue that the $28 billion the tax is 
expected to raise in fiscal year 2006 warrants the estate tax's 
existence.

A. Inequality and the distribution of wealth, income and consumption

    Perhaps the most common argument made in favor of the 
estate tax is that it reduces income and wealth inequality. 
Supporters of the estate tax maintain that since the high tax 
rates apply only to the ``rich,'' the tax should unambiguously 
reduce inequality. This assertion actually relies on two 
assumptions: normatively, that high estate tax rates are 
consistent with a liberal political philosophy; and 
empirically, that high estate tax rates do in fact reduce 
inequality.
    Both of these assumptions are flawed. First, the estate tax 
fails on liberal and progressive grounds because it discourages 
work and savings in favor of conspicuous consumption. The 
liberal philosophical argument against the estate tax has been 
articulated by legal scholar Edward McCaffery of the University 
of Southern California Law School, who is a ``self-acknowledged 
liberal (in the modern sense of the term), who believes that it 
is appropriate for the government to distribute or redistribute 
resources from rich to poor.'' \9\ McCaffery argues that the 
estate tax undermines the very concepts of fairness and 
equality that liberals ought to support:
---------------------------------------------------------------------------
    \9\ Edward J. McCaffery and Richard E. Wagner, ``A Declaration of 
Independence from Death Taxation: A Bipartisan Appeal,'' Public 
Interest Institute, Policy Study (July 2000), 4. See also, Edward J. 
McCaffery, ``The Uneasy Case for Wealth Transfer Taxation,'' Yale Law 
Journal 104, no. 2 (November 1994): 283-365.

          Liberals should think that a death tax encourages 
        behaviors that a liberal society ought not to like--
        high-end leisure, encrusted forms of ownership, 
        aggressive inter vivos giving--while discouraging the 
        socially beneficial behaviors of work, savings, and 
        thrift. . . .
          The material equality that a liberal should care 
        about is precisely equality in consumption or 
        lifestyle. What we should all want our wealthiest, most 
        economically productive citizens to do is to continue 
        to work and save, not spend it all on themselves or 
        stop working and consume leisure time. Yet once again a 
        death tax is precisely backwards on this--liberal--
        score.\10\
---------------------------------------------------------------------------
    \10\ McCaffery and Wagner, 6, 18-19.

    On the second assumption, there is little evidence that the 
estate tax actually reduces inequality to any substantive 
degree. A large body of empirical and theoretical research has 
emerged showing that inheritance either is not a major source 
of inequality, or thatgovernment policies aimed at breaking up 
inheritance are likely to be ineffective. There are five reasons for 
such findings.
    First, there is only a weak correlation between wealth and 
income. For example, a person can be very wealthy but have 
little or negative income (or vice versa). An article published 
in the Federal Reserve Bank of Minneapolis's Quarterly Review 
found that many low-income households have substantial amounts 
of wealth, and vice versa. For example, the average wealth of 
the bottom 1 percent of the income distribution is enough to 
place such a household in the top wealth quintile. \11\ 
Conversely, households in the bottom 1 percent of the wealth 
distribution have an average income that places them in the 
middle of the income distribution. \12\ One reason for such 
results is the life-cycle of income and savings: as workers 
enter retirement, their income falls dramatically while their 
asset levels are relatively high. In addition, some wealthy 
households may have transitory business losses or losses in 
capital income that temporarily place them at the bottom of the 
income distribution. Thus, a reduction of wealth transfers can 
have only a limited impact on the distribution of earnings.
---------------------------------------------------------------------------
    \11\ Santiago Budria Rodriguez, Javier Diaz-Gimenez, Vincenzo 
Quadrini and Jose-Victor Rios-Rull, ``Updated Facts on the U.S. 
Distributions of Earnings, Income, and Wealth,'' Federal Reserve Bank 
of Minneapolis, Quarterly Review 26, no. 3 (Summer 2002): 6.
    \12\ Ibid.
---------------------------------------------------------------------------
    Alan Blinder, a member of President Bill Clinton's Council 
of Economic Advisers, found that only about 2 percent of 
inequality was attributable to the unequal distribution of 
inherited wealth, leading him to conclude that ``a radical 
reform of inheritance policies can accomplish comparatively 
little income redistribution.'' \13\ Elsewhere Blinder has 
written that ``The reformer eyeing the estate tax as a means to 
reduce inequality had best look elsewhere.\14\
---------------------------------------------------------------------------
    \13\ Alan S. Blinder, Toward an Economic Theory of Income 
Distribution (Cambridge, MA: MIT Press, 1974).
    \14\ Alan S. Blinder, ``Inequality and Mobility in the Distribution 
of Wealth,'' Kyklos 29 (1976): 618-9.
---------------------------------------------------------------------------
    Second, efforts to curtail savings transfers induce wealth 
holders to increase their consumption, thereby increasing the 
inequality of consumption. Joseph Stiglitz, who served as 
Chairman of President Clinton's Council of Economic Advisers, 
has found that, taking into account the long-term impact on 
capital accumulation, the estate tax may ultimately increase 
income inequality. Even if the government acts to offset these 
capital accumulation effects, Stiglitz argued that the 
``desirability of the estate tax may still be questioned, not 
only because of the distortions which it introduces but also 
because it may actually increase inequality in the distribution 
of consumption.''\15\
---------------------------------------------------------------------------
    \15\ Joseph E. Stiglitz, ``Notes on Estate Taxes, Redistribution, 
and the Concept of Balanced Growth Path Incidence,'' Journal of 
Political Economy 86, no. 2 (1978): S137-S150.
---------------------------------------------------------------------------
    Stiglitz further argued that inheritances actually decrease 
inequality: because inheritances redistribute income within 
families, they may decrease inequality in lifetime 
consumption.\16\ In yet another analysis, Stiglitz concluded 
that ``it would seem clear that inheritances are unambiguously 
equality increasing'' in terms of consumption, and an argument 
can be made that inheritances reduce inequality of income and 
wealth as well.\17\ The conclusions reached by Blinder and 
Stiglitz have been replicated by numerous other 
researchers.\18\
---------------------------------------------------------------------------
    \16\ David L. Bevan and Joseph E. Stiglitz, ``Intergenerational 
Transfers and Inequality,'' Greek Economic Review 1, no. 1 (August 
1979): 13.
    \17\ Joseph E. Stiglitz, ``Equality, Taxation and Inheritance,'' in 
Personal Income Distribution: Proceedings of a Conference Held by the 
International Economic Association, Noordwijk aan Zee, Netherlands, 
April 18-23, 1977, eds. Wilhelm Krelle and Anthony F. Shorrocks, 283 
(New York, NY: North-Holland Publishing Company, 1978).
    \18\ For a review of additional research, see the discussion of 
Davies (1982), Hugget (1996), and Verbit (1978) in Miller, The 
Economics of the Estate Tax, 6.
---------------------------------------------------------------------------
    Third, empirical and theoretical research on 
intergenerational wealth transfers has repeatedly found that 
such transfers have relatively little impact on the 
distribution of income and wealth. For example, a theoretical 
model of wealth distribution by Jagadeesh Gokhale and Laurence 
Kotlikoff found that bequests actually reduce wealth 
inequality.\19\ Shinichi Nishiyama, in a technical paper from 
the Congressional Budget Office, simulated the effect of a 100 
percent estate and gift tax, concluding that income and wealth 
inequality would be no better, and by some measures worse, than 
the baseline estimate.\20\ In a similar vein, Edward Wolff's 
analysis of wealth distribution led him to write:
---------------------------------------------------------------------------
    \19\ Jagadeesh Gokhale and Laurence J. Kotlikoff, ``Simulating the 
Transmission of Wealth Inequality,'' American Economic Review 92, no. 2 
(May 2002): 265-269.
    \20\ Shinichi Nishiyama, ``Bequests, Inter Vivos Transfers, and 
Wealth Distribution,'' Congressional Budget Office, Technical Paper 
Series 2000-8 (December 2000), 22-23.

          The most surprising finding is that inheritances and 
        other wealth transfers tend to be equalizing in terms 
        of the distribution of household wealth. Indeed, the 
        addition of wealth transfers to other sources of 
        household wealth has had a sizable effect on reducing 
        the inequality of wealth. . . . Oddly enough, though 
        wealth inequality has risen in the United States 
        between 1983 and 1998, the increase may have been even 
        greater were it not for the mitigating effects of 
        inheritances and gifts.\21\
---------------------------------------------------------------------------
    \21\ However, Wolff also writes that ``the current structure of the 
estate tax is quite good from the standpoint of equity.'' Edward N. 
Wolff, ``Bequests, Saving, and Wealth Inequality: Inheritances and 
Wealth Inequality, 1989-1998,'' American Economic Review 92, no. 2 (May 
2002): 263.

    Fourth, the considerable degree of wealth and income 
mobility in society means that government efforts to 
redistribute wealth will necessarily meet with limited success. 
Many U.S. households move up and down the income and wealth 
ladder. For example, one study found that between 1966 and 
1981, more than half of all households changed wealth 
quintiles.\22\ Another study reported that one-third of 
households in the bottom wealth quintile move up to a higher 
wealth quintile after just five years.\23\
---------------------------------------------------------------------------
    \22\ Nancy A. Jianakoplos and Paul L. Menchik, ``Wealth Mobility,'' 
Review of Economics and Statistics 79, no. 1 (February 1997): 18-31.
    \23\ Ana Castaneda, Javier Diaz-Gimenez and Jose-Victor Rios-Rull, 
``Accounting for the U.S. Earnings and Wealth Inequality'' Journal of 
Political Economy 111, no. 4 (August 2003): 848.
---------------------------------------------------------------------------
    To illustrate the degree of wealth mobility, consider the 
results of a study by economists Kerwin Kofi Charles and Erik 
Hurst, published in the Journal of Political Economy.\24\ That 
study found robust movement up and down wealth quintiles across 
generations. Figure 2 displays the percent of families that 
changed wealth quintiles from one generation to the next. For 
example, close to two-thirds (64 percent) of children of 
parents in the poorest wealth quintile (i.e., poorest fifth of 
families) ended up in a higher wealth quintile than their 
parents.\25\ Likewise, children of parents in the wealthiest 
quintile had a 64 percent chance of being in a different wealth 
quintile than their parents.\25\ In other words, for every 
person who remains in the same wealth quintile as their 
parents, two to three change to a different quintile.
---------------------------------------------------------------------------
    \24\ Kerwin Kofi Charles and Erik Hurst, ``The Correlation of 
Wealth across Generations,'' Journal of Political Economy 111, no. 6 
(December 2003): 1155-1182.
    \25\ Similar results were found by Executive Office of the 
President, Council of Economic Advisers, The Annual Report of the 
Council of Economic Advisers (Washington, DC; Government Printing 
Office, 2003), 199. 


    Thus, not only do children in poorer households move up the 
wealth distribution, but children in wealthier households move 
down. Alexis de Tocqueville observed this phenomenon back in 
1835, when he wrote ``wealth circulates with inconceivable 
rapidity, and experience shows that it is rare to find two 
succeeding generations in the full enjoyment of it.'' \26\ More 
recently, there is evidence of such patterns in the Forbes 
annual list of the richest Americans. For example, of the 
original top 400 richest persons who made the first list in 
1982, only 50 names--just 13 percent--were still on the list in 
2004.\27\ In fact, many of the famous fortunes in America from 
the early twentieth century did not have a single family member 
left on the 2004 list, including such notable families as 
DuPont, Mellon and Rockefeller.\28\
---------------------------------------------------------------------------
    \26\ Alexis de Tocqueville, Democracy in America--Volume I (1835; 
reprint, New York: Vintage Books, 1945), 53.
    \27\ Maria Elena Lagomasino, ``How to Stay Rich,'' Forbes, 10/11/
04, online at http://www.forbes.com/400richest/.
    \28\ Peter Newcomb, ``Family Fortunes,'' Forbes, 10/11/04, online 
at http://www.forbes.com/400richest/.
---------------------------------------------------------------------------
    The fifth reason that the estate tax is likely to be 
ineffective at reducing inequality is that most wealth 
households did not become wealthy because of inheritances. 
Numerous studies confirm the conclusion that inheritances are 
not a major source of wealth for many of the wealthy. A survey 
of wealthy investors by Prince & Associates found that just 7 
percent of respondents identified inheritance as thesource of 
their wealth.\29\ In The Millionaire Next Door, authors Thomas Stanley 
and William Danko report that 81 percent of millionaires are first-
generation rich, and just 14 percent cite inheritance as the source of 
their wealth.\30\ A 1989 study that examined the top 10 percent of the 
income distribution found that only 9 to 12 percent of such households 
attributed more than half of their wealth to gifts and 
inheritances.\31\ RAND economist James P. Smith has found that 
inheritances account for less than 8 percent of the wealth in the 
wealthiest 5 percent of households.\32\ Among Forbes' 2003 list of the 
top 100 richest Americans, inheritance is the source of wealth for just 
8 percent, compared to 76 percent who made the list through 
entrepreneurship (Table 3).\33\ In a survey of households worth at 
least $5 million done for Deutsche Bank Private Banking, respondents 
estimated that on average 18 percent of their wealth came from 
inheritance or gifts, and that in the combined pool of wealth of all 
surveyed households, less than 11 percent originated from 
inheritance.\34\ While the exact point estimates differ from study to 
study, they are remarkably consistent in showing that less than 20 
percent of the assets of the wealthy originates from inheritance.
---------------------------------------------------------------------------
    \29\ ``Majority of Rich Investors Made Fortunes through Hard Work 
According to Private Asset Management Study,'' Business Wire, 6/14/94.
    \30\ Thomas J. Stanley and William D. Danko, The Millionaire Next 
Door: The Surprising Secrets of America's Wealthy (Atlanta, GA: 
Longstreet Press, 1996), 16, 32.
    \31\ Michael D. Hurd and Gabriella Mundaca, ``The Importance of 
Gifts and Inheritances among the Affluent,'' in The Measurement of 
Saving, Investment, and Wealth, eds. Robert E. Lipsey and Helen Stone 
Tice, 737-763 (Chicago, IL: University of Chicago Press, 1989).
    \32\ James P. Smith, ``Inheritances and Bequests,'' In Wealth, 
Work, and Health, ed. James P. Smith and Robert J. Willis, 121-149 (Ann 
Arbor, MI: University of Michigan Press, 1999), 137.
    \33\ Analysis of October 2003 Forbes data in Paul A. Samuelson and 
William D. Nordhaus, Microeconomics, 18th ed. (Boston, MA: McGraw Hill, 
2005), 388.
    \34\ Paul G. Schervish and John J. Havens, ``Extended Report of the 
Wealth with Responsibility Study,'' Social Welfare Research Institute, 
Boston College (March 2001), 10. 


    The fact that four out of five millionaires are first-
generation rich raises the question: if inheritance is not the 
source of their wealth, how did these individuals become 
millionaires? The data in Table 3 already demonstrate the 
central importance of entrepreneurship. In addition, Stanley 
and Danko show that a primary mechanism of achieving wealth is 
for families to manage their money effectively and lead a 
frugal lifestyle. Contrary to conventional wisdom, most 
millionaires do not lead high-priced lifestyles. For example, 
the typical millionaire has never spent more than $400 on a 
suit and paid just $24,800 for his current automobile.\35\
---------------------------------------------------------------------------
    \35\ Stanley and Danko, 31, 112.
---------------------------------------------------------------------------

B. Charitable contributions

    Another objection to a reduction in the estate tax is that 
it would reduce contributions to charitable organizations. 
Because the estate tax allows individuals to deduct from their 
taxable estate any bequests to charitable organizations, there 
is a significant tax advantage to donate money at one's death. 
Reducing the tax on estates, the argument goes, could cause 
people to donate less money to charity. Recent research on this 
subject, however, indicates that the charitable tax deduction 
exerts only a modest, if any, stimulative effect. Although the 
charitable deduction may affect the timing of donations, it may 
not significantly alter the overall level of giving. 


    Despite the substantial tax benefits, a casual review of 
the data provides little evidence that tax incentives greatly 
affect charitable bequests. According to IRS data, only 18.5 
percent of taxable estate tax returns actually made a 
charitable bequest on returns filed in 2004.\36\ In other 
words, four out of five taxable estate tax returns did not take 
advantage of the price benefit of a charitable bequest. Given 
the steep marginal tax rates of the estate tax, one might 
expect charitable bequests to be much more common. Remarkably, 
a similar percentage--22 percent--of households nationwide 
(most of whom do not receive tax benefits from charitable 
bequests) have either already included a charitable bequest in 
their will (8 percent) or are considering doing so (14 
percent).\37\
---------------------------------------------------------------------------
    \36\ The term ``taxable estate tax returns'' refers to returns that 
actually paid some amount of estate tax. Joint Economic Committee 
calculations based on data from Internal Revenue Service, ``Estate Tax 
Returns for 2005,'' online at http://www.irs.gov/taxstats/indtaxstats/
article/0,,id=96442,00.html.
    \37\ Scott R. Lumpkin, ``A New Perspective on Philanthropy: Planned 
Giving in the United States,'' Trusts & Estates 140, no. 6 (June 2001): 
14-17, 48.
---------------------------------------------------------------------------
    In addition to looking at patterns of giving among estate 
tax returns, it is useful to consider patterns of charitable 
giving over time. Proponents of the estate tax assert that all 
else being equal, a reduction in estate taxes reduces the tax 
benefit of charitable bequests and should result in lower 
bequest levels. The estate tax reductions that began in 2002 
provide an opportunity to test this assertion.
    The picture is somewhat complicated, however, by the fact 
that EGTRAA requires fewer estates to file returns. Some 
estates that no longer are required to file returns may still 
be making charitable bequests, but those gifts are not included 
in IRS data. Between 2001 and 2004 the number of estate tax 
returns filed with the IRS fell 42 percent, and the aggregate 
value of gross estates on those returns dropped by $23 billion 
(16 percent) in inflation-adjusted dollars. In light of these 
numbers, it is perhaps not surprising that total charitable 
bequests on estate tax returns fell $2.3 billion between 2001 
and 2004, though the decline among taxable estates was just 
$923 million (in 2005 dollars). An additional consideration is 
that there are significant fluctuations from year to year 
unrelated to changes in tax policy. Looking over a 46 year time 
period (1959 to 2004), total charitable bequests are closely 
correlated with overall charitable giving.\38\
---------------------------------------------------------------------------
    \38\ The correlation statistic between the two data series is 
0.990. The data being compared are total charitable giving from all 
sources and all charitable bequests (including those from decedents who 
did not file an estate tax return). JEC calculation using data from 
AAFRC Trust for Philanthropy, Giving USA 2005 (New York, NY: AAFRC 
Trust for Philanthropy, 2005), 194-195.
---------------------------------------------------------------------------
    Nonetheless, the evidence suggests that the impact of the 
estate tax reductions has been mild or even non-existent. In 
fact, the 2005 edition of Giving USA, published annually by the 
AAFRC Trust for Philanthropy (an organization that seeks to 
advance philanthropy), reported that ``Despite predictions, 
there has been no observed impact on charitable giving from the 
gradual change in estate tax filing requirements.'' \39\ A 
number of facts are consistent with such a conclusion. First, 
the total amount of charitable bequests in nominal dollars, on 
and off of estate tax returns, was exactly the same in 2001 
(before EGTRRA) and 2004: $19.8 billion.\40\ Second, the size 
of the average charitable bequest on estate tax returns has 
increased significantly, rising more than 40 percent between 
2001 and 2004 (Figure 3).\41\ Third, bequests as a share of 
gross estate have increased after EGTRAA, growing from 7.4 
percent over 1999-2001, compared to 7.9 percent for 2002-2004; 
among taxable returns, the share rose from 7.4 percent to 8.5 
percent.\42\ Finally, the percent of estate tax returns that 
made a charitable bequest rose from 16.9 percent for the period 
1999-2001 to 17.7 percent for the period 2002-2004; for taxable 
returns, the rates were 20.6 percent and 21.2 percent, 
respectively.\43\ As noted above, IRS data do not tell the 
whole story, since the data exclude charitable bequests by 
estates no longer subject to the estate tax.
---------------------------------------------------------------------------
    \39\ Ibid., 29.
    \40\ In constant terms, the change between 2001 and 2004 was a drop 
of 6.2 percent. AAFRC Trust for Philanthropy, 194.
    \41\ Joint Economic Committee calculations based on data from 
Internal Revenue Service, ``Estate Tax Returns,'' (various years), 
online at http://www.irs.gov/taxstats/indtaxstats/article/
0,,id=96442,00.html.
    \42\ Ibid.
    \43\ Ibid.
---------------------------------------------------------------------------
    Notably, these changes generally follow the same patterns 
across different estate sizes. For example, among taxable 
returns, total bequests for estates greater than $5 million 
declined just eight tenths of a percentage point; bequests were 
also similar for estates greater than $10 million. Likewise, 
the increases in the percent of estates leaving a bequest and 
bequests as share of estates are all concentrated in the larger 
estates (the very estates most likely to face the highest 
marginal rates, and which therefore might be expected to be 
most responsive to rate reductions).
    To a certain degree, even these numbers overstate the scope 
of charitable giving, as a very small number of estates account 
for the vast majority of bequests to charity. The most recent 
data indicate that the wealthiest 0.5 percent of decedents in 
the U.S. accounted for 76 percent of all charitable bequests 
made in 2004. In fact, a mere 0.011 percent of decedents (272 
estate tax returns out of 2.4 million deaths) accounted for 
close to one-third (31 percent) of all charitable bequests that 
year.\44\ This concentration of charitable bequests among a 
very few decedents raises the question of why some wealthy 
estates make very large donations, while others make none at 
all.
---------------------------------------------------------------------------
    \44\ A similar pattern holds over the last five years as well. 
Joint Economic Committee calculations based on data from AAFRC Trust 
for Philanthropy; Internal Revenue Service; and U.S. Department of 
Health and Human Services, Center for Disease Control, National Vital 
Statistics Reports 53, no. 21 (June 28, 2005), data updated 2/15/2006, 
1.
---------------------------------------------------------------------------
    The evident answer to this question is that gifts to 
charity are influenced by factors other than tax benefits, such 
as altruism or amount of after-tax wealth. As Boston College 
researcher Paul Schervish has observed, ``Charitable giving, 
while spurred on by increased material wherewithal, is advanced 
even more by increased spiritual wherewithal.'' \45\ Survey 
data show that charitable intent outweighs tax incentives as a 
motivation for charitable bequests. For example, in one survey 
of very wealthy families, the number one factor cited by 
respondents as likely to increase charitable giving was ``Find 
worthy cause that you feel passionate about.'' \46\ Other 
research bears out such findings.\47\
---------------------------------------------------------------------------
    \45\ Paul G. Schervish, ``Wealth and Philanthropy,'' in 
Philanthropy in America: A Comprehensive Historical Encyclopedia, ed. 
Dwight F. Burlingame, 507 (Santa Barbara, CA: ABC-CLIO, 2004).
    \46\ Schervish and Havens, 27.
    \47\ See, for instance, Len Scholl, ``Successful Charitable 
Planning Starts with an Understanding of Client Motivations,'' National 
Underwriter: Life & Health 108, no. 47 (December 13, 2004): 14-15; and 
Janice H. Burrill, ``The Effects of Estate Tax `Repeal' on 
Philanthropy,'' Trusts & Estates 140, no. 10 (October 2001): 20-26.
---------------------------------------------------------------------------
    Formal research into the impact of a reduction in estate 
taxes generally finds that there are two opposite effects. 
First, there is an increase in the tax price of making a 
donation, which dampens the tax benefits of giving. Second, 
there is an increase in the amount of after-tax wealth, which 
boosts giving by augmenting available resources. Debate over 
the impact of estate tax repeal on charitable giving generally 
boils down to which of these two effects dominates. Some 
research has found that the charitable deduction significantly 
increases charitable bequests.\48\ One study even predicted 
repealing the estate tax would reduce charitable bequests by 
between 22 percent and 37 percent.\49\
---------------------------------------------------------------------------
    \48\ See, for example, Michael J. Brunetti, ``The Estate Tax and 
Charitable Bequests: Elasticity Estimates Using Probate Records,'' 
National Tax Journal 63, no. 2 (June 2005): 165-188.
    \49\ Jon M. Bakija and William Gale, ``Effects of Estate Tax Reform 
on Charitable Giving,'' Urban-Brookings Tax Policy Center (July 2003).
---------------------------------------------------------------------------
    Other research, however, suggests that the stimulative 
effect of the charitable deduction is not as large. For 
example, a 2000 study by economist David Joulfaian found that 
charitable giving is highly sensitive to after-tax wealth. The 
net impact of the estate tax on charitable bequests is 
difficult to quantify, leading Joulfaian to suggest that ``the 
estate tax has a modest effect on giving.'' \50\ In a 2005 
study from the U.S. Treasury Department's Office of Tax 
Analysis, Joulfaian utilized more recent data to find that the 
estate tax ``has little effect on bequests.'' \51\ That study 
went on to conclude:
---------------------------------------------------------------------------
    \50\ David Joulfaian, ``Estate Taxes and Charitable Bequests by the 
Wealthy,'' National Bureau of Economic Research, Working Paper 7663 
(April 2000), 21.
    \51\ David Joulfaian, ``Estate Taxes and Charitable Bequests: 
Evidence from Two Tax Regimes,'' U.S. Department of Treasury, Office of 
Tax Analysis, OTA Paper 92 (March 2005), 19.

          The estimated effects of estate taxation vary 
        considerably depending on whether behavior and estate 
        planning reflect the current or expected tax regimes. 
        If donors are assumed to respond to the tax regime in 
        place at the date of death, then estate tax repeal 
        would lead to a small reduction in bequests. On the 
        other hand, if donors plan with the future tax regime 
        in mind, then estate tax repeal may lead to a small 
        increase in gifts.\52\ (emphasis added)
---------------------------------------------------------------------------
    \52\ Ibid., 20.

    One of the most revealing studies on this subject found 
that individuals who gave generously during their life gave 
little at death, while those who gave little during life tended 
to give much more at death.\53\ In brief, this research 
suggests that tax incentives play a relatively limited role in 
determining total lifetime giving. Tax incentives may induce 
some donors to give their contributions earlier in life, but on 
balance, it appears that tax incentives (both income and 
estate) do not greatly alter the total amount of charitable 
giving made over an individual's lifetime.
---------------------------------------------------------------------------
    \53\ Eugene Steuerle, ``Charitable Giving Patterns of the 
Wealthy,'' in America's Wealth and the Future of Foundations, ed. 
Teresa Odendahl, 203-221 (New York, NY: The Foundation Center, 1987).


    The estate tax may actually be a significant barrier to 
charitable giving, as estate taxes crowd out charitable 
bequests. Decisions about charitable bequests typically are 
made on the basis of after-tax wealth. If an estate faces a 
large tax liability, then there are fewer resources left over 
to allocate between heirs and charities. An increase in after-
tax wealth could, therefore, offset, in part or in whole, the 
effect of losing the tax benefit of giving.
    Survey evidence supports this perspective. A survey of 
wealthy households (net worth of at least $5 million) found 
that respondents expected to distribute 16 percent of their 
estates to charity and 37 percent to taxes (Table 4). However, 
respondents also indicated how they would prefer to distribute 
their wealth, with 26 percent going to charity and just 9 
percent to taxes. In other words, for a $10 millionestate, the 
wealth holder might expect to leave $1.6 million to charity. In the 
absence of excessive estate taxation, the amount going to charity would 
increase more than 60 percent to $2.6 million.\54\
---------------------------------------------------------------------------
    \54\ Schervish and Havens, 35.
---------------------------------------------------------------------------

C. Federal revenue

    A third objection to cutting estate taxes is the loss of 
government revenue. The estate tax accounts for a relatively 
small portion of federal revenue. Although the $28 billion that 
the estate tax is expected to raise in 2006 is hardly 
insignificant, it amounts to only 1.2 percent of the $2.3 
trillion in total receipts (Figure 4). Over the next five years 
(2006-2010), the Congressional Budget Office estimates that 
estate tax revenue will account for 1.0 percent of total 
revenue.\55\
---------------------------------------------------------------------------
    \55\ U.S. Congress, Congressional Budget Office, The Economic and 
Budget Outlook: Fiscal Years 2007-2016 (Washington, DC: Congressional 
Budget Office, 2005), 84.
---------------------------------------------------------------------------
    In a curious twist of analysis, the Joint Committee on 
Taxation
    (JCT) has estimated that the total revenue loss from estate 
tax repeal would actually exceed the revenue the tax raises. At 
the time of JCT's analysis, the estate tax was expected to 
raise $218 billion over 2011 to 2015 (the years when the 
current reduction and repeal of the estate tax expires).\56\ 
However, JCT estimates that over that same time period repeal 
would lose $281 billion.\57\ In other words, the revenue lost 
from estate tax repeal equals 129 percent of the actual revenue 
that it is supposed to raise.\58\ This appears to be the same 
as pouring 13 gallons of water out of a 10 gallon jug.
---------------------------------------------------------------------------
    \56\ U.S. Congress, Congressional Budget Office, The Economic and 
Budget Outlook: Fiscal Years 2006-2015 (Washington, DC: Congressional 
Budget Office, 2005), 78.
    \57\ The JCT maintains that estate tax repeal would also reduce 
capital gains revenue. U.S. Congress, Joint Committee on Taxation, 
``Estimated Budget Effects of the Revenue Provisions Contained in the 
President's Fiscal Year 2006 Budget Proposal,'' JCX-10-05 (3/9/2005)
    \58\ For a critique of JCT's methodology, see Daniel Clifton, 
``Learning from History: JCT's Static Score Can Not Determine the Real 
Revenue Effect of Repealing the Estate Tax,'' American Family Business 
Institute (July 2005).


    Notwithstanding JCT's peculiar methods of accounting, there 
is abundant evidence that the estate tax, along with its high 
compliance costs and impact on capital accumulation, may 
actually cause income tax revenue losses for the federal 
government. In addition, the primary payers of the estate tax, 
the wealthy, tend to be well-educated about and willing to 
engage in extensive tax avoidance strategies.\59\ In fact, the 
estate tax affords so many avoidance and minimization 
opportunities that some observers have dubbed it a ``voluntary 
tax.'' \60\ It is difficult for any tax to assess accumulated 
savings and capital because such holdings can be manipulated 
through tax-free transfers and favorable asset valuation.
---------------------------------------------------------------------------
    \59\ See generally Munnell, infra note 75; and Wojcieh Kopczuk and 
Joel Slemrod, ``The Impact of the Estate Tax on the Wealth Accumulation 
and Avoidance Behavior of Donors,'' National Bureau of Economic 
Research, Working Paper 7690 (October 2000).
    \60\ See George Cooper, A Voluntary Tax?: New Perspectives on 
Sophisticated Estate Tax Avoidance (Washington, DC: Brookings 
Institution, 1979); and Edward J. McCaffery, ``A Voluntary Tax? 
Revisited,'' in Proceedings: 93rd Annual Conference on Taxation and 
Minutes of the Annual Meeting of the National Tax Association, November 
9-11, 2000, ed. James R. Hines, Jr., 268-274 (Washington, DC: National 
Tax Association, 2001).
---------------------------------------------------------------------------
    Estate taxes, as well, are ultimately self-defeating in the 
sense that they simply encourage consumption of savings rather 
than leaving bequests. This fact led Joseph Stiglitz, chairman 
of President Clinton's Council of Economic Advisers, to 
conclude that,

          Of course, prohibitively high inheritance tax rates 
        generate no revenue; they simply force the individual 
        to consume his income during his lifetime.\61\ 
        (emphasis added)
---------------------------------------------------------------------------
    \61\ Bevan and Stiglitz, 21.

    The impact of the estate tax on overall revenues primarily 
comes from reduced wealth accumulation (or increased 
consumption) and increased tax avoidance efforts. These factors 
impact revenue through the inefficiencies and distortions 
introduced by the estate tax, which in turn, reduce the amount 
of taxable income and wealth in the economy, thereby depressing 
federal tax revenue.
    The impact of these effects is most apparent in the 
negative impact on income tax revenue. Most assets generate 
some degree of taxable income: stocks are taxed on their 
dividends and realized capital gains, checking and savings 
accounts produce taxable interest, annuities typically yield 
income that is at least partially taxable, and many bonds 
generate taxable interest. If taxable asset levels are lowered 
due to the estate (either from reduced savings or increased 
avoidance), then the income and other taxes are also reduced.
    A study by Stanford University economist Douglas Bernheim 
examined the impact of just one aspect of tax avoidance: the 
tax-induced shifting of resources from parents to heirs. In 
general, income tax revenue is lost whenever assets are 
transferred from parents in high income tax brackets to 
children (who typically face lower tax rates) or to tax-exempt 
organizations through charitable bequests and family trusts. 
Through an analysis of estate tax returns under different 
assumptions and tax regimes, Bernheim found that the income tax 
revenue loss associated with these factors is very large 
relative to the revenue raised by the estate tax. In sum, 
Bernheim concluded:

          Although it is very difficult to estimate these 
        effects precisely, in recent years true estate tax 
        revenues may well have been negative.\62\ (emphasis 
        added)
---------------------------------------------------------------------------
    \62\ B. Douglas Bernheim, ``Does the Estate Tax Raise Revenue?'' in 
Tax Policy and the Economy, vol. 1, ed. Lawrence H. Summers, 113-138 
(Cambridge, MA: MIT Press, 1987).

    Additional research shows that tax rates have a significant 
impact on such giving to heirs. Bernheim and others have found 
that such inter vivos giving is ``highly responsive to 
applicable gift andestate tax rates.'' \63\ Joulfaian also has 
reached results that ``demonstrate that taxes have significant effects 
on the timing of transfers.'' \64\ These findings lend credence to the 
contention that the estate tax results in at least some revenue loss 
under the income tax due to premature transfers to heirs.
---------------------------------------------------------------------------
    \63\ B. Douglas Bernheim, Robert J. Lemke and John Karl Scholz, 
``Do Estate and Gift Taxes Affect the Timing of Private Transfers,'' 
National Bureau of Economic Research, Working Paper 8333 (June 2001), 
i.
    \64\ David Joulfaian, ``Choosing Between Gifts And Bequests: How 
Taxes Affect the Timing of Wealth Transfers,'' U.S. Department of the 
Treasury, Office of Tax Analysis, OTA Paper 86 (May 2000), 23.
---------------------------------------------------------------------------
    In addition, a growing body of literature examines the 
effect of the estate tax on the size of estates reported to the 
IRS. Most recently, David Joulfaian, of the U.S. Treasury's 
Office of Tax Analysis, has published evidence that suggests 
that ``estate taxes have a dampening effect on the reported 
size of taxable estates.'' \65\ Analyzing data from a 50 year 
period (1949-2001), Joulfaian estimates that the estate tax 
reduces the size of reported estates by 14 percent.
---------------------------------------------------------------------------
    \65\ David Joulfaian, ``The Behavioral Response of Wealth 
Accumulation to Estate Taxation: Time Series Evidence,'' Office of Tax 
Analysis, U.S. Department of the Treasury, OTA Paper 96, (November 
2005), 1.
---------------------------------------------------------------------------
    To put the 14 percent estimate in perspective, consider 
that for 2004, total taxable estates reported to the IRS 
amounted to approximately $108 billion. If that amount reflects 
the 14 percent reduction estimated by Joulfaian, then the true 
level of taxable estates was actually $125 billion. In other 
words, the estate tax itself reduced the reported level of 
estates by $17.5 billion.
    In another study on the subject, Wojciech Kopczuk and Joel 
Slemrod examined the size of reported estates and summary 
measures of the estate tax rate structure. Looking at data from 
1916 to 1996, they found that higher rates are ``generally 
negatively related to the reported aggregate net worth of the 
top estates as a fraction of national wealth,'' a finding that 
is consistent with the notion that estate taxes reduce wealth 
accumulation and increase tax avoidance.\66\ The authors go on 
to report a negative relationship between marginal estate taxes 
and the reported net worth of estates, concluding:
---------------------------------------------------------------------------
    \66\ Wojciech Kopczuk and Joel Slemrod, ``Wealth Accumulation and 
Avoidance Behavior,'' in Rethinking Estate and Gift Taxation, eds. 
William G. Gales, James R. Hines, Jr. and Joel Slemrod, 338-339 
(Washington, DC: Brookings Institution Press, 2001).

          When we investigate measures of the tax rate that 
        prevailed during one's lifetime rather than at death, 
        the estimated negative behavioral response to estate 
        taxes is more pronounced. In particular, the marginal 
        tax rate at the age of 45 dominates all other measures, 
        and the estimated elasticity with respect to (one 
        minus) the tax rate is 0.16, and is statistically 
        significant. Such a number is also economically 
        significant, because it implies that an estate tax rate 
        of 50 percent would reduce the reported net worth of 
        the richest half of the population by 10.5 percent when 
        its effect is fully realized many years later.\67\
---------------------------------------------------------------------------
    \67\ Ibid., 339.

    In yet another study, Kenneth Chapman, Govind Hariharan and 
Lawrence Southwick, Jr. found evidence that higher estate tax 
rates result in reduced asset levels. Following significant 
rate increases in 1941 and 1977, estate tax revenue as a share 
of GDP decreased. In contrast, after rates were lowered in 
1984, revenue as a share of GDP increased.\68\ A regression 
analysis of revenue data and tax rates provided ``evidence that 
tax revenues from the estate tax declined during periods of 
higher tax rates, which suggests that individuals may be 
reducing the amount of their bequeathable (taxable) estates in 
response to the higher taxes.'' \69\ In other words, the 
evidence indicates that higher tax rates are associated with a 
smaller amount of taxable assets. This finding reinforces the 
findings of Joulfaian and Kopczuk and Slemrod reported above.
---------------------------------------------------------------------------
    \68\ Under the Economic Recovery Act of 1981 and subsequent 
legislation, top statutory estate tax rates were gradually reduced from 
70 percent to 55 percent. The year 1984 marks the completion of the 
rate phase down.
    \69\ Kenneth Chapman, Govind Hariharan and Lawrence Southwick, Jr., 
``Estate Taxes and Asset Accumulation,'' Family Business Review 9, no. 
3 (Fall 1996): 267.
---------------------------------------------------------------------------
    Other research has quantified the true revenue effect from 
repeal of the estate tax. The CONSAD Research Corporation 
developed a computer simulation model to estimate the revenue 
impact of permanent estate tax repeal coupled with limited 
step-up in basis for the calculation of estates' capital gains 
realizations.\70\ The CONSAD model predicts such a proposal 
would yield a net gain to the U.S. Treasury:
---------------------------------------------------------------------------
    \70\ Under the proposal reviewed by CONSAD, assets would receive no 
step-up in basis. Instead, heirs would receive a $1.3 million exemption 
from capital gains taxes, but everything above that level would be 
taxed at the capital gains tax rate when the assets are sold.

          Those results demonstrate that immediate repeal of 
        the estate tax and adoption of the specified limited 
        step-up in basis will generate a cumulative net 
        increase in government tax revenues equal to $38.0 
        billion over the period from 2003 through 2012. That 
        net increase will consist of $231.2 billion in 
        additional revenues from the capital gains tax and the 
        personal income tax, which will more than offset the 
        forgone $193.0 billion in estate tax revenues.\71\
---------------------------------------------------------------------------
    \71\ Wilbur A. Steger and Frederick H. Rueter, ``The Effects on 
Government Revenues from Repealing the Federal Estate Tax and Limiting 
the Step-Up in Basis for Taxing Capital Gains,'' (Pittsburgh, PA: 
CONSAD Research Corporation, 2003), 4.

    The conclusion to be made from this collection of research 
is that the estate tax clearly results in losses in federal 
income tax revnues. Even aside from economic loss caused by 
reduced asset accumulation, the true net revenue of the estate 
tax to the federal treasury is less than the official, static 
measures of its revenue yield. Although the exact magnitude of 
the effect is not known, the research of Bernheim and CONSAD 
supports the contention that repeal of the estate tax will not 
result in a revenue loss for the federal government (and may 
even result in a net revenue gain).

                 IV. ARGUMENTS AGAINST ESTATE TAXATION

    Opposition to the estate tax generally emphasizes five 
negative effects of the tax. The five arguments considered here 
are that the estate tax: inhibits capital accumulation and 
economic growth; threatens the survival of family businesses 
and depresses entrepreneurial activity; hinders income and 
wealth mobility; violates the principles of good tax policy, 
such as simplicity and fairness; and adversely impacts the 
conservation of environmentally sensitive land.

A. Economic growth

    Of all taxes imposed by the federal government, the estate 
tax is one of the most harmful to economic growth when measured 
on a per-dollar-of-revenue-raised basis.\72\ Although 
relatively small in terms of revenue raised, the estate tax 
exerts a disproportionately negative impact on the economy. At 
its basest level, the estate tax adds yet another layer to the 
already heavy taxation of savings and investment. Most of these 
savings have already been previously subjected to the income 
tax at least once.
---------------------------------------------------------------------------
    \72\ Of course, the true net revenue yield of the estate tax may be 
significantly closer to zero. If so, the ratio of costs to revenue 
raised is much higher.
---------------------------------------------------------------------------
    The negative economic effects primarily manifest in three 
ways. First, the estate tax has excessively high compliance 
costs. Although it is possible to largely avoid estate taxes, 
doing so requires substantial expenditures and undesired 
allocation of resources.\73\ Alicia Munnell, a member of 
President Clinton's Council of Economic Advisers, estimated 
that the costs of complying with estate tax laws are roughly 
the same size as the revenue raised. Specifically, in an 
article co-authored with Henry Aaron, Munnell wrote that
---------------------------------------------------------------------------
    \73\ See supra note 60.

          In the United States, resources spent on avoiding 
        wealth transfer taxes are of the same general magnitude 
        as the [revenue] yield, suggesting that the ratio of 
        excess burden to revenue of wealth transfer taxes is 
        among the highest of all taxes.\74\
---------------------------------------------------------------------------
    \74\ Aaron and Munnell, 139.

---------------------------------------------------------------------------
Elsewhere, Munnell has written:

          The compliance, or more appropriately, the avoidance 
        costs of the transfer tax system may well approach the 
        revenue yield.\75\
---------------------------------------------------------------------------
    \75\ Alicia H. Munnell, ``Wealth Transfer Taxation: The Relative 
Role for Estate and Income Taxes,'' New England Economic Review, 
Federal Reserve Bank of Boston (November/December 1988): 19.

The estate tax is expected to raise $28 billion in fiscal year 
2006. If the estate tax generates $1 in compliance costs for 
every $1 in revenue, then the aggregate cost of the estate tax 
would amount to roughly $56 billion in 2005: $28 billion in 
revenue costs and $28 billion in avoidance costs. Thus, for 
every dollar of tax revenue raised by the estate tax, another 
dollar is wasted simply to comply with or avoid the tax.
    A 2001 report from Douglas Holtz-Eakin (former Director of 
the Congressional Budget Office) and Donald Marples provides 
estimates of the distortion costs of the estate tax that are 
consistent with the figures above. Holtz-Eakin and Marples 
report that the distortion costs of the estate tax are 
equivalent to approximately 26 percent of pre-retirement 
savings.\76\ Over the years 2001-2005, these costs averaged $34 
billion per year.\77\
---------------------------------------------------------------------------
    \76\ Douglas Holtz-Eakin and Donald Marples, ``Estate Taxes, Labor 
Supply, and Economic Efficiency,'' Special Report, American Council for 
Capital Formation (January 2001).
    \77\ Joint Economic Committee calculations using the methodology 
described in Holtz-Eakin and Marples, ``Estate Taxes,'' supra note 76; 
and inflation-adjusted (2005 dollars) data from U.S. Department of 
Commerce, Bureau of Economic Analysis, ``Personal Income and Its 
Disposition,'' Tables 2.1 and 1.1.9, online at http://www.bea.gov/bea/
dn/nipaweb/index.asp.
---------------------------------------------------------------------------
    Second, the estate tax results in significant economic 
inefficiencies. For example, Holtz-Eakin and Marples have found 
that replacing the estate tax with a simple capital income tax 
would increase economic efficiency.\78\ A 1988 study by Roger 
Gordon and Joel Slemrod found that differences in the rate of 
taxation on capital exacerbate distortions caused by the tax 
system.\79\ In tandem with the high compliance costs, the 
distortions caused by the estate tax decrease economic 
efficiency and serve as a negative influence on economic 
growth.
---------------------------------------------------------------------------
    \78\ Douglas Holtz-Eakin and Donald Marples, ``Distortion Costs of 
Taxing Wealth Accumulation: Income Versus Estate Taxes,'' National 
Bureau of Economic Research, Working Paper 8261 (April 2001), 21.
    \79\ Roger H. Gordon and Joel Slemrod, ``Do We Collect Any Revenue 
from Taxing Capital Income,'' in Tax Policy and the Economy, vol. 2, 
ed. Lawrence H. Summers, 89-130 (Cambridge, MA: MIT Press, 1988).
---------------------------------------------------------------------------
    Finally, the estate tax is a tax on capital, and ultimately 
reduces the amount of capital in the economy. This effect 
results both from reduced incentives to save and invest, and 
because the tax forces privately held assets to be liquidated 
and transferred to governmental control. Wealth that would 
otherwise serve productive uses in the economy as capital 
assets shifts to consumption-intensive government uses. Holtz-
Eakin and Marples, for example, have reported a clear and 
significant negative relationship between capital accumulation 
and estate taxes.\80\ Similarly, James Poterba, an economist at 
the Massachusetts Institute of Technology, has estimated that 
the federal estate tax increases the effective tax burden on 
capital income by 1.3 to 1.9 percentage points.\81\
---------------------------------------------------------------------------
    \80\ Holtz-Eakin and Marples, ``Distortion Costs of Taxing Wealth 
Accumulation.'' See also Kopczuk and Slemrod, ``Wealth Accumulation.''
    \81\ James Poterba, ``The Estate Tax and After-Tax Investment 
Returns,'' University of Michigan, Office of Tax Policy Research, 
Working Paper 98-11 (December 1997), 17, 40.
---------------------------------------------------------------------------
    By reducing the after-tax return on investment, the estate 
tax encourages consumption and discourages savings, which in 
turn cause the capital stock to grow at a slower rate. To 
illustrate this effect, consider a situation where parents must 
choose between leaving an asset to their children or consuming 
it themselves. When faced with a 46 percent marginal tax rate, 
the ``price'' of bequeathing $1 is $1.85 (i.e., in order for an 
heir to receive $1, the decedent must leave $1.85 in pre-tax 
assets). Alternatively, the parents could consume significantly 
more of that $1.85 for their own benefit. In the presence of 
high marginal estate tax rates, the decision between 
consumption and saving is significantly biased in favor of 
consumption. In his public finance textbook, Stiglitz, while 
admitting to some ambiguity, argues that on balance estate 
taxes ``probably'' reduce savings.\82\
---------------------------------------------------------------------------
    \82\ Joseph E. Stiglitz, Economics of the Public Sector, 1st ed. 
(New York: W.W. Norton & Company, 1986), 487.
---------------------------------------------------------------------------
    In addition, the U.S. imposes one of the heaviest tax 
burdens on estates among industrialized economies. According to 
an American Council for Capital Formation survey of 50 nations, 
the average tax rate on estates is just 24 percent.\83\ With a 
top estate tax rate of 46 percent in 2006, family businesses 
and intergenerational transfers are at a significant 
disadvantage internationally. Only Japan and South Korea have 
steeper tax rates on estates than the U.S. Nearly half the 
countries surveyed--including Canada, China, Australia, Mexico, 
Russia, India, Sweden and Switzerland--have no death tax 
whatsoever.
---------------------------------------------------------------------------
    \83\ American Council for Capital Formation, ``New International 
Survey Shows U.S. Death Tax Rates among Highest,'' Special Report (July 
2005), online at http://www.accf.org.
---------------------------------------------------------------------------
    A comprehensive estimate of all the negative impacts of the 
estate tax on the economy is beyond the scope of this paper. 
However, an econometric framework is available for analyzing 
the effect of the estate tax on the existing capital stock. 
According to published research, every $1 reduction in the 
annual flow of intergenerational transfers is associated with a 
corresponding loss of roughly $39 in the long-run amount of 
capital in the economy.\84\ The 1998 Joint Economic Committee 
study The Economics of the Estate Tax estimated that the effect 
of the estate tax on capital accumulation in 1995 was a loss of 
approximately $497 billion. Using the same methodology, but 
with updated data, the present study estimates that the estate 
tax has reduced the stock of capital in the economy by 
approximately $847 billion, or 3.8 percent.\85\ To put this 
figure in perspective, the estate tax raised $761 billion (in 
inflation-adjusted dollars) over 1942 to 2001. While it is 
likely that some of these tax payments would have been consumed 
instead of saved, it is also likely that considerably more 
resources would have been transferred intergenerationally due 
to increased saving, reduced compliance costs and compounding. 
The estimate of lost capital does not account for any of the 
incentive, compliance or distortion effects noted above.
---------------------------------------------------------------------------
    \84\ Laurence J. Kotlikoff and Lawrence H. Summers, ``The Role of 
Intergenerational Transfers in Aggregate Capital Accumulation,'' 
Journal of Political Economy 89, no. 4 (1981): 706-732; and Laurence J. 
Kotlikoff and Lawrence H. Summers, ``The Contribution of 
Intergenerational Transfers to Total Wealth: A Reply,'' in Modelling 
the Accumulation and Distribution of Wealth, eds. Denis Kessler and 
Andre Masson, 53-76 (Oxford, England: Clarendon Press, 1988).
    \85\ The estimate of $847 billion represents the long-run increase 
in private fixed assets that would exist in 2001 if the estate tax did 
not exist. The estimate was calculated as the steady-state amount of 
capital that would result if all estate tax payments were instead 
passed from one generation to the next. For a more detailed description 
of the methodology used to quantify the impact on capital accumulation, 
see the Methodology Appendix in Miller, The Economics of the Estate 
Tax, 36-39.
---------------------------------------------------------------------------
    Thus, if the estate tax had not existed over the last 
several decades, the amount of capital in the economy would be 
nearly $850 billion higher. Since capital is a fundamental 
ingredient for economic growth, the loss of such capital 
reduces economic output. Although the exact magnitude of the 
impact on economic growth is difficult to assess, the direction 
of the effect is unambiguously negative.\86\
---------------------------------------------------------------------------
    \86\ Nishiyama (supra note 20) provides an alternative perspective 
confirming this finding. Simulating the effect of a 100 percent estate 
and gift tax, Nishiyama found that gross national product (GNP) would 
drop by between 3.6 percent and 4.9 percent. National wealth would fall 
even further, declining 11 percent to 16 percent.
---------------------------------------------------------------------------

B. Family businesses and entrepreneurial activity

    In addition to the aggregate effect on capital accumulation 
and economic efficiency, the estate tax exerts a strongly 
negative influence on entrepreneurial activity. 
Entrepreneurship infuses the economy with risk-takers willing 
to exploit new technologies and enables families to achieve 
upward income mobility. By hindering entry into self-employment 
and by breaking up family-run businesses, the estate tax 
inhibits economic efficiency and stifles innovation.
    Prior to EGTRRA, the tax code offered family businesses 
some limited estate tax relief. The chief provision was a 
deduction for qualified family-owned businesses that allowed 
such firms to shelter up to $1.3 million from estate taxation. 
However, EGTRRA repealed this provision effective in 2004, when 
the unified credit increased to allow all estates to shield 
$1.5 million in assets, thus superseding the older provision. 
Other provisions preserved in EGTRRA for family-run businesses 
include the ability to apply to the IRS to pay estate tax bills 
in installments over 14 years. This feature is useful for 
family farms, which may be asset-rich but cash-poor. Family 
businesses may also attempt to apply special valuation rules to 
their enterprise, which allow them to be valued at their 
current actual usage (subject to caps on the reduction in 
value), rather than at a potentially more valuable usage. 
EGTRRA made it easier for family businesses to qualify for 
these benefits.
    Although these tax provisions provide some relief, they are 
often inadequate to prevent the estate tax from breaking up 
many family businesses. A 2005 article in Tax Notes dissects 
estate tax relieftargeted at family businesses to find that 
such provisions are of limited value. The complexity of the relevant 
laws and regulations is sufficient to deter many law firms from even 
considering seeking such relief for their clients.\87\
---------------------------------------------------------------------------
    \87\ William W. Beach, Harold I. Apolinsky and Craig M. Stephens, 
``Targeted Family Business Carveout Fails to Avoid Estate Tax,'' Tax 
Notes (4/18/2005): 365-368.
---------------------------------------------------------------------------
    The actual usage patterns of the family business provisions 
reflect this conclusion. Prior to EGTRRA, there were three 
provisions primarily aimed at providing relief to small and 
family-owned businesses: special ``current use'' valuation 
(Internal Revenue Code sec. 2032A), an additional exemption for 
qualified family-owned businesses (sec. 2057), and extended 
payment period (sec. 6166). In 1999, there were 103,979 estate 
tax returns filed, of which 11,0196 returns included a closely-
held business interest.\88\ Of these firms, just 225 estates 
took advantage of the special use valuation, and 888 made use 
of the exemption for family business; a relatively meager 524 
returns elected to use the extended payment option.\89\
---------------------------------------------------------------------------
    \88\ Internal Revenue Service.
    \89\ U.S. Congress, Joint Committee on Taxation, Description and 
Analysis of Present Law and Proposals Relating to Federal Estate and 
Gift Taxation, JCX-14-01 (3/14/2001), 34.
---------------------------------------------------------------------------
    IRS data indicate that between 1995 and 2004, more than 
37,000 estates that paid estate taxes included closely-held 
businesses among their assets, and that these closely-held 
business assets were worth a cumulative total of $67 billion in 
2005 dollars.\90\ In addition, taxable estate tax returns 
included 24,000 with farm assets, 50,000 with limited 
partnerships, and nearly 28,000 with other noncorporate 
businesses over the last ten years (Figure 5).\91\ The assets 
in these three categories had a cumulative value of $37 
billion. Thus, tens of thousands of small and family 
businesses, worth $104 billion, were subject to the estate tax 
over the last ten years. These data clearly indicate that the 
estate tax has broad and significant costs for thousands of 
family businesses.
---------------------------------------------------------------------------
    \90\ This is a conservative estimate of the number of firms 
affected by the estate tax since it ignores businesses that did not pay 
estates taxes, either because they expended enough resources to avoid 
the tax or because the costs of estate planning impeded the growth of 
such firms. Joint Economic Committee calculations based on data from 
Internal Revenue Service.
    \91\ Note that these tax data only list farm assets and do not 
include the value of farmland (which is included in the broad category 
of real estate assets). However, since the presence of farm assets 
likely correlates closely with farm businesses, the number of taxable 
returns with farm assets is a reasonable proxy for the number of farm 
businesses. 


    Survey data suggest that the estate tax continues to be a 
primary reason why small businesses fail to survive beyond one 
generation. Close to two-thirds (64 percent) of respondents in 
one survey of family businesses reported that the estate tax 
makes survival of the business more difficult.\92\ In other 
surveys, 87 percent of black-owned firms and 93 percent of 
manufacturing firms responded that the estate tax was an 
impediment to survival.\93\ A survey of family business owners 
by Prince & Associates found that 98 percent of heirs cited 
``needed to raise funds to pay estate taxes'' when asked why 
family businesses fail.\94\ Even if only a small percentage of 
the 550,000 small businesses that fail annually are 
attributable to the estate taxes, the cumulative number 
affected over time could be substantial.\95\ In the context of 
the survey and tax data described here, it is easy to see how 
the estate tax has contributed to the failure of thousands of 
small and family-run businesses.
---------------------------------------------------------------------------
    \92\ Joseph H. Astrachan and Roger Tutterow, ``The Effect of Estate 
Taxes on Family Business: Survey Results,'' Family Business Review 9, 
no. 3 (Fall 1996): 303-314.
    \93\ Joseph H. Astrachan and Craig E. Aronoff, ``A Report on the 
Impact of the Federal Estate Tax: A Study of Two Industry Groups'' 
(Marietta, GA: Kenneseaw State College, Family Enterprise Center, 
1995).
    \94\ Russ Alan Prince and Karen Maru File, Marketing to Family 
Business Owners (Cincinnati, OH: National Underwriter, 1995), 35.
    \95\ Also, there were an estimated 23.7 million small businesses in 
2003. Joint Economic Committee calculations using 1999-2003 data from 
U.S. Small Business Administration, Office of Advocacy, The Small 
Business Economy (Washington, DC: Government Printing Office, 2004), 
and data online at http://www.sba.gov/advo/index.html.
---------------------------------------------------------------------------
    Estate tax planning is crucial for the succession of family 
businesses to the next generation. The presence of the estate 
tax already makes such succession planning unnecessarily 
complicated and painful. Yet the current situation in which the 
level of estate taxation is uncertain precludes sound planning. 
As the law now stands, the estate tax will slowly be phased out 
over the next few years until it is completely repealed in 
2010. However, effective January 1, 2011, the repeal itself is 
revoked, and the estate tax returns to the level that existed 
in 2001. Thus, a difference in death of just a single day could 
mean the difference between no estate tax at all or extremely 
punitive taxation.
    The estate tax represents a significant barrier to small 
and family-run businesses. Research showing this fact comes 
from Holtz-Eakin and Marples, who wrote in 2001 (prior to the 
estate tax phase-down and repeal in EGTRRA):

          The study shows that entrepreneurs face an expected 
        estate tax liability that is typically nearly five 
        times as large as that of non-entrepreneurs. Of course, 
        one might immediately suspect that entrepreneurs, 
        especially those who survive to later in their working 
        careers, are simply more successful. The data, however, 
        show that simply having greater wealth is not the whole 
        story; instead, entrepreneurs face significantly higher 
        average and marginal tax rates because of the type of 
        investments they make.\96\ (emphasis added)
---------------------------------------------------------------------------
    \96\ Holtz-Eakin and Marples, ``Estate Taxes, Labor Supply, and 
Economic Efficiency,'' 4.

    Not only do entrepreneurs face higher tax rates, but they 
are also less likely to have the resources needed to meet their 
estate tax liabilities. Facing high estate tax rates, many 
business owners purchase life insurance to provide their heirs 
with additional liquid resources to pay the estate tax. 
However, even the addition of life insurance payments leaves 
businesses with insufficient resources. Researchers Holtz-
Eakin, John W. Philips and Harvey Rosen, writing in a 1999 
---------------------------------------------------------------------------
study, reported:

          Our results suggest that owners of businesses buy 
        more [life] insurance than other individuals, but even 
        together with the liquid assets in their portfolios, 
        there is insufficient money to cover estate taxes.\97\
---------------------------------------------------------------------------
    \97\ Douglas Holtz-Eakin, John W. Phillips and Harvey S. Rosen, 
``Estate Taxes, Life Insurance, and Small Business,'' National Bureau 
of Economic Research, Working Paper 7360 (September 1999), 23.

    The principal reason that estate taxes cause such 
disruption to family businesses is that they impose large cash 
demands on firms that generally have limited access to liquid 
assets. For example, the typical small business owner has 60 
percent of the family net worth invested in the business.\98\ 
Smaller firms, typically lacking access to capital from 
financial markets, may be unable to obtain the optimal amount 
of capital to finance their investments. Intergenerational 
transfers function, in essence, as a sort of internal financing 
mechanism. To the degree that estate taxes reduce or limit 
intergenerational transfers, they also reduce the amount of 
financing available for investment in small or family-run 
enterprises.
---------------------------------------------------------------------------
    \98\ John L. Ward, Drew Mendoza, Joseph H. Astrachan, and Craig E. 
Aronoff, ``Family Business: The Effect of Estate Taxes'' (Chicago, IL: 
Center for Family Business and Family Enterprise Center, 1995), 29.
---------------------------------------------------------------------------
    Inheritances play an important role in alleviating the 
liquidity constraints that impede the formation and success of 
small businesses. A 1994 study found that individuals who 
receive an inheritance are more likely to become self-employed, 
and those who are already self-employed are more likely to 
remain so.\99\ Overall, the authors estimate that receiving a 
$270,000 inheritance results in a 1.3 percentage point increase 
in survival probability and a 20 percent increase in gross 
receipts.\100\ Larger inheritances would further improve 
survival probabilities.
---------------------------------------------------------------------------
    \99\ Douglas Holtz-Eakin, David Joulfaian and Harvey S. Rosen, 
``Sticking It Out: Entrepreneurial Survival and Liquidity 
Constraints,'' Journal of Political Economy 102, no. 1 (February 1994): 
68-71.
    \100\ Holtz-Eakin, Joulfaian and Rosen estimate the effect to be 
$150,000 in 1985 dollars. When adjusted for inflation (using the 
consumer price index), that amount translates to $272,258 in 2005 
dollars.
---------------------------------------------------------------------------

C. Social mobility

    The estate tax also has consequences for social mobility. 
Limiting intergenerational transfers impedes the ability of 
families to climb the economic ladder from one generation to 
the next. For many parents, bequeathing accumulated savings to 
their children may allow the succeeding generation to move into 
higher wealth or income groups. For others, passing on the 
family business creates the opportunities needed for heirs to 
improve their economic well-being.
    To the degree that the estate tax disrupts the transmission 
of family wealth to succeeding generations, the estate tax 
hinders upward income mobility. Entrepreneurship is a key means 
by which lower-income households move to a higher income class. 
For instance, one study found that low-wealth workers who 
become self-employed are more than twice as likely to move to a 
higher wealth class than are individuals who continue 
traditional work.\101\ Research shows that blacks are more 
likely to become self-employed if their parents are self-
employed, and that self-employed black and Hispanic men have 
higher long-run earnings than their wage and salary 
counterparts.\102\ By making it more difficult for minorities 
to continue a family business, the harmful effects of estate 
taxes are magnified for black-, Hispanic- and Asian-owned 
enterprises.
---------------------------------------------------------------------------
    \101\ Vincenzo Quadrini, ``Entrepreneurship, Saving and Social 
Mobility,'' Federal Reserve Bank of Minneapolis, Discussion Paper 116 
(March 1997).
    \102\ Robert W. Fairlie, ``The Absence of the African-American 
Owned Business: An Analysis of the Dynamics of Self-Employment,'' 
Journal of Labor Economics 17, no. 1 (January 1999): 80-108; and Robert 
W. Fairlie, ``Does Business Ownership Provide a Source of Upward 
Mobility for Blacks and Hispanics?'' in Public Policy and the Economics 
of Entrepreneurship, ed. Douglas Holtz-Eakin and Harvey S. Rosen, 153-
179 (Cambridge, MA, MIT Press, 2004).
---------------------------------------------------------------------------
    Key black business leaders have advocated estate tax 
repeal, arguing that it is only since the Civil Rights Act of 
1964 that blacks have been able to accumulate wealth. Robert L. 
Johnson, the founder of Black Entertainment Television and 
contributor to Democrat political causes, has even argued that 
``Elimination of the estate tax will help close the wealth gap 
in this nation between African-American families and white 
families.'' \103\ Oprah Winfrey has lamented the negative 
aspects of the estate tax on her TV show, saying ``I think it's 
irritating that once I die, 55% of my money goes to the United 
States government . . . You know why that's irritating? Because 
you would have already paid nearly 50%.'' \104\ Harry C. 
Alford, the president and CEO of the National Black Chamber of 
Commerce, summed up the importance of wealth accumulation for 
the black community:
---------------------------------------------------------------------------
    \103\ Ernest Holsendolph, ``Bush Picks up Unexpected Ally in BET 
founder,'' The Atlanta Journal and Constitution, 8/26/2001. See also 
``African-American Business Leaders Call for End to Estate Tax,'' New 
Pittsburgh Courier, 4/11/2001.
    \104\ Oprah Winfrey, as quoted in Editorial, ``Death's Taxes,'' 
Wall Street Journal (7/28/1999).

          We, as a people, have been freed from physical 
        slavery for over 134 years and we have yet to begin 
        building wealth. We cannot begin utilizing all of the 
        advantages of this free economy until we have gained 
        enough wealth to actively participate. It's just not 
        civil rights; civil rights can get you dignity and 
        respect but we need more. It's just not political 
        empowerment; look at Zimbabwe or South Africa where we 
        now have enormous political empowerment but, yet, no 
        power due to lack of Black wealth. Civil rights and 
        political clout are nice but economic empowerment will 
        get you freedom and authority. Freedom and authority 
        are the keys to earthly happiness. . .
          Getting rid of the `death tax' will start to create a 
        needed legacy and begin a cycle of wealth building for 
        Blacks in this country. That would be a great start to 
        breaking the economic chains that bind us.\105\
---------------------------------------------------------------------------
    \105\ Harry C. Alford, ``Blacks Should Help In Doing Away with the 
'DEATH TAX','' National Black Chamber of Commerce, online at http://
www.nationalbcc.org/editorials/article.asp?id=62&scope=editorials 
[accessed 4/19/06].

    A similar sentiment has been expressed by leaders in the 
Hispanic community. The significance of passing a family 
business to the next generation was the subject of a 2004 
article in Hispanic Trends by J.R. Gonzales, former president 
---------------------------------------------------------------------------
of the Hispanic Chamber of Commerce:

          What's happening here is that as Hispanics begin 
        achieving the American Dream, they become more focused 
        on keeping it--passing their hard-earned success to the 
        next generation. While other issues continue to be of 
        concern--immigration, health care and education, in 
        particular--new issues like repeal of the Death Tax 
        begin to move forward.
          These Hispanic business owners have undertaken 
        enormous financial risk: often, they were forced to 
        borrow from friends and family to build their 
        businesses and keep them afloat, and they feel a unique 
        responsibility, as Hispanics, to pass on what they've 
        built to their children.\106\
---------------------------------------------------------------------------
    \106\ J.R. Gonzales, ``The Death Tax: A Menace to 
Entrepreneurship,'' Hispanic Trends (October 31, 2004).

    A 2004 study by Boston College researchers John Havens and 
Paul Schervish shows that much African-American wealth will be 
subject to the estate tax: 29 percent of African-American 
wealth is now held in estates worth $1 million or more.\107\ 
African-Americans are also increasingly likely to be subject to 
the estate tax, with the number of estates worth at least $1 
million increasing by more than 130 percent over the next 
generation.\108\ The authors further estimate that over 2001-
2055, African-American households are likely to pay between 
$192 billion and $257 billion in federal estate taxes.\109\ Put 
another way, the estate tax will wipe out between 11 and 13 
percent of all African-American wealth.
---------------------------------------------------------------------------
    \107\ John J. Havens and Paul G. Schervish, ``Wealth Transfer 
Estimates for African American Households,'' Boston College, Center on 
Wealth and Philanthropy (October 2004), 19.
    \108\ Ibid., Table 10.
    \109\ Ibid., 16-17.
---------------------------------------------------------------------------
    Recent data from the U.S. Census Bureau also suggest that 
minority-owned businesses are increasingly likely to be 
affected by the estate tax. Census Bureau data show that the 
number of Hispanic-, black- and Asian-owned business grew 
rapidly between 1997 and 2002, greatly exceeding the growth 
rate for the rest of U.S. businesses.\110\ As can be seen in 
Table 5, the number of Hispanic-owned firms grew by 31 percent 
between 1997 and 2002. Over the same time period, the number of 
black-owned firms jumped by a dramatic 45 percent, and Asian 
firms rose 23.7 percent. These growth rates far outpace the 6.7 
percent rate for the rest of U.S. businesses. These data imply 
that more minority-owned firms will be affected by the estate 
tax in the future.


    \110\ Data on business ownership come from the 2002 Economic 
Census, Survey of Business Owners. The data presented come from three 
different sources, all published by the U.S. Census Bureau: Black-Owned 
Firms: 2002, SB02-00CS-BLK (4/18/06); Hispanic-Owned Firms: 2002, SB02-
00CS-HISP (3/21/06); and ``Preliminary Estimates of Business Ownership 
by Gender, Hispanic or Latino Origin, and Race: 2002'' (7/28/05), 
available online at http://www.census.gov/csd/sbo/.
---------------------------------------------------------------------------
    Ironically, the more successful Asian-, Hispanic- and 
black-owned firms are the very ones to be hit hardest by the 
estate tax.
    For many low-income minority or ethnic groups, the estate 
tax represents an obstacle to successful family businesses. In 
a 2004 survey of Hispanic business owners by the Impacto Group, 
two out of three (66 percent) respondents said the estate tax 
affects their ability to meet company goals by distracting 
their attention and wasting resources.\111\ Half of all 
respondents in that survey report knowing of a Hispanic small 
business that has experienced hardship because of the estate 
tax liability, including ``selling off'' equipment or the 
business. One quarter of respondents said they themselves would 
sell part of the business to pay the tax, and 10 percent would 
delay expansion of the business. In addition, as previously 
noted, 87 percent of black-owned firms in a 1995 survey 
responded that the estate tax was an impediment to 
survival.\112\
---------------------------------------------------------------------------
    \111\  Impacto Group LLC, ``Five-State Executive Interview Study of 
100+ Hispanic Family-Owned Businesses on Federal Estate Taxes'' 
(Washington, DC: Impacto Group LLC, 7/14/2004).
    \112\ Astrachan and Aronoff.
---------------------------------------------------------------------------
    The experiences of many of the 200-plus black newspapers in 
the U.S. illustrate this point. Many of these firms are family-
run businesses that are struggling to maintain circulation and 
are underfinanced.\113\ For example, The Chicago Defender, 
founded in 1905, was one of the leading African-American 
newspapers in the U.S. for much of the twentieth century. In 
1997, however, the owner and publisher of the newspaper, John 
Sengstacke, died and left a $3 million estate tax liability 
that the family could not afford. The paper was in serious 
danger of going under until a nephew of the owner came forward 
with a proposal to buy the paper.\114\ Although The Chicago 
Defender survived, its story demonstrates how the estate tax 
can threaten the survival of family-businesses with marginal 
financial health.
---------------------------------------------------------------------------
    \113\ Kathy Bergen, ``Black Papers Fight for Life; Population 
Grows, but Readership, Ads in Decline,'' Chicago Tribune, 8/4/2002.
    \114\ Mark J. Konkol, ``Judge Gives Approval to Sale of Defender,'' 
Chicago Sun-Times, 5/2/2002.
---------------------------------------------------------------------------

D. Fairness, simplicity and efficiency

    The estate tax violates the three principles of good tax 
policy: equity (fairness), simplicity and efficiency. The large 
number of tax avoidance options permitted under the estate tax 
means that the tax will result in a tax burden distributed 
unfairly among payers of the tax, will be unnecessarily 
complicated, and will significantly distort taxpayer behavior. 


    In terms of equity and simplicity, the existence of so many 
loopholes virtually guarantees that the estate tax will violate 
the principles of horizontal and vertical equity, as well as 
that of simplicity. An individual worth $5 million can not only 
pay less in estate taxes than other individuals worth $5 
million, but can pay less than those worth $1 million. 
According to IRS data for 2004 returns, the average estate tax 
rate for the largest estates (gross estates over $20 million) 
is actually lower than the average tax rate for estates in the 
$2.5 to $5 million range (Figure 6).\115\ This aspect of estate 
taxation was summarized by Munnell, who wrote:
---------------------------------------------------------------------------
    \115\ Joint Economic Committee calculations based on data from 
Internal Revenue Service.

          Horizontal and vertical equity considerations have 
        disappeared in the estate and gift area; tax 
        liabilities depend on the skill of the estate planner, 
        rather than on capacity to pay.\116\ (emphasis added)
---------------------------------------------------------------------------
    \116\ Munnell, 18.

    An efficient tax is one that raises a given amount of 
revenue while causing the least distortion in behavior. An 
efficient tax should not impede economic growth or change the 
way people behave. As previously noted, Aaron and Munnell 
estimate that the compliance costs of the estate tax are 
---------------------------------------------------------------------------
roughly the same size as the amount of revenue raised:

          In the United States, resources spent on avoiding 
        wealth transfer taxes are of the same general magnitude 
        as the [revenue] yield, suggesting that the ratio of 
        excess burden to revenue of wealth transfer taxes is 
        among the highest of all taxes.\117\
---------------------------------------------------------------------------
    \117\ Aaron and Munnell, 139.

    In 2006, the estate and gift taxes are expected to raise 
$28 billion. However, if the ratio of revenue to costs equals 
one, then the true cost to the economy of these taxes will be 
closer to $56 billion. In other words, for every $1 removed 
from the economy to pay estate taxes, another $1 is wasted in 
order to comply with or legally avoid the tax. The estate tax 
also causes changes in savings, investment and consumption 
behavior.\118\ Measured in these terms, the estate tax is 
highly inefficient.
---------------------------------------------------------------------------
    \118\ For examples of distorations, see supra notes * to Sec. , =, 
*, , Sec. , *, and Sec. , and accompanying text.
---------------------------------------------------------------------------

E. Environmental conservation

    An often overlooked aspect of the estate tax is its harmful 
effect on the environment. The impact manifests when heirs are 
forced to divide up or develop environmentally sensitive land 
in order to pay estate taxes. The problem of estate taxation 
faced by private landowners was addressed in 1995's The 
Keystone Report, the collective efforts of environmentalists, 
landowners, business groups, and government agencies to 
identify and recommend solutions to the problems that private 
landowners face in conserving threatened and endangered species 
and habitats. With regard to estate taxes, The Keystone Report 
found that:

          Federal estate tax requirements are a major obstacle 
        for private landowners whose land stewardship has been 
        sensitive to its environmental value and who would like 
        to be able to pass on their land to their heirs without 
        destroying that value. The imposition of federal estate 
        taxes often forces large parcels of environmentally 
        valuable land to be broken up into smaller, less 
        environmentally valuable parcels. Some of the best 
        remaining habitat for endangered species is put at risk 
        in this manner.\119\
---------------------------------------------------------------------------
    \119\ Keystone Center, The Keystone Dialogue on Incentives for 
Private Landowners to Protect Endangered Species--Final Report 
(Washington, DC: Keystone Center, 1995), 26.

    When the time comes to pay estate taxes, real estate assets 
often generate a substantial tax liability that can only be 
paid by developing the land. The impact is most apparent for 
natural habitats that are destroyed. Endangered species are 
affected as well, since half of all listed species are 
primarily found on privately-owned land.\120\ These effects of 
estate taxation led Michael Bean of The Nature Conservancy to 
label the estate tax as ``highly regressive in the sense that 
it encourages the destruction of ecologically important land in 
private ownership.'' \121\
---------------------------------------------------------------------------
    \120\ U.S. Fish & Wildlife Service, Endangered Species Program, 
``Our Endangered Species Program and How It Works with Landowners'' 
(May 2003), online http://www.fws.gov/endangered/landowner/index.html.
    \121\ Michael J. Bean, ``Shelter from the Storm,'' The New Democrat 
(April 1997).
---------------------------------------------------------------------------
    A 2001 analysis of estates and rural land holdings found 
that estate taxes have a significant impact on land use. 
According to this study, conducted prior to EGTRRA, 
approximately 2.6 million acres of forest land must be 
harvested each year to pay for the estate tax.\122\ Another 1.3 
million acres must be sold to raise funds to pay estate taxes, 
of which close to one-third (29 percent) is either developed or 
converted to other uses. Moreover, 36 percent of forest estates 
incur an estate tax liability, a rate far higher than the 
overall rate in the U.S. population. The estate tax undoubtedly 
is bad for environmentally-important habitats and is a serious 
impediment to preserving endangered and threatened species.
---------------------------------------------------------------------------
    \122\ John Greene, Tamara Cushing, Steve Bullard, and Ted Beauvis, 
``Effect of the Federal Estate Tax on Rural Land Holdings in the 
U.S.,'' in Forest Policy for Private Forestry: Global and Regional 
Challenges, eds. Lawrence D. Teeter, Benjamin Cashore and Dao Zhang, 
211-218 (New York, NY: CABI Publishing, 2003).
---------------------------------------------------------------------------
    In recognition of the adverse environmental impact of 
taxing estates, the federal tax code grants limited estate tax 
relief for qualifying conservation easements, land that is set 
aside for environmental conservation. Land owners are exempt 
from paying estate taxes on the value of land that is lost due 
to the conservation easement (subject to several requirements). 
The Taxpayer Relief Act of 1997 granted estates that donate 
such easements an additional tax deduction worth 40 percent (up 
to a maximum of $500,000) of the remaining value of the land. 
EGTRRA further assisted conservation efforts by repealing a key 
limit on land eligibility, making more land eligible to qualify 
as a conservation easement.\123\
---------------------------------------------------------------------------
    \123\ Public Law No.: 105-34. 
    
    
    Unfortunately the potential benefits of conservation 
easements are curtailed by a number of restrictions and 
limitations that discourage or prevent land owners from taking 
advantage of them. The restrictions that land owners must meet 
in order to qualify for a conservation include the overall 
value of the exclusion amount relative to the size of the 
estate, how long the decedent owned the land and whether or not 
the land acquisition was debt-financed. Other considerations, 
which might discourage use of a conservation easement, include 
the exclusion of the value of any development rights and the 
inability to step-up the land's basis.
    Ultimately, the benefit of conservation easements should be 
measured by their actual usage. Data from the IRS indicate that 
very few estates actually take advantage of the conservation 
easement. In 2004, just 46 estates out of 62,718 estate tax 
returns (0.07 percent) set aside land for conservation 
easements (Table 6).\124\ Over the last five years (2000-2004), 
the total number of conservation easements was just 232 out of 
443,000 returns (0.05 percent). The value of deductions for 
conservation easement is also small, just $11.7 million in 
2004, or 0.004 percent of the value of all estate returns 
reported that year.
---------------------------------------------------------------------------
    \124\ Internal Revenue Service, Statistics of Income Division, 
unpublished data provided by Martha Eller Gangi, 4/3/06.
---------------------------------------------------------------------------
    As these data suggest, the conservation easement provisions 
fall considerably short of remedying the tax's adverse 
environmental impact. Even with the limited conservation 
easement now in place, many estates will not, for a variety of 
reasons, take advantage of the option. Although many 
environmentalists would prefer expanding conservation easement 
options rather than complete repeal of the estate tax, it is 
nonetheless clear that the federal estate tax harmful to 
endangered and threatened species and their habitats.

                             V. CONCLUSION

    This study documents the extensive costs associated with 
the federal estate tax. The detrimental effects of the estate 
tax are grossly disproportionate to the modest amount federal 
revenue it raises (if it raises any net revenue at all). Estate 
taxes result in a large amount of wasted economic activity. 
Over its lifetime, the presence of the estate tax has cost the 
economy roughly $850 billion in capital stock. Moreover, the 
estate tax destabilizes family businesses at one of their most 
vulnerable points, the succession from one generation to the 
next. Not only have the enormous liquidity demands of the 
estate tax have contributed to the break up of thousands of 
small businesses, but the tax also inhibits income and wealth 
mobility. Lastly, the estate tax threatens the destruction of 
environmentally sensitive land. In generating these outcomes, 
the estate tax violates the basic principles of a good tax 
system--simplicity, fairness and efficiency.
    If the estate tax generated sufficiently large benefits, 
then an argument could be made to justify its existence. 
However, the weight of evidence indicates that the estate tax 
lacks sufficiently redeeming qualities. A large and growing 
body of theoretical and empirical research supports the 
contention that the estate tax does little, if anything, to 
reduce inequality. In addition, research indicates that the 
deduction for charitable bequests stimulates little or no 
additional giving. Even the $28 billion in revenue it raises is 
misleading, since estate tax avoidance activities likely 
generate substantial revenue losses under the income tax. In 
short, the estate tax is characterized by significant economic, 
social and environmental costs, yet generates little in the way 
of measurable benefits.
    The estate tax is an unnecessary feature of the current 
federal tax system. The estate tax's punitive tax rates are not 
only the highest of all federal taxes, but are imposed at the 
most inappropriate of times--the death of a loved one. As if 
mourning such a loss were not enough, the federal government 
worsens the pain by seeking to confiscate up to one-half of all 
the decedent's savings, very often accumulated through hard 
work, frugality, deferred consumption and entrepreneurship. 
This final injurious grievance simply strengthens the 
conclusion that the estate tax generates costs to taxpayers, 
the economy and the environment that far exceed any potential 
benefits that it might arguably produce. Based on the facts and 
analysis presented here, there is no compelling reason to even 
have a permanent estate tax, and a number of reasons to 
eliminate the tax altogether. Death and taxes may indeed be 
inevitable, but there is no reason the two have to converge 
simultaneously.



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    Online at http://www.census.gov/csd/sbo/.
U.S. Congress, Congressional Budget Office. The Economic and 
    Budget Outlook: Fiscal Years 2006-2015. Washington, DC: 
    Congressional Budget Office, 2005.
----. The Economic and Budget Outlook: Fiscal Years 2007-2016. 
    Washington, DC: Congressional Budget Office, 2006.
U.S. Congress, Joint Committee on Taxation. Description and 
    Analysis of Present Law and Proposals Relating to Federal 
    Estate and Gift Taxation. JCX-14-01 (3/14/2001).
----. ``Estimated Budget Effects of the Revenue Provisions 
    Contained in the President's Fiscal Year 2006 Budget 
    Proposal.'' JCX-10-05 (3/9/2005).
U.S. Department of Commerce, Bureau of Economic Analysis. 
    ``Personal Income and Its Disposition.'' Tables 2.1 and 
    1.1.9. Online at http://www.bea.gov/bea/dn/nipaweb/
    index.asp.
U.S. Department of Health and Human Services, Center for 
    Disease Control. National Vital Statistics Reports 53, no. 
    21 (June 28, 2005). Data updated 2/15/2006.
U.S. Fish & Wildlife Service, Endangered Species Program. ``Our 
    Endangered Species Program and How It Works with 
    Landowners.'' May 2003. Online at http://www.fws.gov/
    endangered/landowner/index.html.
U.S. Small Business Administration, Office of Advocacy. The 
    Small Business Economy. Washington, DC: Government Printing 
    Office, 2004.
Verbit, G.P. ``Do Estate and Gift Taxes Affect Wealth 
    Distribution?'' Trusts & Estates 117, no. 10 (October 
    1978): 598-616.
Ward, John L., Drew Mendoza, Joseph H. Astrachan, and Craig E. 
    Aronoff. ``Family Business: The Effect of Estate Taxes.'' 
    Chicago, IL and Marietta, GA: Center for Family Business 
    and Family Enterprise Center, 1995.
Wolff, Edward N. ``Bequests, Saving, and Wealth Inequality: 
    Inheritances and Wealth Inequality, 1989-1998.'' American 
    Economic Review 92, no. 2 (May 2002): 260-264.
  Five Challenges That China Must Overcome To Sustain Economic Growth


                            I. INTRODUCTION

    Since 1979, reform has transformed the People's Republic of 
China (PRC) from an impoverished autarkic socialist economy 
into a vibrant mixed economy that is open to international 
trade and investment. This study describes the genesis of 
economic reform under Paramount Leader Deng Xiaoping from 1979 
to 1992 and reviews the subsequent performance of the Chinese 
economy.
    Despite its success, the PRC confronts five serious 
challenges that it must overcome to sustain rapid economic 
growth in the future:
           unfavorable demographics;
           corruption and a weak rule of law;
           financially distressed state-owned 
        enterprises (SOEs) and state-influenced enterprises 
        (SIEs);
           a dysfunctional financial system; and
           domestic and international imbalances.
    The PRC's response to these challenges will, of course, 
determine the future performance of the Chinese economy. 
However, since the Chinese economy is so large and well 
integrated into the global economy, the performance of the 
Chinese economy will also affect the performance of the United 
States and other economies throughout the world.
    So far, the PRC's approach to reform has been incremental. 
This study concludes that this incremental approach may be 
reaching the limits of its effectiveness. The economic 
challenges that the PRC now faces are deeply interrelated. A 
more comprehensive approach to reform is needed.

                     II. GENESIS OF ECONOMIC REFORM

    Between 1979 and 1992, the Communist Party of China (CPC) 
lost its political legitimacy. The excesses of the Cultural 
Revolution repulsed the Chinese people and eroded their belief 
in communism as an ideology.\1\ The contrast between the rapid 
development of the Japanese, South Korean, and other market-
oriented economies in northeast and southeast Asia and the lack 
of development in the Chinese economy demonstrated the failure 
of communism as an economic system. Finally, the fall of the 
Berlin Wall in 1989 and the dissolution of the Soviet Union in 
1991 undermined their confidence in communism as a political 
system.
---------------------------------------------------------------------------
    \1\ On May 16, 1966, Chairman Mao Zedong launched the Great 
Proletarian Cultural Revolution to regain some of the political power 
that he had lost to CPC rivals after the economic disaster of the Great 
Leap Forward. During the next two years, Mao's wife, Jiang Qing, and 
other supporters organized the Red Guards to seize control of party 
organizations and government organs. Because of this power struggle, 
millions of Chinese died, were imprisoned, or were injured. Although 
Mao officially terminated the Cultural Revolution in 1969, historians 
date the end of the Cultural Revolution to the arrest of the Gang of 
Four (i.e., Jiang Qing and three of her associates, Zhang Chunqiao, Yao 
Wenyuan, and Wang Hongwen) in 1976.
---------------------------------------------------------------------------
    Paramount Leader Deng Xiaoping was determined to preserve 
the communist regime in the PRC. After careful study, Deng 
identified several policy errors that contributed to the 
failure of the Soviet Union and its satellites:
           The Soviet economy could not sustain the 
        costs of the Soviet Union's global military 
        confrontation with the United States during the Cold 
        War.
           The liberalization of the political system 
        in Soviet Union and its satellites before economic 
        reforms could produce prosperity allowed dissatisfied 
        electorates to vote the communists out of power.
    To regain political legitimacy, Deng decided that the CPC 
must transform its image, so that the Chinese people would 
perceive the CPC as the provider of their economic prosperity. 
Deng realized that an autarkic socialist economy could not 
deliver prosperity. Therefore, Deng concluded that the PRC had 
to adopt market-oriented economic policies and institutions and 
open itself to international trade and investment.
    While immediate and sweeping policy changes would have sped 
the transformation of the PRC into a market economy, a ``big 
bang'' approach to reform would have also caused severe short-
term dislocations during the transition. Unlike the former 
Soviet satellites, the CPC could have not blamed these 
transition costs on a previous regime. Moreover, any overt 
rejection of communism may have triggered a coup attempt among 
hardliners within the CPC.
    Therefore, Deng decided to introduce economic policy 
changes gradually. Experiments were to be conducted in special 
economic zones, revised on the basis of results, and then 
adopted throughout the PRC. This incremental approach to reform 
would allow the CPC leadership sufficient time to isolate and 
neutralize opponents and to redefine communism. Indeed, the CPC 
has subsequently displayed remarkable ideological flexibility 
(e.g., describing market economics as socialism with Chinese 
characteristics).
    During his trip to southern China during the spring of 
1992, Deng proclaimed a ``bargain'' that still guides the PRC 
today:
     Domestically, the PRC would liberalize the economy 
to provide prosperity to the Chinese people, while the PRC 
would suppress political dissent.
     Internationally, the PRC would pursue ``peaceful 
development'' by:
           opening itself to international trade and 
        investment;
           being a ``good neighbor'' in Asia;
           avoiding direct military confrontations with 
        the United States; and
           securing access to oil and other natural 
        resources even if the PRC must deal with rogue regimes.
    The PRC rejected the failed import-substitution development 
strategies that India and Latin America had pursued in the 
1970s and 1980s and instead copied the successful export-
promotion development strategies of the Japanese, South Korean, 
and other economies in northeast and southeast Asia. The PRC 
relied on exports and foreign direct investment to:
           introduce the price system;
           correctly align domestic incentives; and
           import needed management skills and 
        technology.
    The PRC sought to exploit its comparative advantage in 
abundant low-cost labor with:
           labor-intensive manufacturing of low-tech 
        goods (e.g., apparel, footwear, sporting goods, and 
        toys) for export; and
           labor-intensive final assembly of medium-
        tech consumer electronics and information technology 
        products from imported parts for export.
        
        
                    III. RESULTS OF ECONOMIC REFORM

    Reform has boosted the PRC's economy and improved the 
living standards of its people. Real GDP growth averaged 9.7 
percent from 1979 to 2005 (see Graph 1).\2\ In the first half 
of 2006, the Chinese economy grew at an annualized rate of 10.9 
percent. This growth has lifted 400 million Chinese out of 
poverty.\3\
---------------------------------------------------------------------------
    \2\ China National Bureau of Statistics/Haver Analytics.
    \3\ [U]sing the World Bank's $1 per day income standard, the number 
of poor is estimated to have dropped from about 490 million to 88 
million over the same period, a decline in poverty incidence from 49 
percent in 1981 to 6.9 percent in 2002. World Bank, Shanghai Poverty 
Conference: Case Study Summary (2004).
---------------------------------------------------------------------------
    Reform has made the PRC a major trading power. In 1979, the 
PRC accounted for 1.3 percent of the world's two-way trade in 
goods (see Graph 2).\4\ Real growth in the PRC's two-way trade 
in goods averaged 13.7 percent from 1979 to 2005.\5\ By 2005, 
the PRC accounted for 8.8 percent of the world's two-way trade 
in goods (see Graph 2).\6\
---------------------------------------------------------------------------
    \4\ Excludes intra-European Union goods trade. Author's calculation 
based on International Monetary Fund/Haver Analytics data.
    \5\ International Monetary Fund/Haver Analytics.
    \6\ Excludes intra-European Union goods trade. Author's calculation 
based on International Monetary Fund/Haver Analytics data. 


    While the PRC's trade performance may seem outstanding, it 
is actually quite typical for economies in northeast and 
southeast Asia that followed an export-promotion development 
strategy. During the twenty-six years after the takeoff of 
their economies, Japan, South Korea, and Singapore had similar 
or better trade performances than the PRC (see Graph 3).\7\
---------------------------------------------------------------------------
    \7\ Author's calculation based on International Monetary Fund/Haver 
Analytics data.


    The PRC's heavy reliance on foreign direct investment (FDI) 
distinguishes its development strategy and its post-takeoff 
performance from other populous economies in northeast and 
southeast Asia.\8\ From 1979 to 2005, the PRC received a 
cumulative $633 billion of FDI on a historical cost basis (see 
Graph 4).\9\


    \8\ The ``city-state'' economies of Hong Kong and Singapore are 
also heavily reliant on foreign direct investment.
    \9\ China National Bureau of Statistics/Haver Analytics.
---------------------------------------------------------------------------
    The Chinese subsidiaries of foreign multinational firms 
produced 19.1 percent of the PRC's value-added for industrial 
firms in 2003 (the last year in which comprehensive firm-level 
data are available) \10\ and accounted for 58.3 percent of the 
PRC's exports of goods and 58.7 percent of its imports of goods 
in 2005 (see Graph 5).\11\ Unlike Japan or South Korea twenty-
six years after the takeoff of their economies, the PRC has 
spawned relatively few Chinese multinational firms that 
manufacture own-design, own-brand goods for global markets.
---------------------------------------------------------------------------
    \10\ OECD Economic Survey: China (Paris: Organization for Economic 
Cooperation and Development, 2005): 133.
    \11\ China National Bureau of Statistics/Haver Analytics.
    
    
                      IV. UNFAVORABLE DEMOGRAPHICS

    The first challenge that the PRC must overcome is 
unfavorable demographics. Without significant immigration, the 
PRC's declining fertility rate will cause its working-age 
population to peak in 2015 and then decline. Simultaneously, 
the PRC's increasing longevity rate will swell both the number 
of the elderly and the elderly as a percentage of total 
population.

A. Declining labor force

    Because of the PRC's one-child policy and rising per capita 
income, the PRC's fertility rate fell to 1.70 per woman during 
2000-2005--well below the population maintenance rate (see 
Graph 6). Consequently, the PRC's working-age population (ages 
15-64) will peak in 2015 and then begin to shrink (see Graph 
7).\12\
---------------------------------------------------------------------------
    \12\ United Nations Population Division, World Populations 
Prospects: The 2004 Revision Population Database, http://esa.un.org/
unpp/p2k0data.asp.


    In major cities, the economic boom has already created a 
shortage of highly skilled workers and professionals, boosting 
---------------------------------------------------------------------------
their real compensation. The Financial Times recently reported:

          Five years ago, to employ an engineer in China cost a 
        tenth of the figure in the U.S., says Michael Marks, 
        chairman of Flextronics, a U.S.-listed company that is 
        the world's second biggest contract manufacturer for 
        the electronics industry. ``Today the difference is 
        only half.'' \13\
---------------------------------------------------------------------------
    \13\ Peter Marsh, ``Foreign Makers Find Advantages on More Familiar 
Turf,'' Financial Times (May 7, 2006).

    Real compensation for less skilled or unskilled workers has 
also begun to grow, but at a slower pace. Because of higher 
labor costs, the ``China price''--the price that major 
retailers (e.g., Walmart, Carefour) are willing to pay to their 
suppliers based on the cost of importing similar goods from 
China--increased for the first time in 2005.\14\
---------------------------------------------------------------------------
    \14\ Tom Mitchell, ``How China is Handling Cost Rises by Boosting 
Value,'' Financial Times (May 7, 2006).
---------------------------------------------------------------------------
    Currently, the PRC has a ``floating population'' of about 
140 million unemployed or underemployed people. At the PRC's 
current growth rate, however, these ``floaters'' will be fully 
absorbed into the economy by 2015.
    Consequently, the PRC cannot remain a low-wage economy. 
After 2015, labor shortages should significantly increase the 
real compensation of all Chinese workers. This will force the 
PRC to shed many of its current jobs in labor-intensive 
industries and assembly operations. To foster continued 
economic growth, the PRC will need to climb the ``development 
ladder'' by
           encouraging Chinese firms to develop their 
        own brands and designs;
           switching from labor-intensive to capital-
        intensive manufacturing; and
           expanding the service sector.

B. Graying population

    Higher living standards have boosted the PRC's life 
expectancy at birth to 71.5 years during 2000-05 (see Graph 
8).\15\ Since the increase in longevity is expected to 
continue, the PRC's elderly population should increase from 100 
million, or 7.6 percent of the total population, to 320 
million, or 23.0 percent of the total population, in 2045.\16\ 
Consequently, the elderly support ratio (i.e., the ratio of 
elderlyChinese to working-age Chinese) is expected to drop from 
9.3 in 2005 to 2.7 in 2045 (see Graph 9).\17\


    \15\ United Nations Population Division, World Populations 
Prospects: The 2004 Revision Population Database (2004). Found at: 
http://esa.un.org/unpp/p2k0data.asp.
    \16\ Author's calculation based on the United Nations Population 
Division data.
    \17\ Ibid.
---------------------------------------------------------------------------
    Unlike other major economies, the PRC lacks a comprehensive 
system of either government old-age pensions or private 
retirement saving plans. Reform eliminated Mao's ``iron rice 
bowl'' system under which state-owned enterprises provided 
their workers with comprehensive social-welfare benefits. 
Today, only 15 percent of urban workers are eligible for 
government old-age pensions.\18\ Few private retirement plans 
are available. Consequently, the elderly must rely on their own 
savings or their family for retirement income. 


    \18\ The PRC has a pay-as-you-go defined benefit old-age pension 
plan for urban workers in the formal sector. Employers pay a payroll 
tax equal to 20 percent of an employee's base wage or salary. Covered 
employees are eligible for an old-age pension of 20 percent of the 
average wage in their locality after (1) completing fifteen years of 
service and (2) reaching the age of 60 for men, 50 for woman in manual 
labor, and 55 for other women. In addition, employees must contribute 
an additional 8 percent of their base wage or salary to defined 
contribution plans, of which 5 percentage points goes to a government 
notional plan and 3 percentage points goes to individual accounts. Upon 
retirement, annuity payments from the government notional plan are 
based an employee's notional balance divided by 120. Urban workers in 
the informal sector, rural workers, and self-employed individuals are 
not eligible for any of these plans.
---------------------------------------------------------------------------
    The lack of a government social safety net and the limited 
availability of consumer credit, insurance products, and 
private retirement plans drive Chinese households to save 
prodigious sums. In 2005, the PRC's gross saving rate was 49.1 
percent of GDP (see Graph 10).\19\ The PRC's gross saving rate 
is extraordinarily high compared to other major economies (see 
Graph 11). Until the PRC develops a comprehensive social safety 
net and deepens its market for financial services, Chinese 
households are unlikely to reduce their extraordinarily high 
saving rate. Consequently, the PRC may incur difficulties 
shifting from export-led to domestic consumption-driven 
economic growth. 


    \19\ Author's calculation based upon data from China National 
Bureau of Statistics/Haver Analytics.
---------------------------------------------------------------------------

                  V. CORRUPTION AND A WEAK RULE OF LAW

    The PRC has adopted a ``rule by law,'' but still lacks a 
``rule of law.'' Although there have been significant 
procedural improvements in the drafting of legislation, many 
Chinese laws and regulations \20\ still lack clarity, their 
enforcement may be arbitrary, and courts are subject to 
political influence. Consequently, property rights are 
insecure.
---------------------------------------------------------------------------
    \20\ Central and subsidiary governments now publish proposed laws 
and regulations and provide time for public comments before enactment. 
Public hearings have caused officials to modify some proposed laws and 
regulations.
---------------------------------------------------------------------------
    Individuals and private firms must rely on guanxi (i.e., 
connections) with officials to protect themselves and their 
property. During the last quarter century, economic reform has 
produced a de facto political decentralization that has allowed 
officials to exploit their guanxi to enrich themselves and 
their families through corruption.
    While the PRC is nominally a unitary state, it has many 
levels of subsidiary government--provinces, prefectures, 
cities, counties, towns, and villages. The central government 
is quite small, employing about 500,000 of the estimated 36 
million working in governmental functions.\21\
---------------------------------------------------------------------------
    \21\ China in the Global Economy, ``Civil Service Reform in China'' 
(Paris: Organization for Economic Cooperation and Development, 2005): 
55-60.
---------------------------------------------------------------------------
    The PRC's government is organized as a matrix. Each 
department in the central government is paired with similar 
departments in subsidiary governments. Policy is vertical 
(i.e., the heads of central government departments in Beijing 
determine policy and direct its implementation through similar 
departments in subsidiary governments), but administration is 
horizontal (i.e., the heads of subsidiary governments make 
personnel decisions and fund the operations of all departments 
in their subsidiaries).
    Under Mao, the PRC's government functioned as a hierarchal 
structure since the central government tightly controlled the 
economy. Reform has allowed local party leaders to acquire 
great wealth through legitimate business investments and 
various corrupt payments. Both legitimate tax receipts from a 
booming economy and corrupt payments have also reduced the 
financial dependency of subsidiary governments on central 
government transfers. Together these changes have limited the 
central government's ability to implement policy changes and 
control corrupt practices. Employees in local departments may 
have greater loyalty to local government officials and party 
leaders than to department heads in Beijing. The Chinese use an 
old proverb to describe this problem, ``The mountain is high, 
and the emperor is far away.''
    Corruption is both widespread and costly in the PRC. 
Transparency International reported that the PRC scored 3.2 on 
its Corruption Perceptions Index 2005 (10 is corruption-
free).\22\ Chinese economist Angang Hu \23\ estimated that 
corruption costs the PRC's government an amount to equal 15 
percent of GDP in lost revenue and skimmed funds.\24\ The China 
Economic Quarterly (2005) reported that provincial and local 
government officials extracted the equivalent of 91 percent of 
the profits of private firms in 2003 through non-tax costs, 
including fees, tanpai (i.e., forced expenditures on unwanted 
provincial or local goods or services), or zhaodai (i.e., the 
entertainment of provincial or local government officials).\25\
---------------------------------------------------------------------------
    \22\ Transparency International Corruptions Practices Index 2005, 
found at http://transparency.org.
    \23\ The family name of this Chinese economist is listed last, 
according to western fashion.
    \24\ Julie Chao, ``China is Losing Battle with Corruption,'' 
Milwaukee Journal Sentinel (December 8, 2002).
    \25\ China Economic Quarterly (First Quarter 2005): 48.
---------------------------------------------------------------------------
    Indigenous creative industries could create new high-skill, 
high-wage jobs to replace the low-skill, low-wage jobs in 
labor-intensive manufacturing and assembly operations that the 
PRC is likely to lose in future years. However, corruption 
stifles the development of indigenous creative industries that 
depend on secure intellectual property rights.
    Corruption, particularly the uncompensated seizure of land 
for development, fuels growing unrest. The reported number of 
mass protests soared ten-fold over twelve years, reaching 
87,000 protests in 2005 (see Graph 12).\26\ The central 
government has responded to the growing number of mass protests 
by:
---------------------------------------------------------------------------
    \26\ Found at: http://www.chinabalancesheet.com/Documents/
Data_Domestic_Sociopolitical.PDF. 
---------------------------------------------------------------------------
           acknowledging problems;
           appeasing ordinary protestors by making 
        superficial changes (e.g., dismissing and prosecuting 
        corrupt local officials); and
           punishing protest leaders to prevent local 
        protests from coalescing into a national movement.
    So far, the central government has been able to contain 
local protests. How successful this strategy will be in future 
is difficult to predict. 


VI. FINANCIALLY DISTRESSED STATE-OWNED ENTERPRISES AND STATE-INFLUENCED 
                              ENTERPRISES

    Early economic reforms that introduced the price system and 
profit incentives to the SOEs did not significantly improve 
their performance. Consequently, President Jiang Zemin 
announced the zhuada fangxiao policy (i.e., grab the big, dump 
the small) at the Fifteenth Party Congress in 1997. Under this 
policy, the central government retained ownership of state-
owned enterprises that:
           produce defense goods and services;
           are in industrial sectors targeted for 
        economic development; or
           are hopelessly insolvent, but employ 
        millions.
    The central government has transformed many of the large 
state-owned enterprises that it had retained into shareholding 
enterprises by issuing minority shares to investors. While 
shareholding enterprises exhibit many of the characteristics of 
private corporations, the central government still exercises 
effective control over their operations. At year-end 2005, the 
central government still controlled 66 percent of the market 
value of all shareholding enterprises through non-marketable 
shares. In the Australian Financial Review, Stephen Wyatt 
concluded:

          In fact, the entire privatization of China's state-
        owned enterprises is still more hype than reality. . . 
        . The government's strategy is still to list minority 
        shares in state-owned groups in order to raise capital 
        and import better governance while ultimately retaining 
        control . . .\27\
---------------------------------------------------------------------------
    \27\ Stephen Wyatt, ``Privatization More Hype than Reality,'' 
Australian Financial Review (June 7, 2005).

    The remaining small- and medium-sized state-owned 
enterprises were converted into a variety of state-influenced 
enterprises:
           Township and village enterprises (TVEs) in 
        rural areas;
           Cooperative enterprises owned by their 
        employees;
           Collective enterprises owned by provincial 
        governments and local governments in urban areas;
           Private domestic enterprises often sold to 
        officials or their families; and
           Joint enterprises owned by a state-owned 
        enterprise in conjunction with another type of 
        enterprises.
    SOEs and SIEs remain a major part of the PRC's economy:
           Producing 47.8 percent of the value-added 
        among industrial firms in the PRC during 2003 (see 
        Graph 13); \28\ 
        
        
    \28\ OECD Survey: 126.
---------------------------------------------------------------------------
           Employing 99.8 million in urban areas during 
        2005 (see Graph 14); \29\
---------------------------------------------------------------------------
    \29\ China National Bureau of Statistics/Haver Analytics.
---------------------------------------------------------------------------
           Employing 142.7 million in rural areas 
        during 2005 (see Graph 15) \30\ and
---------------------------------------------------------------------------
    \30\ Ibid.
---------------------------------------------------------------------------
            Accounting for 74.1 percent of the PRC's 
        investment in fixed assets during 2005 (see Graph 16) 
        \31\ SOEs and SIEs are a significant source of 
        patronage for the CPC. In 2003, SOEs and SIEs employed 
        5.3 million party members as executives or senior 
        managers.\32\
---------------------------------------------------------------------------
    \31\ Author's calculation based on data from China National Bureau 
of Statistics/Haver Analytics.
    \32\ Minxi Pei, ``Politics Blamed for China's Trillion-Dollar Bad 
Debts,'' The Australian (May 9, 2006). Found at http://
www.theaustralian.news.com/printpage/0,5942,19067992,00.html. 


    However, SOEs and SIEs are notoriously inefficient. The 
Organization for Economic Cooperation and Development (OECD) 
measured the total factor productivity (TFP) in a broad cross-
section of firms in the PRC. TFP refers to the portion of the 
increase in economic output that cannot be attributed to 
increases in the quantity or the quality of factor inputs. 
Thus, TFP represents the gains in output from efficiency and 
innovation. The OECD found that the TFP of private Chinese 
firms and Chinese subsidiaries of foreign multinational firms 
is double the TFP of SOEs and one and one-half times the TFP of 
SIEsduring 1998-2003 after controlling for size, location, and 
industry (see Graph 17).\33\
---------------------------------------------------------------------------
    \33\ OECD Survey: 86.
    
    
    Consequently, the average return on equity was 6.7 percent 
in all SOEs during 2003.\34\ Moreover, the OECD found insolvent 
or unprofitable SOEs and SIEs accounted for 11 percent of the 
workers, 23 percent of the fixed assets, and 22 percent of the 
outstanding debt in all SOEs and SIEs. Marginally profitable 
SOEs and SIEs accounted for 9 percent of the workers, 7 percent 
of the fixed assets, and 18 percent of the outstanding debt in 
all SOEs and SIEs. When combined, these financially distressed 
SOEs and SIEs accounted for 20 percent of the workers, 30 
percent of the fixed assets, and 40 percent of the outstanding 
debt in all SOEs and SIEs (see Graph 18).\35\
---------------------------------------------------------------------------
    \34\ OECD Survey: 105.
    \35\ OECD Survey: 102-104.
---------------------------------------------------------------------------
    SOEs and SIEs use their guanxi to secure favorable 
regulations and preferential access to loans from Chinese banks 
and other depository institutions. Consequently, many SOEs and 
SIEs face a ``soft budget constraint'' (i.e. Chinese banks and 
other depository institutions lend to the SOEs and SIEs without 
regard to their ability to repay their loans). Non-market loans 
allow many financially distressed SOEs and SIEs to continue 
operations and invest in new fixed assets when market 
discipline would force these SOEs and SIEs to shutter 
operations or to forego the acquisition of fixed assets.


                 VII. A DYSFUNCTIONAL FINANCIAL SYSTEM

A. Bank-centric, state-directed financial system

    The PRC's financial system is very bank-centric. At year-
end 2004, corporate debt issues amounted to 1 percent of GDP in 
China compared to 143 percent of GDP in the United States.\36\ 
At year-end 2005, equity issues (marketable shares) amounted to 
6 percent of GDP in China compared to 148 percent of GDP in the 
United States;\37\ and loans at banks and other depository 
institutions amounted to 105 percent of GDP in China compared 
to 56 percent of GDP in the United States (see Graph 19).\38\
---------------------------------------------------------------------------
    \36\ OECD Survey: 42; author's calculation based on data from World 
Federation of Exchanges and U.S. Bureau of Economic Analysis/Haver 
Analytics.
    \37\ Author calculation based on data from China Securities 
Regulatory Commission/Haver Analytics, China National Bureau of 
Statistics/Haver Analytics, New York Stock Exchange and NASDAQ/Haver 
Analytics, and U.S. Bureau of Economic Analysis/Haver Analytics.
    \38\ Author's calculation based on data from the People's Bank of 
China/Haver Analytics, China National Bureau of Statistics/Haver 
Analytics, Federal Reserve Flow of Funds/Haver Analytics, and U.S. 
Bureau of Economic Analysis/Haver Analytics.


    Banking assets are highly concentrated in the PRC (see 
Graph 20). The four major state-owned commercial banks--the 
Agricultural Bank of China, the Bank of China, China 
Construction Bank, and the Industrial Commercial Bank of 
China--controlled 57.1 percent of banking assets at year-end 
2005.\39\ Twelve joint stock commercial banks\40\ controlled 
another 16.8 percent of banking assets at year-end 2005.\41\
---------------------------------------------------------------------------
    \39\ Ibid.
    \40\ The twelve joint stock commercial banks are:
    1. Bank of Communications
    2. CITIC Bank
    3. Everbright Bank
    4. Evergrowing Bank
    5. Hua Xia Bank
    6. Guangdong Development Bank
    7. Shenzhen Development Bank
    8. China Merchants Bank
    9. Shanghai and Pudong Development Bank
    10. Industrial Bank
    11. Minsheng Bank
    12. Zheshang Bank
    \41\ Author's calculation based on data from People's Bank of 
China/Haver Analytics.


    Despite some progress in developing credit evaluation and 
risk management skills, non-market criteria may still influence 
over one-half of lending decisions. This occurs through both 
guanxi loans\42\ and policy loans.\43\ Non-market lending 
affects the overall composition of the loan portfolios in 
Chinese banks and other depository institutions. While banks in 
other economies extend most of their loans to households and 
small- to medium-sized private firms, 64.5 percent of 
outstanding loans in the PRC at year-end 2005 were extended to 
SOEs and SIEs (see Graph 21).\44\
---------------------------------------------------------------------------
    \42\ Guanxi lending refers to loans that banks make to individuals, 
firms, organizations, or governments based on personal relationships 
between bank officers and borrowers. Under guanxi lending, banks grant 
borrowers larger loans, lower interest rates, or more favorable terms 
than banks would willingly grant to borrowers without a personal 
relationship.
    \43\ Policy lending refers to loans that banks make to individuals, 
firms, organizations, or governments based on government regulations or 
suasion rather than market criteria. Under policy lending, banks grant 
borrowers larger loans, lower interest rates, or more favorable terms 
than banks would willingly grant in the absence of government 
regulation or suasion.
    \44\ Author's calculation based on data from People's Bank of 
China/Haver Analytics. Allocation of commercial loans to SOEs and SIEs 
and to private firms based on Diana Farrell et al., Putting China's 
Capital to Work: The Value of Financial System Reform (McKinsey Global 
Institute, May 2006): 11.
---------------------------------------------------------------------------
    Centrally directed industrial policy still governs the 
issuance of debt and equity securities in the PRC. The State 
Council--the equivalent of the President's cabinet in the 
United States--mustapprove the issuance of all equity 
securities on Chinese stock exchanges. The National Development and 
Reform Commission, which is the PRC's industry policy agency and 
reports to the State Council, must approve the issuance of all 
corporate debt securities. Consequently, nearly all of the proceeds 
from corporate debt and equity issues in the PRC have gone to SOEs and 
SIEs.\45\
---------------------------------------------------------------------------
    \45\ Ibid.: 15.
    
    
B. Economic costs of non-market allocation of financing

    In a recent study of the PRC's financial system, Farrell et 
al. (2006) found that the non-market allocation of financing 
harms the Chinese economy in two ways:
         Non-market allocation of financing reduced the 
        potential size of the PRC's GDP by $321 billion a year 
        or about 14 percent of its current GDP; \46\ and
---------------------------------------------------------------------------
    \46\ Ibid: 81.
---------------------------------------------------------------------------
         Non-market allocation of financing has slashed 
        the average real return on savings in the PRC to a mere 
        0.5 percent over the last decade. This compares to an 
        average real return on savings in the United States of 
        3.1 percent over the same period.\47\
---------------------------------------------------------------------------
    \47\ Ibid: 90-91.
---------------------------------------------------------------------------

C. Nonperforming loans

    Chinese banks and other depository institutions had a large 
legacy of nonperforming loans from non-market lending to SOEs 
and SIEs prior to 1999. Approximately $170 billion of 
nonperforming loans have been transferred from the four major 
state-owned commercial banks to four asset management companies 
during 1999 and 2000.\48\ So far, the asset management 
companies have disposed of 67 percent of these nonperforming 
loans, recovering about 21 cents on $1 of face value. Another 
$136 billion of nonperforming loans have been transferred to 
asset management companies during the last two years.
---------------------------------------------------------------------------
    \48\ The PRC's central government established asset management 
companies to liquidate nonperforming loans. The PRC modeled their asset 
management companies on the Resolution Trust Corporation. Congress 
established the Resolution Trust Corporation in 1989 through the 
Financial Institutions Reform, Recovery, and Enforcement Act. The 
Resolution Trust Corporation liquidated the nonperforming loans and 
other assets of saving and loan associations that had been declared 
insolvent.
---------------------------------------------------------------------------
    Both Chinese officials and private economists acknowledge 
that the PRC has done a good job in identifying and resolving 
pre-1999 nonperforming loans in Chinese banks and other 
depository institutions. However, Chinese officials and private 
economists disagree about the current size of the nonperforming 
loan problem in the PRC. In particular, Chinese officials and 
private economists have differences of opinion on how many 
loans made by Chinese banks and other depository institutions 
since 1998 are now or will become nonperforming loans.
    The China Banking Regulatory Commission reported that 
nonperforming loans in commercial banks have fallen to $164 
billion, or 6.6 percent of GDP as of March 31, 2006.\49\ 
Nonperforming loans in other depository institutions amounted 
to $42 billion, or 1.7 percent of GDP as of March 31, 2006.\50\
---------------------------------------------------------------------------
    \49\ Author's calculations based on data from China Banking 
Regulatory Commission/China National Bureau of Statistics/Haver 
Analytics.
    \50\ Charlene Chu, Lynda Lin, Kate Lin, and David Marshall, 
``China: Taking Stock of Banking System Nonperforming Loans,'' Fitch 
Ratings (May 30, 2006). Found at http://www.fitchratings.com/dtp/pdf2-
06/bchi3005.pdf.
---------------------------------------------------------------------------
    In a widely publicized study, Ernst & Young estimated that 
nonperforming loans amounted to $911 billion, or 41 percent of 
GDP at year-end 2005.\51\ The People's Bank of China and the 
China Banking Regulatory Commission vigorously disputed the 
Ernst & Young estimate. Under pressure from Chinese officials, 
Ernst & Young, which audits the Bank of China and the 
Industrial Commercial Bank of China, withdrew its study nine 
days after its release.\52\
---------------------------------------------------------------------------
    \51\ Global Nonperforming Loan Report, Ernst & Young (May 3, 2006): 
14. Author's calculation of nonperforming loans as a percent of GDP.
    \52\ Elaine Kurtenbach, ``Ernst & Young Nixes Report Putting 
China's Potential Nonperforming Loans at US$911 Billion,'' Financial 
Times (May 15, 2006). Found at http://search.ft.com/search Article?id= 
060515009128&query= Ernst+%26+Yo ung+China&vsc_appId=power 
Search&offset= 0&results To Show=10&vsc--su bject Concept=&vsc_company 
Concept=&state=More&vsc--publication Groups=TOPWFT&searchCat=-1.
---------------------------------------------------------------------------
    However, the withdrawn Ernst & Young estimate is broadly in 
line with other private estimates. As of March 31, 2006, for 
example, Fitch Ratings estimated that commercial banks and 
other depository institutions had another $270 billion of 
problem loans in addition to $164 billion of officially 
reported nonperforming loans in commercial banks, $42 billion 
of officially reported nonperforming loans in other depository 
institutions, and $197 billion of nonperforming loans remaining 
in the asset management companies.\53\ If all of the estimated 
problem loans become nonperforming, then nonperforming loans 
would equal $673 billion, or 27.3 percent of GDP as of March 
31, 2006.
---------------------------------------------------------------------------
    \53\ Charlene Chu, Lynda Lin, Kate Lin, and David Marshall, 
``China: Taking Stock of Banking System Nonperforming Loans,'' Fitch 
Ratings (May 30, 2006). Found at http://www.fitchratings.com/dtp/pdf2-
06/bchi3005.pdf.
---------------------------------------------------------------------------
    Because of insecure property rights, capricious zoning, 
arbitrary inspections, and widespread corruption, individuals 
and private firms without strong guanxi with the government and 
party officials cannot easily participate in the real estate 
industry. Thus, most construction firms and developers in the 
PRC are SOEs or SIEs. Real estate speculation is now rampant in 
major Chinese cities. On June 13, 2006, Business Week recently 
reported:

         People's Bank of China deputy governor Wu Xiaoling has 
        warned publicly that the value of total private and 
        commercial investment in real estate shot up from about 
        2.5 percent of total gross domestic product in 2001 to 
        8.6 percent in 2005. Real estate bubbles will affect 
        the economy and people's lives seriously, especially 
        when bubbles burst,\54\
---------------------------------------------------------------------------
    \54\ Brian Bremner, ``China: Big Economy, Bigger Peril?'' Business 
Week (June 13, 2006). Found at: http://www.businessweek.com/globalbiz/
content/jun2006/gb20060613--16805 0.htm.

    In the last few years, Chinese banks and other depository 
institutions have aggressively lent to SOEs and SIEs for 
construction and real estate development. This explosive loan 
growth may be creating mountains of new nonperforming loans in 
Chinese banks and other depository institutions that bank and 
government officials have not yet recognized.

D. Recapitalization

    To recapitalize ailing banks, the PRC's central bank, the 
People's Bank of China, injected $60 billion of foreign 
exchange reserves into the four major state-owned commercial 
banks between 2003 and 2005. During 2005, foreign financial 
services firms invested $18 billion in minority shares in 
Chinese banks (see Table 1).
    An initial public offering (IPO) of 13 percent of the 
shares raised $9.2 billion for the China Construction Bank in 
October 2005, while an IPO of 10.5 percent of the shares raised 
$9.7 billion for the Bank of China in May 2006. During the rest 
of 2006, IPOs are expected to raise about $10 billion for the 
Industrial Commercial Bank of China, $2 billion for the China 
Merchants Bank, $1 billion for the Minsheng Bank, and $1 
billion for the CITIC Bank.

          Table 1.--Foreign Direct Investment in Chinese Banks
------------------------------------------------------------------------
          Chinese Banks            Foreign Investors       Ownership
------------------------------------------------------------------------
Industrial Commercial Bank of     Goldman Sachs,      10%
 China.                            American Express,
                                   & Allianz Group.
China Construction Bank.........  Bank of America...  8.67% (may
                                                       increase to
                                                       19.9%)
                                  Temasek Holdings..  5.98%
Bank of China...................  Royal Bank of       10%
                                   Scotland.
                                  Merrill Lynch, Li   10%
                                   Ka-Shing, &
                                   Temasek Holdings.
                                  UBS...............  1.6%
                                  Asian Development   0.24%
                                   Bank.
Bank of Communications..........  HSBC..............  19.9%
Shanghai Pudong Development Bank  Citigroup.........  4.6% (may increase
                                                       to 24.9%)
Minsheng Bank...................  IFC...............  0.93%
                                  Temasek Holdings..  3.9%
Industrial Bank.................  Hang Seng Bank....  15.98%
                                  IFC...............  4%
                                  Singapore           5%
                                   Investment.
Hu Xia Bank.....................  Deutsche Bank.....  9.9%
                                  Sal Oppenheim.....  4.08%
                                  Pangaea Capital     6.9%
                                   Management.
Shenzhen Development Bank.......  Newbridge Capital.  17.98% (will drop)
                                  GE Capital........  7.3% (pending)
Guangdong Development Bank......  Citigroup.........  Seeking 85%
Beijing Bank....................  ING Group.........  19.9%
                                  IFC...............  5%
Shanghai Bank...................  HSBC..............  8%
                                  IFC...............  7%
Nanjing City Commercial Bank....  IFC...............  5%
                                  BNP...............  19.2%
Tiajin Bohai Bank...............  Standard Chartered  19.99%
Hangzhou City Commercial Bank...  Commonwealth Bank   19.99%
                                   of Australia.
Jinan City Commercial Bank......  Commonwealth Bank   11%
                                   of Australia.
Xian City Commercial Bank.......  IFC...............  2.5%
                                  Bank of Nova        2.5%
                                   Scotia.
Ping An Bank....................  HSBC..............  27%
Nanchong City Commercial Bank...  DEG...............  10%
                                  SIDT..............  3.3%
Ningbo City Commercial Bank.....  Oversea-Chinese     12.2%
                                   Banking Corp..
------------------------------------------------------------------------

    In March 2006, the Economist Intelligence Unit observed:

          [Q]uestions remain over whether risk management 
        standards in the banking sector have improved in a way 
        that would prevent such problems from re-emerging. One 
        particular problem is the government's strong control 
        over lending patterns, which encourages capital to be 
        allocated on the basis of policy rather than 
        profit.\55\ Senior PRC officials face a conundrum. If 
        the government were to cede its control over Chinese 
        banks, they would curtail their non- market lending and 
        strengthen their balance sheets. Market lending would 
        use Chinese saving more efficiently. Consequently, the 
        PRC's long-term real GDP growth would be higher, and 
        Chinese households would earn a better return on their 
        savings. However, curtailing non-market lending would 
        cause many financially distressed SOEs and SIEs to 
        fail, leading to higher unemployment in the short run. 
        These short-term dislocations could break the 
        ``bargain'' that has kept the CPC in power.
---------------------------------------------------------------------------
    \55\ Economist Intelligence Unit (2006): 30.

    Non-market lending may buy political stability for a time. 
However, in its accession agreement with the World Trade 
Organization, the PRC committed to open its domestic banking 
market to foreign banks in 2007, allowing them make loans to 
and receive deposits from all Chinese households and firms in 
yuan. Implementing this commitment will create a viable 
alternative to Chinese banks and other depository institutions 
for Chinese households and firms.
    Unlike the United States, the central government does not 
insure deposits in Chinese banks and other depository 
institutions. If financial weaknesses are allowed to fester, 
runs, in which a large number of depositors suddenly attempt to 
withdraw all of their funds from Chinese banks and place them 
in ``safer'' foreign banks, could soon occur. Runs could cause 
some Chinese banks to fail. To avert a financial panic and a 
possible recession, the People's Bank of China and the central 
government would likely be forced to bail out failing banks.

              VIII. DOMESTIC AND INTERNATIONAL IMBALANCES

    On July 21, 2005, the PRC broke its previous peg with the 
U.S. dollar, revalued the renminbi \56\ by 2.1 percent, and 
instituted an adjustable exchange rate tied to a basket of 
currencies including the U.S. dollar. Prior to this change, the 
People's Bank of China actively intervened in foreign exchange 
markets to maintain the peg of the renminbi to U.S. dollar. 
Nevertheless, the People's Bank of China continued to actively 
intervene to limit any appreciation of the renminbi against the 
U.S. dollar. One year after this change, the renminbi has 
appreciated by only 3.56 percent against the U.S. dollar (from 
1 yuan equal to 12.0824 U.S. cents on July 21, 2005, to 1 yuan 
equal to 12.5128 U.S. cents on July 20, 2006).\57\
---------------------------------------------------------------------------
    \56\ In the United States, ``dollar'' is both the name of the U.S. 
currency and of its unit of account. In the People's Republic of China, 
the ``renminbi'' is the name of the PRC's currency, and ``yuan'' is the 
name of the PRC's unit of account.
    \57\ Equivalently, the U.S. dollar has depreciated by only 3.44 
percent against the renminbi (from $1 equal to 8.2765 yuan on July 21, 
2005, to $1 equal to 7.9918 yuan on July 20, 2006). Federal Reserve 
Bank of New York/Haver Analytics.
---------------------------------------------------------------------------
    Graph 22 shows the accumulation of foreign exchange 
reserves in terms of both U.S. dollars and as a percentage of 
the PRC's GDP. By year-end 2005, the People's Bank of China 
accumulated $819 billion, or 36.8 percent of GDP, in foreign 
exchange reserves. Through June 2006, the People's Bank of 
China accumulated foreign exchange reserves of $941 billion, an 
increase of 14.9 percent in just six months.\58\
---------------------------------------------------------------------------
    \58\ People's Bank of China, State Administration of Foreign 
Exchange, and China National Bureau of Statistics /Haver Analytics.


    Interventions of the People's Bank of China suppress the 
foreign exchange value of the renminbi below a market-
determined level. In November 2005, Morris Goldstein at the 
Institute for International Economics estimated that the 
renminbi was undervalued by between 20 percent and 40 percent 
using an underlying balance approach and by between 20 percent 
and 30 percent using a global payments balance approach. This 
is broadly in line with the majority of private sector 
estimates.\59\ This exchange rate policy contributes to both 
domestic and international balances.
---------------------------------------------------------------------------
    \59\ Morris Goldstein, Renminbi Controversies, Prepared for the 
Conference on Monetary Institutions and Economic Development, Cato 
Institute, November 3, 2005, revised December 2005): 1-4.
---------------------------------------------------------------------------
    Graph 23 shows how the interventions of the People's Bank 
of China drive the PRC's external imbalances. In the absence of 
official intervention, the sign on the current account balance 
and the financial account balance should be opposite. However, 
during the last six years, the PRC has run both current account 
surpluses (in horizontal stripe) and financial account 
surpluses (in vertical stripe). Official intervention through 
the reserve account (as represented by the solid black line 
with diamonds) has made current account and financial account 
surpluses possible simultaneously.


A. Underconsumption and dependency on export-led growth

    Chinese farmers are notoriously inefficient. The average 
productivity of a Chinese farmer is one-sixteenth of the 
average productivity of other Chinese workers. This widening 
productivity gap is increase income inequality between urban 
and rural areas in the PRC. The OECD reported that the average 
income of urban workers was three times the average income of 
rural workers.\60\
---------------------------------------------------------------------------
    \60\ OECD Survey: 44-45.
---------------------------------------------------------------------------
    Chinese farmers may lease agricultural land from local 
governments for up to 30 years.\61\ Unlike residential, 
commercial, or industrial lessees, however, agricultural 
lessees may not mortgage or transfer their leases. Moreover, a 
survey found that only 13 percent of agricultural leases forbid 
local officials from reallocating land during the term of a 
lease.\62\ If agricultural lessees were to stop farming and 
move to a city, they would forfeit their leases, and their land 
would be redistributed to other farmers.\63\ Consequently, 
Chinese farmers have neither the ability nor the incentive to 
invest in fixed assets that would improve their productivity 
and increase their income.
---------------------------------------------------------------------------
    \61\ The implementation of 30-year leasing is not universal and 
varies widely both among and within provinces. A survey found that only 
one-third of the villages in eleven provinces had implemented 30-year 
leasing. In the remaining villages, half of the agricultural land was 
leased on a long-term basis, while the remainder was leased through 
annual actions. OECD Survey: 113.
    \62\ OECD Survey: 113.
    \63\ In some cases, farmers may change their residential 
registration to a nearby village without losing their leases. However, 
these lessees may be required to pay additional fees to their local 
government to retain their leases. OECD Survey: 113.
---------------------------------------------------------------------------
    Under its accession agreement with the World Trade 
Organization, the PRC agreed to open its domestic market to 
agricultural imports. If the renminbi were to appreciate 
rapidly and substantially, many Chinese farmers would not be 
able to compete with cheaper agricultural imports and would 
cease farming.
    Because millions of Chinese are still employed in 
agriculture, currency appreciation could trigger mass 
unemployment and political instability in rural areas. On May 
16, 2006, Business Week reported:

          To the Chinese government, the agricultural industry 
        and small farm villages are the biggest political 
        issue,'' says former Japanese financial diplomat Eisuke 
        Sakakibara.\64\
---------------------------------------------------------------------------
    \64\ Brian Bremner, ``Controlling China's Runaway Growth,'' 
Business Week (May 16, 2006). Found at: http://www.businessweek.com/
globalbiz/content/may2006/gb20060516_457180.htm.

    Under the ``harmonious society'' policy, President Hu 
Jintao is trying to increase rural income and provide 
alternative employment for displaced farmers by abolishing the 
two-thousand-year-old agricultural tax, expanding micro-
financing for starting small businesses, and investing in mega-
projects in rural areas. Consequently, Hu wants the renminbi to 
appreciate very slowly until the benefits of these measures 
become apparent.
    However, this exchange rate policy creates profound 
imbalances in the rest of the PRC's economy. Intervention 
reduces the real incomes of Chinese workers and their 
consumption of imported goods and services. Consequently, the 
PRC cannot rely on domestic consumption to drive its economic 
expansion. The PRC remains overly dependent on exports and 
investment for economic growth.
    Consequently, the PRC's two-way trade as a percent of its 
GDP is far higher than other populous economies (see Graph 24).


B. Overinvestment and malinvestment

    While the People's Bank of China has tried to sterilize its 
interventions, the International Monetary Fund reported that 
China was only able to mop-up about half of the excess 
liquidity through bond sales. The remainder of this excess 
liquidity has contributed to rapid growth in both M2 and loans 
since 2000. The International Monetary Fund noted that the loan 
growth would have been even higher without the administrative 
interventions of the People's Bank of China and the China 
Banking Regulatory Commission (see Graph 25).


    The combination of (1) excessive liquidity from 
interventions that has not been fully sterilized and (2) guanxi 
loans and policy loans extended by Chinese banks has channeled 
funds to SOEs and SIEs, which invest in fixed assets. This 
aggressive lending helped to boost the PRC's rate of gross 
investment in fixed assets to 42.1 percent of GDP in 2005 (see 
Graph 26).\65\ The PRC's gross investment rate is far higher 
than other major economies (see Graph 27).
---------------------------------------------------------------------------
    \65\ Author's calculations based on data from China National Bureau 
of Statistics/Haver Analytics.


    Although the PRC's non-market allocation of financing may 
boost production and investment in the short term, the PRC's 
economic growth is sustainable over the long term if, and only 
if, firms:
           produce goods and services that the market 
        demands; and
           invest in fixed assets that have a positive 
        net present value.\66\
---------------------------------------------------------------------------
    \66\ Net present value is the expected future revenues from an 
investment discounted by a rate that reflects the real interest rate, 
expected future inflation, and the risk associated with such investment 
less the current and future costs (also discounted) associated with the 
same investment.
---------------------------------------------------------------------------
    The rapid accumulation of fixed assets by the SOEs and the 
SIEs suggests that overinvestment (i.e., the acquisition of too 
many fixed assets for producing goods and services given 
expected future demand) and malinvestment (i.e., the 
acquisition of the wrong types of fixed assets for producing 
goods and services to meet expected future demand) may be 
occurring in the PRC. According to the Economist Intelligence 
Unit, ``Oversupply has driven down prices in many industries, 
such as vehicles, steel, and aluminum.'' \67\ Moreover, the 
Economist Intelligence Unit reported:
---------------------------------------------------------------------------
    \67\ Economist Intelligence Unit (2006): 25.

         Government officials have long warned of oversupply in 
        the [steel] sector, and in December 2005 the head of 
        the National Development and Reform Commission, Ma Kai, 
        declared that oversupply had led steel prices to 
        decline to 2003 levels, with the prices of some steel 
        products falling below cost. (This was a serious 
        admission for a Chinese official, as it could pave the 
        way for anti-dumping suits in China's steel export 
        markets.) \68\
---------------------------------------------------------------------------
    \68\ Economist Intelligence Unit (March 2006): 25-26.

    An economic boom caused by overinvestment and malinvestment 
is not sustainable. The inevitable liquidation of 
overinvestment and malinvestment could cause a recession in the 
PRC and slow economic growth in the rest of the world.
    To keep the renminbi undervalued, the People's Bank of 
China exchanges yuan for the U.S. dollars that the PRC's 
current and financial account surpluses pump into the Chinese 
economy. This intervention leaves Chinese banks and other 
depository institutions flush with cash. To remain profitable, 
Chinese banks are lending their excess deposits.
    Senior PRC officials are clearly concerned that the 
excessive lending is fueling an overinvestment and 
malinvestment bubble. Fearing that higher interest rates would 
attract more foreign capital, the People's Bank of China is 
reluctant to increase interest rates significantly to curb the 
rapid growth of domestic bank loans and the resulting inflation 
of an investment bubble. Instead, senior officials are relying 
on moral suasion and regulatory changes to moderate loan 
growth. On June 16, 2006, the Financial Times reported that the 
State Council had issued a series of edicts intended to curb 
the rapid growth of bank lending and new investments in real 
estate development. The article observed:

          The root cause of the liquidity bubble, say 
        economists, is China's managed currency, which has only 
        appreciated by about 3 percent against the dollar since 
        last July's decision to end a decade-long peg to the 
        greenback.\69\
---------------------------------------------------------------------------
    \69\ Richard McGregor, ``Beijing Reins in Lending in Bid to Cool 
Growth,'' Financial Times (June 16, 2006).

    Without a significant appreciation in the renminbi, private 
economists doubt that such administrative measures will have a 
significant effect.

C. International imbalances

    Because other developing Asian economies have labor-
intensive industries and assembly operations that compete with 
thePRC, central banks in these economies fear that currency 
appreciation would put local firms or local subsidiaries of foreign 
multinational firms at a competitive disadvantage against Chinese firms 
or Chinese subsidiaries of foreign multinational firms. Thus, other 
developing Asian economies have mimicked the PRC's exchange rate policy 
(see Graph 28). 


    The People's Bank of China and central banks in other 
developing Asian economies use their accumulated foreign 
exchange to buy foreign debt securities, mainly U.S. Treasuries 
and Agencies, creating a non-market financial inflow into the 
United States. Given the accounting relationship between the 
current account and the capital and financial accounts, this 
non-market financial inflow increases the foreign exchange 
value of the U.S. dollar, the U.S. current account deficit, and 
the U.S. financial account surplus above market-determined 
levels. According to some economists, if the PRC and other 
developing Asian economies were to float their currencies, the 
U.S. current account deficit could decline by up to 10 
percent.\70\
---------------------------------------------------------------------------
    \70\ C. Fred Bergsten, ``Clash of the Titans,'' Newsweek 
(international edition), April 24, 2006.
---------------------------------------------------------------------------

                              IX. ANALYSIS

    The PRC's current policies may not support a long-term 
continuation of the rapid growth that the Chinese economy has 
enjoyed in recent years. Because of the growing size of the 
Chinese economy and its deep integration through investment and 
trade flows with the rest of the world, a recession in the PRC 
would have adverse effects on the global economy.
    The CPC's desire to retain power drove economic reform and 
shaped its contours. Senior officials are well aware that the 
PRC confronts a number of interrelated challenges to continued 
economic growth:
           A smaller working-age population will reduce 
        China's labor supply. The combination of a higher labor 
        demand and a smaller labor supply will inevitably 
        increase the real compensation for all Chinese workers. 
        Consequently, the PRC's current comparative advantage 
        of low-cost labor will erode. The PRC will begin to 
        shed many of the low-wage jobs in labor-intensive 
        manufacturing and assembly operations that it has 
        gained. To sustain economic growth and create high-wage 
        replacement jobs, the PRC must climb the development 
        ladder.
           The PRC currently faces a shortage of 
        professionals and highly skilled workers. To alleviate 
        this shortage, the PRC has increased the number of 
        colleges and universities by 61.0 percent from 1,075 in 
        1990 to 1,731 in 2004 and quadrupled the number of 
        students in post-secondary education.\71\ However, this 
        rapid expansion in the number of students appears to 
        have undermined the quality of the post-secondary 
        education that many students are receiving. Only about 
        10 percent of Chinese graduates receiving engineering 
        degrees, for example, possess the minimum skills 
        necessary for employment with U.S. engineering 
        firms.\72\ As the PRC begins to climb the development 
        ladder, the demand for professionals and highly skilled 
        workers will increase dramatically. The quality 
        problems with the Chinese workforce may decelerate the 
        PRC's economic growth rate.
---------------------------------------------------------------------------
    \71\ Economist Intelligence Unit (March 2005): 20.
    \72\ Guy de Jonquieres, ``The Critical Skills Gap,'' Financial 
Times (June 12, 2006).
---------------------------------------------------------------------------
           Corruption and the weak protection of 
        intellectual property rights may retard the development 
        of Chinese firms in creative industries that would help 
        the PRC climb the development ladder.
           The PRC's rapidly aging population poses 
        additional problems. The lack of a social safety net, 
        along with the limited availability of private 
        retirement plans,consumer credit, and insurance 
products, drive Chinese households to save prodigiously. The resulting 
extraordinarily high gross saving rate hampers the PRC's ability to 
transition from export-led to domestic consumption-driven growth.
           SOEs and SIEs are generally inefficient. 
        Many financially distressed SOEs and SIEs need large 
        subsidies to survive. Guanxi loans and policy loans to 
        subsidize financial distressed SOEs and SIEs have been 
        a major cause of the nonperforming loan problem in 
        Chinese banks and other depository institutions. Guanxi 
        loans have also encouraged SOEs and SIEs to invest 
        heavily in construction and real estate development. 
        Many of these investments are speculative. A tidal wave 
        of new nonperforming loans in Chinese banks and other 
        depository institutions may now be forming.
           Non-market lending to SOEs and SIEs reduces 
        the amount of credit available to Chinese households 
        and private businesses, lowers the PRC's potential 
        growth rate, and hinders the PRC's transition from 
        export-led to domestic consumption-driven growth.
           An undervalued renminbi creates excess 
        liquidity in state-influenced Chinese banks and other 
        depository institutions. Excess liquidity encourages 
        bankers to lend aggressively. In turn, easy credit 
        encourages SOEs and SIEs that are insulated from price 
        signals and profitability constraints to make 
        speculative investments in fixed assets. The nexus 
        among an undervalued exchange rate, state-influenced 
        Chinese banks, and SOEs and SIEs is apparently creating 
        widespread overinvestment and malinvestment in the PRC. 
        This is especially true in the real estate sector. Such 
        an investment bubble is unsustainable over the long 
        term.
           An undervalued renminbi also fans 
        protectionist sentiment abroad. Protectionism is 
        particularly dangerous for the PRC, whose economic 
        growth has been extraordinarily dependent on exports 
        and foreign direct investment.
           The absence of secure and transferable 
        property rights in agricultural land and the limited 
        availability of credit inhibit Chinese farmers from 
        making the investments in fixed assets necessary to 
        increase low agricultural productivity and raise rural 
        incomes. The wide and growing income gap between rural 
        and urban China is fueling social tensions. Because 
        inefficient Chinese farmers cannot compete with cheaper 
        agricultural imports if the foreign exchange value of 
        the renminbi were to increase substantially, senior 
        officials have resisted any substantial increase in the 
        foreign exchange value of the renminbi. However, this 
        official reluctance is simultaneously inflating an 
        investment bubble domestically and creating 
        unsustainable imbalances internationally, which 
        together threaten the PRC's rapid economic growth.
    Senior officials fear that comprehensive reforms to resolve 
these interrelated challenges would cause significant economic 
dislocations and increase unemployment and political unrest in 
the short run and could weaken the CPC's sway over the Chinese 
economy in the long run. Consequently, senior officials have 
responded with incremental policy changes. However, the PRC may 
be reaching the limits of the effectiveness of its incremental 
approach to reform.
    The PRC must begin to climb the development ladder as 
Japan, South Korea, and Singapore have done and southeast Asian 
economies such as Malaysia and Thailand are doing. The 
distortions from an undervalued exchange rate, non-market 
lending, overinvestment, and malinvestment--particularly by the 
SOEs and SIEs and in the real estate sector--are interrelated. 
The economic imbalances created by these distortions, along 
with rising disgust at widespread corruption, are fueling 
social unrest, especially in rural China. Consequently, a more 
comprehensive approach to solving these problems is needed.
    To quell social unrest, the PRC must curb corruption, 
strengthen the rule of law, and narrow the productivity and 
income gaps between workers in rural and urban China. To avoid 
a nasty recession, the PRC must begin to reduce some of the 
growing imbalances in its economy. Simultaneous reforms of the 
PRC's agricultural land policies, its financial services 
sector, and its foreign exchange rate regime are necessary to 
resolve these festering problems and sustain rapid economic 
growth.

                             X. CONCLUSION

    Although the Chinese economy is booming, the PRC faces five 
major challenges to sustain rapid economic growth in the 
future:
           unfavorable demographics;
           corruption and a weak rule of law;
           financially distressed SOEs and SIEs;
           a dysfunctional financial system; and
           domestic and international imbalances.
    The PRC's response to these challenges will, of course, 
determine the future performance of the Chinese economy. 
However, since the Chinese economy is so large and well 
integrated into the global economy, the performance of the 
Chinese economy will also affect the performance of the United 
States and other economies in the world.
    So far, the PRC's approach to reform has been incremental. 
This incremental approach may be reaching the limits of its 
effectiveness. The challenges that the PRC now faces are deeply 
interrelated. A more comprehensive approach to reform is 
needed.

                       Ranking Minority Member's

                       Views and Links to Minority

                                 Reports

     Ranking Minority Member's Views and Links to Minority Reports

                              I. OVERVIEW

    In 2006, President Bush and his supporters claimed that the 
economy was doing well and that all Americans were benefiting 
from his policies. For many Americans, however, those claims 
rang hollow because their own incomes were not growing fast 
enough to keep up with higher costs for energy, health care, 
and other critical expenditures, and they were not confident 
about their economic future.
    A disconnect between aggregate indicators of economic 
performance and the experience of typical American families has 
been a feature of the economy under President Bush. While 
corporate profits and executive pay rebounded after the dot.com 
collapse and the 2001 recession, the wages and incomes of most 
Americans did not. Since 2001, the economy has grown but the 
benefits of economic growth and productivity have shown up in 
the bottom lines of companies and in the incomes of highly 
compensated individuals--not in the paychecks of most workers.
    For the most part, the Bush Administration and the 
Republican majority in the Congress have been blind to the 
challenges facing American families struggling with high energy 
prices, rising health care expenses, and the mounting costs of 
sending their kids to college. A rare exception came only 
recently when Treasury Secretary Paulson, shortly after taking 
office, acknowledged that,

          . . . we still have challenges, and amid this 
        country's strong economic expansion, many Americans 
        simply aren't feeling the benefits. Many aren't seeing 
        significant increases in their take-home pay. Their 
        increases in wages are being eaten up by high energy 
        prices and rising health-care costs, among others.

    Instead of pursuing policies that address those problems, 
however, the Administration has espoused policies such as 
repeal of the estate tax and Social Security privatization that 
aggravate underlying market trends toward widening income 
inequality and increasing income insecurity. At the same time, 
they have opposed policies such as increasing the minimum wage.
    In 2006 the Bush Administration and the Republican majority 
in the Congress once again pursued budget and tax policies that 
added to the deficit, lowered taxes for the well-to-do, and 
reduced spending for programs that benefit middle- and lower-
income families. The major tax legislation enacted, for 
example, was a $70 billion tax reconciliation bill that 
extended dividend and capital gains provisions that were not 
set to expire for at least two years and that mainly benefit 
high-income taxpayers. Yet that legislation made only a 
temporary one-year fix to the alternative minimum tax (AMT) and 
failed to extend popular expiring provisions such as the R&D 
tax credit.
    The Republican majority tried several times to eliminate or 
substantially scale back the federal estate tax, the most 
progressive tax currently on the books. Had that effort been 
successful it would have added almost $1 trillion to the 
federal debt in the first ten years after going into effect. At 
one point, the Majority tried to achieve near elimination of 
the estate tax by holding hostage a long-overdue increase in 
the minimum wage and the extension of several popular tax 
measures that were due to expire.
    That ploy failed, but an increase in the minimum wage will 
have to wait until the Democratic-controlled 110th Congress 
convenes in January. Unless the 109th Congress acts in its 
final lame-duck week, so too will the extension of tax measures 
such as the deduction for qualified tuition and related 
expenses, the deduction for state and local sales tax, the 
research and development credit, the work opportunity and the 
welfare-to-work credits, the deduction for expenses of school 
teachers, and the election to treat combat pay as earned income 
for the earned income credit.
    The United States is at war and yet there is no sense of 
the shared sacrifice that has united this country in past 
conflicts. Ironically, the estate tax was first adopted in the 
nineteenth century to pay for government shortfalls due to 
wartime spending. Our military families are making tremendous 
sacrifices, and too many of them have made the ultimate 
sacrifice in service to our country. With $320 billion 
appropriated or pending for Iraq operations to date and the 
number of service men and women killed approaching 3,000, the 
human and financial tolls are each more staggering than 
imagined.
    The country faces mounting war costs of about $10 billion 
per month, the impending retirement of the baby boom 
generation, and deficits as far as the eye can see. Yet the 
Bush Administration has focused its efforts on bettering the 
lives of those that need it the least while leaving hard 
working families further behind.
    The President's tax cuts are a drain on national saving and 
our children and grandchildren will pay the price. The personal 
saving rate, which these tax cuts were presumably designed to 
stimulate, has been going down and is now negative. On average, 
people are spending more than their current income. To be sure, 
soaring corporate profits and retained earnings have boosted 
the business part of private saving. But this is offset by 
budget deficits, which these tax cuts will only increase.
    Ultimately, the result of the Administration's 
irresponsible fiscal policy is that many domestic priorities 
get shortchanged. We need a change in direction for the 
majority of American families to share in the benefits of 
economic growth and productivity and to secure the country's 
economic future.

                        II. THE ECONOMY IN 2006

    In early 2006, the U.S. economy rebounded from the previous 
year's hurricanes and continued its business-cycle recovery 
from the 2001 recession. However, weakness in the housing 
market became an increasing drag on growth in the second and 
third quarters of the year. Because other sectors such as 
business investment and net exports did not provide sufficient 
offsetting strength, economic growth slowed to a rate below 
what most forecasters think is a pace consistent with achieving 
and maintaining full employment.
    Inflation was a worry as energy prices rose sharply through 
the first eight months of the year. However, energy price 
declines in September and October produced a fall in the 
overall consumer price index (CPI) and an easing of concerns 
about underlying (``core'') consumer price inflation.
    Monetary policy reached a critical juncture in 2006. The 
Federal Reserve switched from a policy of gradually raising 
interest rates to one of holding rates constant as economic 
growth moderated. The Fed has indicated that it will be 
sensitive to incoming data on the outlook for both economic 
growth and inflation in setting the course of monetary policy 
going forward.
    The budget deficit declined more than expected in 2006. 
Nevertheless, the deficit remains large, the budget outlook 
going forward has not improved, and the country has an 
unsustainable payments imbalance with the rest of the world. 
The consequences of large federal budget deficits have been 
depressed national saving and increased borrowing from the rest 
of the world. Low national saving and the need to pay back 
foreign borrowing with interest means future national income 
will be lower than if we were financing our national investment 
with our own national saving.

Economic growth

    The economy slowed during the first three quarters of 2006. 
Most forecasters recognized that the first-quarter's growth 
rate of 5.6 percent at an annual rate was a temporary spurt 
that reflected an economic rebound from the Gulf Coast 
hurricanes and other special factors that had tempered growth 
late in 2005. The sharpness of the subsequent slowing, however, 
may have been greater than many forecasters were expecting. The 
economy grew at a 2.6 percent annual rate in the second quarter 
and then slowed even more sharply to just a 2.2 percent annual 
rate in the third quarter. That pace is well below the 3 to 
3\1/2\ percent range that most economists, including Fed 
Chairman Bernanke, believe is sustainable without generating 
inflationary pressures.
    The key contributor to the growth slowdown was residential 
investment, which plunged at an 18.0 percent annual rate in the 
third quarter after falling 11.1 percent in the second quarter. 
That decline in new housing investment subtracted 0.7 
percentage point from the overall growth rate in the second 
quarter and 1.2 percentage points from the overall growth rate 
in the third quarter.

Employment and wages

    After fluctuating in the 4.6 to 4.8 percent range for the 
first nine months of 2006, the unemployment rate dipped 
unexpectedly to 4.4 percent in October. Other labor market 
indicators, however, suggested caution before concluding that 
there has been any significant tightening of the labor market.
    First, the decline in the unemployment rate was not matched 
by increased entry into the labor force that might indicate 
greater confidence in finding a job. In fact, both the fraction 
of the population working or looking for work (the labor force 
participation rate) and the proportion of the population with a 
job (the employment-to-population ratio) remained a full 
percentage point lower than they were at the start of the 2001 
recession.
    Second, employers added just 92,000 jobs to their payrolls 
in October, when 125,000 to 140,000 jobs per month are needed 
to keep pace with normal growth in the labor force. In the six 
months ending in October payroll employment growth averaged 
just 138,000 jobs per month. The unemployment rate and payroll 
employment come from two separate surveys that do not always 
agree, but most experts think that payroll job growth is the 
better indicator of the strength of the labor market.
    Finally, the stagnation of real (inflation-adjusted) wages 
over most of the recovery from the 2001 recession does not 
point to a tight labor market. Productivity (output per hour) 
has grown at a healthy 2.8 percent annual rate during the 
recovery from the 2001 recession, but real hourly compensation 
of employees (wages plus benefits) has grown at less than half 
that rate (1.3 percent annually). Historically, growth in real 
hourly compensation has tended to grow roughly in line with 
productivity.
    Benefit costs have grown much faster than wages and 
salaries, not because employers are providing more generous 
benefits but because health insurance costs are rising and 
employers have had to make contributions to restore the 
solvency of their pension plans. Those higher benefit costs are 
squeezing take home pay. From August 2003, when job losses 
peaked, until August 2006, real average hourly earnings fell 
1.4 percent. Recent sharp declines in inflation have pushed up 
real wages but the overall picture since January 2001 remains 
one of stagnation.

Inflation and monetary policy

    After rising 3 percent in the first eight months of 2006, 
the consumer price index declined by 0.5 percent in September 
and another 0.5 percent in October. Energy prices were the 
driving force in the rise and subsequent decline of the CPI. 
Consumer energy prices rose 14.4 percent in the first eight 
months of this year, and then fell 7.2 percent in September and 
another 7.0 percent in October. Nevertheless, energy prices 
remain high. In October 2006, consumer energy prices were 35 
percent higher than they were in January 2001, while the 
overall consumer price index was 14.9 percent higher.
    The core CPI, which excludes the volatile food and energy 
prices, rose at a 2.8 percent annual rate in the first 10 
months of 2006. That rate is higher than what the Fed would be 
comfortable with on a long-term sustained basis, but core 
inflation has moderated over the course of the year. Four 
months of 0.3 percent increases from March through June, were 
followed by three months of 0.2 percent increases, and the core 
CPI rose just 0.1 percent in October.
    In the fall of 2006, the Fed still sees inflation pressures 
as likely to moderate over time, in part because the economy is 
slowing. Recent declines in energy prices reduce the chance 
that energy prices will feed into future core inflation. Wages 
have not been a source of inflationary pressure so far in the 
recovery from the 2001 recession. Nominal wages have picked up 
some recently, but Federal Reserve Chairman Bernanke has said 
that growth in real wages is not incompatible with stable 
inflation. With profit margins unusually high, companies can 
absorb increases in real wages without raising prices 
excessively.
    The Fed has cautioned that it still sees some inflation 
risks. The challenge it faces is that if it raises interest 
rates further to keep inflationary trends and expectations from 
rising, it could choke off the economic expansion, slowing job 
growth further, and leaving working Americans with only meager 
gains in take home pay with which to cover their already high 
energy, tuition, and health care bills.

Fiscal policy

    The federal budget deficit for fiscal year 2006 was $248 
billion. That is smaller than the deficit in the preceding 
three years and smaller than the estimate in the President's 
January budget. However, it is still one of the largest 
deficits on record in nominal dollars. More importantly, the 
reduction in the deficit does not reflect explicit deficit-
reduction efforts on the part of the Bush Administration. The 
overwhelming majority of policy actions by the Bush 
Administration and the Republican majority in the Congress have 
added to the deficit not lowered it.
    Tax revenues grew in fiscal year 2006, as they always do in 
a business-cycle expansion. Revenues also came in higher than 
expected for other reasons unrelated to policy actions. 
Nevertheless, the real story of the budget under President Bush 
continues to be a deterioration compared with the situation he 
inherited. The $5.6 trillion 2002-2011 budget surplus that was 
being projected when President Bush took office in January 2001 
has turned into a deficit over that same period projected to be 
at least $2.9 trillion.
    The direct consequence of those large federal budget 
deficits has been to reduce government saving. Neither the tax 
cuts nor anything else has stimulated an offsetting increase in 
private saving, hence national saving has declined as well. 
Because foreigners, including foreign governments, continued to 
be willing to lend to the United States and acquire U.S. 
assets, the United States was able to draw on foreign saving to 
make up for the loss of national saving. Without that foreign 
borrowing, long-term interest rates would have been much 
higher. However, the returns from investment financed by 
foreign saving mainly go to the foreign investors and not to 
raising future U.S. national income.
    At some point, the United States will have to pay for the 
irresponsible budget policies of the last six years. That day 
of reckoning has been postponed by our ability to draw on 
foreign saving. If the rest of the world suddenly decides that 
the risks from investing its savings in the United States 
outweigh the benefits, there could be a run on the dollar, a 
sharp increase in U.S. interest rates, and possibly an 
international financial crisis. Even if the rest of the world 
continues to lend to the United States, the U.S. external debt 
will continue to mount and interest on that debt will have to 
be paid out of future national income.

                     III. THE BUSH ECONOMIC RECORD

    Throughout the year the JEC Democrats have issued fact 
sheets and economic policy briefs documenting the discrepancy 
between the claims of the Bush Administration about how well 
the economy is doing and the experience of ordinary middle 
class and working families. The following are some of the 
salient facts about the Bush Administration's economic record.

Unemployment and job growth

    Through November 2006, unemployment remains higher than it 
was when President Bush took office in January 2001, and job 
creation has been lackluster. In particular:
     688,000 more people are unemployed.
     The unemployment rate is up 0.2 percentage point 
to 4.4 percent.
     Long-term unemployment (26 weeks or more) is 60 
percent larger at 1.1 million.
     Job growth has averaged just 49,000 jobs per 
month--and just 31,000 per month in the private sector (monthly 
growth of 125,000 to 150,000 is necessary to absorb a growing 
labor force).
     2.9 million manufacturing jobs have been lost.
    Job losses continued until August 2003 and did not regain 
their pre-recession level until February 2005--the most 
protracted jobs slump since the 1930s. Job growth from August 
2003 through October 2006 averaged just 159,000 jobs per month, 
whereas it was common to see job gains of 200,000 to 300,000 in 
the expansion of the 1990s. In the six months ending in October 
2006, monthly job growth averaged just 138,000.

Wages and other measures of economic well-being

    Most American families have seen their standard of living 
erode on President Bush's watch. American workers have seen 
their productivity grow at a very strong rate, but productivity 
and economic growth have not translated into higher real wages. 
Income gains have been concentrated at the top of the income 
distribution, while poverty and economic insecurity have 
increased. In particular, since President Bush took office:
     The median usual weekly earnings of full-time wage 
and salary workers have declined by 0.9 percent after 
inflation.
     Median household income has declined by $1,273 or 
2.7 percent after inflation.
     5.4 million more people live in poverty, for a 
total of 37 million people in poverty.
     1.3 million more children live in poverty, for a 
total of 12.9 million children in poverty.
     6.8 million more people lack health insurance, for 
a total of 46.6 million uninsured.
     3.7 million fewer workers have an employer-
sponsored retirement plan.

A legacy of deficits and debt

    When President Bush took office, the federal budget was in 
surplus and the national debt was declining. Under President 
Bush, however:
     A $128 billion federal budget surplus in FY 2001 
turned into a $248 billion deficit in FY 2006.
     A $5.6 trillion 10-year projected surplus from 
2002 to 2011 has turned into a projected deficit of at least 
$2.9 trillion.
     Federal debt issued to finance budget deficits 
rose by $1.5 trillion.
    The broad economic indicators preferred by President Bush 
show that the economy has experienced a business cycle recovery 
from the 2001 recession, with strong productivity and rising 
output. However, most American workers have not seen the 
benefits of that recovery in their paychecks. Now, with the 
economy slowing before it has produced an improved standard of 
living for the typical American family, people have a right to 
ask of the Bush economic record, ``Is that all there is?''

                     IV. LINKS TO MINORITY REPORTS

    The following reports were issued by the Joint Economic 
Committee Democrats in 2006:
    Is That All There Is? The Bush Economic Record From the 
Perspective of Working Families. November 2006: Link: http://
www.jec.senate.gov/democrats/Documents/Releases/
isthatallthereis.pdf
    The Way We Were: Comparing the Bush Economy with the 
Clinton Economy. November 2006 Link: http://www.jec.senate.gov/
democrats/Documents/Reports/BushIsNoClinton03 nov2006.pdf
    Relying on the Kindness of Strangers: Foreign Holdings of 
U.S. Treasury Debt. November 2006. Link: http://
www.jec.senate.gov/democrats/Documents/Reports/
foreigndebtkindness ofstrangers.pdf
    Losing Ground: The Middle Class in the Bush Economy. 
September 2006. Link: http://www.jec.senate.gov/democrats/
Documents/Reports/losinggroundthemid dleclasssep2006.pdf
    Some Perspective on Bush Administration Economic Claims. 
September 2006. Link: http://www.jec.senate.gov/democrats/
Documents/Reports/HBCJECJointDoc2 9sep2006.pdf
    Poverty Rate Unchanged From 2004, Up Since 2000. August 
2006. Link: http://www.jec.senate.gov/democrats/Documents/
Reports/poverty2006.pdf
    The Number of Americans Without Health Insurance Rose for 
the Fifth Year in a Row in 2005. August 2006. Link: http://
www.jec.senate.gov/democrats/Documents/Reports/
healthinsurance2006.pdf
    Household Income Up Slightly in 2005, But Down Since 2000. 
August 2006. Link: http://www.jec.senate.gov/democrats/
Documents/Reports/income2006.pdf
    Strange Bedfellows: Minimum Wage Workers and the Wealthy. 
August 2006. Link: http://www.jec.senate.gov/democrats/
Documents/Reports/estatetax2.pdf
    We'll Be Forever in Their Debt: The Economic Consequences 
of Irresponsible Budget Policy. June 2006 Link: http://
www.jec.senate.gov/democrats/Documents/Reports/
debtandtaxes2006.pdf
    Who Will Pay for Repealing the Estate Tax? June 2006. Link: 
http://www.jec.senate.gov/democrats/Documents/Reports/
whowillpayestatetax2006.pdf
    Highlights of the 2006 Social Security Trustees' Report. 
May 2006. Link: http://www.jec.senate.gov/democrats/Documents/
Reports/sstrustees2006.pdf
    Highlights of the 2006 Medicare Trustees' Report. May 2006. 
Link: http://www.jec.senate.gov/democrats/Documents/Reports/
medicaretrustees2006.pdf
    How Strong Is the Economic Recovery and Is Everyone 
Benefiting? April 2006. Link: http://www.jec.senate.gov/
democrats/Documents/Reports/busheconomyapr2006.pdf
    An Overview of the Gender Earnings Gap. April 2006. Link: 
http://www.jec.senate.gov/democrats/Documents/Reports/
earningsgap25apr2006.pdf
    Measuring Poverty. April 2006. Link: http://
www.jec.senate.gov/democrats/Documents/Reports/memapr2006.pdf
    Administration's Health Insurance Tax Credit Proposal Fails 
to Provide a Real Solution to the Uninsured. Updated April 
2006. Link: http://www.jec.senate.gov/democrats/Documents/
Reports/hitaxcredit17apr2006.pdf
    Fact Sheet: The Impact on Families of the FY 2007 House 
Budget Resolution. Updated April 2006. Link: http://
www.jec.senate.gov/democrats/Documents/Reports/
housebudgetfactsap r2006.pdf
    Administration's Health Insurance Proposals: A Boon to the 
Healthy and Wealthy but No Help for the Uninsured. Updated 
April 2006. Link: http://www.jec.senate.gov/democrats/
Documents/Reports/hsas05apr2006.pdf
    The Effects of the President's Social Security Proposal on 
Women. March 2006. Link: http://www.jec.senate.gov/democrats/
Documents/Reports/womenandpriv30mar2006.pdf
    The Impact on Families of the President's Fiscal Year 2007 
Budget Proposals. March 2006. Link: http://www.jec.senate.gov/
democrats/Documents/Reports/fy2007budgetmar2006.pdf
    The President's Savings Proposals: Bigger Tax Breaks but 
Less National Saving. Updated February 2006. Link: http://
www.jec.senate.gov/democrats/Documents/Reports/
presidentssavingsac counts14feb2006.pdf
    Association Health Plans: The Wrong Medicine for Small 
Businesses' Health Insurance Ills and no Help for the 
Uninsured. February 2006. Link: http://www.jec.senate.gov/
democrats/Documents/Reports/ahpreportfeb2006.pdf
    Administration's Proposed Tax Deduction for High-Deductible 
Health Insurance: A Boon to the Healthy and Wealthy but No Help 
for the Uninsured. January 2006. Link: http://
www.jec.senate.gov/democrats/Documents/Reports/
hsas31jan2006.pdf
    The Bush Economy: The Facts Behind the White House Facts. 
January 2006. Link: http://www.jec.senate.gov/democrats/
Documents/Reports/sotu2006.pdf

                          Additional Views of

                    Vice Chairman Robert F. Bennett

        Overview of Current and Recent Macroeconomic Conditions

    The economic expansion continues to mature. Unemployment, 
inflation, and long-term interest rates remain low by 
historical standards. Employment growth and healthy growth in 
the inflation-adjusted (real) gross domestic product (GDP) 
continued throughout the past year. The economy began 2006 with 
rapid growth, perhaps reflecting an alteration of timing of 
economic activities in the aftermath of last year's devastating 
hurricanes. Growth has slowed over the past two quarters, 
partly a reflection of significant adjustments in the housing 
sector, but remains healthy. Most forecasters view the recent 
slowdown as temporary, with real GDP growth expected to return 
to around 3.0%, at an annualized rate, by the end of next year.
    Recent economic conditions display striking contrasts to 
conditions prevailing prior to enactment of pro-growth tax 
relief under the Jobs and Growth Tax Relief Reconciliation Act 
of 2003, enacted in May of 2003. Highlights of the contrasts 
include:
     GDP growth averaging a robust 3.6% following the 
enactment of tax relief, in contrast to the tepid average of 
1.3% from the first quarter of 2001 through the second quarter 
of 2003.
     Growth in real business fixed investment averaging 
6.9% following the enactment of tax relief, in contrast to an 
average 5.6% rate of decline from the first quarter of 2001 
through the second quarter of 2003.
     A decline in the unemployment rate from a recent 
peak of 6.3% in June of 2003 to 4.4% in October of 2006
     Healthy average monthly gains in payroll 
employment of 166,000 per month from June of 2003 through 
October of 2006, in contrast to an average monthly loss of 
91,000 between January of 2001 and May of 2003.
     Strong gains in equity markets following the 
enactment of tax relief, in contrast to losses prior to relief: 
the Dow Jones Industrial Average has risen 39% between early 
June of 2003 and December 5 of 2006, in contrast to a 16% 
decline between the beginning of 2001 and early June of 2003; 
the NASDAQ has risen 54% between early June of 2003 and 
December 5 of 2006, in contrast to a 31% decline between the 
beginning of 2001 and early June of 2003.
     The Institute for Supply Management (ISM) indexes 
of manufacturing and non-manufacturing (service sector) 
activities, which signal expansion when above 50 and 
contraction when below 50, displayed robust expansions 
following tax relief, in contrast to displays of contraction or 
tepid growth prior to tax relief; the ISM manufacturing index 
has averaged a robust 57 since June of 2003, in contrast to a 
contraction-signaling average of 48 from the beginning of 2001 
through May of 2003; the ISM index of non-manufacturing 
activity has averaged a robust 61 since June of 2003, in 
contrast to a much more moderate expansion-signaling average of 
52 from the beginning of 2001 through May of 2003.
    While correlations do not imply causality, there has been a 
clear and striking turnaround in a wide array of economic 
indicators from signals of contraction or tepid growth prior to 
enactment of the pro-growth tax relief in 2003 to signals of 
strong expansion and robust growth following tax relief.
    Despite the recent slowing of growth and corrections in the 
nation's housing market, I am encouraged by the direction the 
economy is heading in terms of growth and opportunity. This 
does not mean that the economy will not face challenges in the 
months and years ahead, but it does mean that recent economic 
policy decisions have paid dividends for the nation's citizens.

                   ECONOMIC GROWTH MODERATED RECENTLY

    Following very rapid 5.6% annualized growth in real GDP in 
the first quarter of 2006, growth slowed to a still-healthy 
2.6% rate in the second quarter and below-trend growth of 2.2% 
in the third quarter. A significant portion of the GDP growth 
slowdown can be attributed to slowing of the housing market 
from an exceptional, record-setting pace from 2003 through most 
of 2005. Residential investment has declined for four straight 
quarters, pulling overall GDP growth down. In the second 
quarter of 2006, residential investment fell by 11%; in the 
third quarter, it fell by 18%. Uncertainty remains concerning 
how long the housing market correction will take, whether 
housing prices will decline substantially, and what effects the 
correction might have on consumer spending and on overall 
employment growth.
    Prior to the recent housing market correction, as new and 
existing home sales repeatedly set record levels and double 
digit rates of home price appreciation were recorded, rapid 
increases in housing valuations likely helped support consumer 
spending. As households perceived large wealth gains in 
housing, they were, perhaps more easily than in the past due to 
financial innovations, able to tap into home equity to help 
support consumption spending. A risk of significant slowing of 
consumer spending exists if the wealth effect works in the 
other direction because of substantial home value declines.
    Thus far, however, substantial declines in housing values 
have not been observed. And many analysts, including former 
Federal Reserve Chairman Alan Greenspan, believe that much of 
the correction in the housing sector is behind us. Others, 
however, believe there is more of a correction to come. In any 
event, consumer spending, which accounts for roughly 70% of 
GDP, has remained healthy throughout the expansion.

                CONSUMER SPENDING HAS REMAINED RESILIENT

    Growth in consumer spending has remained resilient, 
averaging a 3.1% annualized rate since the beginning of 2001, 
despite a sequence of adverse shocks to the economy including 
the tragedy of September 11, 2001, the aftermath of corporate 
accounting scandals, two wars, devastating hurricanes, and a 
prolonged period of significant increases in energy costs. 
Support for consumer spending has come from, among other 
factors, expanding employment and growth in disposable (after-
tax) income. Growth in consumer spending averaged a healthy 
2.9% annualized rate between the beginning of 2001 and the 
enactment of pro-growth tax relief in 2003; it has averaged a 
robust 3.5% following the enactment of tax relief which helped 
Americans keep more of their hard-earned incomes for use in 
private consumption, investment, and saving.

                      IMPROVING INFLATION OUTLOOK

    Increases in energy prices over the past four years 
dominated on the inflation front. Inflation in the overall 
(headline) consumer price index (CPI) in some months ran above 
4.0% on a year-over-year basis, often led by large increases in 
the rate of inflation in the energy-price component of the CPI. 
Inflation in the ``core'' CPI, which excludes volatile energy 
and food prices and is used partly to gauge the extent to which 
energy price increases are feeding into more general inflation 
in prices of other goods and services, has remain relatively 
benign. Core consumer price inflation has, however, risen above 
what most consider the Federal Reserve's comfort zone. Core CPI 
inflation neared 3.0% in the fall of 2006 and inflation in the 
core personal consumption expenditures (PCE) price index, one 
of the Federal Reserve's preferred measures of consumer prices, 
ran close to 2.5%. Many regard the ceiling on the Federal 
Reserve's comfort zone for core PCE inflation to be around 
2.0%, so inflation is still a concern for the Federal Reserve, 
as well as consumers.

               THE FED PAUSED ON ITS TIGHTENING CAMPAIGN

    Beginning in October of 2006, the Federal Reserve ended its 
tightening policy that consisted of increases in its target for 
overnight interest rates. The Fed had raised its overnight 
interest rate target from the 45-year low of 1.00% in 17 
quarter-point increments beginning in late June of 2004 and 
ending in early August of 2006. In the last three meetings of 
the Federal Open Market Committee, the Federal Reserve's 
monetary policymaking committee, the Fed decided to keep its 
overnight interest rate at 5.25%. Despite rising short-term 
interest rates, long-term nominal interest rates have not 
increased significantly and remain low by historical standards.

                      ENERGY PRICES HAVE RETREATED

    A notable feature of recent economic developments is the 
decline, on balance, in energy prices since the summer of 2006. 
Energy prices rose significantly from the beginning of 2004 
through the summer of 2006; the spot price of a barrel of West 
Texas Intermediate crude oil, for example, rose by 117% from 
the beginning of 2004, when the price was around $34 a barrel, 
to over $74 a barrel by July of 2006. Since the summer of 2006, 
however, energy prices have receded; the spot price of a barrel 
of West Texas Intermediate crude oil, for example, has 
retreated from the $74 a barrel level in July to below $60 in 
November. Reductions in energy costs help ease concerns about 
acceleration in inflation and help increase the purchasing 
power of wages, salaries, and incomes of Americans.

                   Features of the Economy Since 2001

    Growth in real GDP has averaged a healthy 2.6% annualized 
rate since the beginning of 2001 and has averaged a robust 3.6% 
since the enactment of pro-growth tax relief in 2003. There 
have been 20 consecutive quarters of growth in real GDP through 
the third quarter of 2006.
    GDP growth has recently slowed from the very rapid 5.6% of 
the first quarter of 2006, down to a still-healthy 2.6% in the 
second quarter and 2.2% in the third quarter. Slowing in the 
housing sector of the economy has contributed significantly to 
the recent growth slowdown; indeed, residential investment 
declined by 11.0% in the second quarter of 2006 and by 18% in 
the third quarter. Forecasters see growth gradually 
accelerating next year, reaching a healthy 3.0% annualized rate 
by the end of the year.


    Consumer spending, which accounts for around 70% of 
economic activity, has remained resilient since the beginning 
of 2001, despite numerous negative shocks to the economy. 
Growth in inflation-adjusted consumer spending has averaged 
3.1% since the beginning of 2001, and an even more impressive 
average of 3.5% since the enactment of pro-growth tax relief in 
2003. 


    Investment growth also contributed substantially to overall 
GDP growth since the enactment of pro-growth tax relief in 
2003. Annualized growth in inflation-adjusted private fixed 
investment spending has averaged a robust 6.9% from the third 
quarter of 2003 through the third quarter of 2006. This stands 
in marked contrast to an average annualized rate of decline of 
5.6% from the beginning of 2001 through the second quarter of 
2003. 


                   JOB CREATION AND LOW UNEMPLOYMENT

    Thirty eight consecutive months of payroll job gains have 
added close to 6.9 million new jobs to business payrolls. In 
the year ending in October of 2006, there were 2.3 million new 
payroll jobs created in the nation's labor markets. Payroll job 
gains have averaged over 166,000 per month since the enactment 
of tax relief in 2003, above the threshold that many believe 
must be crossed for job creation to exceed growth in the 
population. In marked contrast, from the beginning of 2001 
through May of 2003, prior to the pro-growth tax relief enacted 
in 2003, there was an average loss of 91,000 payroll jobs per 
month.


    The unemployment rate in October 2006 was 4.4%, below the 
recent peak of 6.3% in June of 2003. The 4.4% unemployment rate 
is also below the averages of each of the 1950 (4.5%), 1960s 
(4.8%), 1970s (6.2%), 1980s (7.3%), and 1990s (5.8%).


                     WAGES, SALARIES, AND BENEFITS

    Escalating energy costs witnessed over the past few years 
have served to erode the purchasing power of wages and 
salaries. Consider, for example, average hourly earnings. There 
were, for several quarters, declines in the inflation-adjusted 
(real) value of those earnings causedlargely by escalations in 
energy costs. Recent reductions in energy costs have helped restore 
positive growth in real earnings. It is useful to keep in mind that 
average hourly earnings is a very incomplete measure of worker 
compensation that ignores around 20% of the workforce by measuring only 
earnings of non-supervisory workers and ignores around 30% of overall 
worker compensation by measuring only wages and salaries and not 
including benefits.
    More comprehensive measures of compensation accruing to 
American workers, that include benefits as well as wages and 
salaries, show that workers have made real gains since the 
beginning of 2001, which means that there has been positive 
growth in the amount of goods and services they can purchase 
with their overall compensation. For example, in inflation-
adjusted terms, compensation measured in the National Income 
and Product Accounts has grown on a year-over-year basis at an 
average 1.65% pace since the beginning of 2001. Growth in the 
real wage and salary component of overall compensation has 
averaged 1.01%, while growth in the benefits component 
(supplements to wages and salaries) has grown at a very robust 
average 4.61% pace since the beginning of 2001. 


    A key to increases in living standards is growth in 
productivity, as the next chart clearly illustrates. Pro-growth 
tax relief, such as that enacted in 2003, lays a solid 
foundation to facilitate continued strong growth in the 
productivity of American workers. That growth ultimately boosts 
workers' wages, salaries, benefits, and living standards.


                      HEALTHY PRODUCTIVITY GROWTH

    From the beginning of 2001 through the third quarter of 
2006, year-over-year growth in labor productivity--output per 
hour in the non-farm business sector--averaged 3.0%. This is 
well above the 2.0% average of the 1990s and above the long-
term average of 2.3% from the beginning of 1948 through the 
third quarter of 2006.

                 HEALTHY EXPANSION OF BUSINESS ACTIVITY

    Economic activity in both the manufacturing and the service 
sectors of the economy remains healthy, according to surveys by 
the Institute for Supply Management (ISM). The ISM index of 
manufacturing activity had been above a value of 50, indicating 
expansion in the manufacturing sector, for 42 consecutive 
months beginning in May 2003 when tax relief was enacted. The 
index edged down to 49.5 in November of 2006, the first sign of 
a slight contraction in manufacturing for 42 months. The ISM 
index of non-manufacturing (service sector) activity has 
remained above 50 for 44 consecutive months beginning in April 
of 2003. Capacity utilization in the industrial sector 
(manufacturing, mining, and utilities), after hitting a near-
term low of 73.9% in December of 2001, has trended upward to 
over 82.0% for five consecutive months through October of 2006, 
moving into line with long-run historical norms.

                     THE HOUSING MARKET CORRECTION

    New home sales and existing home sales have fallen on a 
year-over-year basis for 10 and 11 consecutive months, 
respectively, through October of 2006, with some months showing 
significant double-digit rates of decline. However, levels of 
activity remain high by historical standards, and recent 
declines in sales follow significant and persistent increases 
in the period 2003 through 2005. Housing starts and building 
permits have shown significant declines in the second half of 
2006, as builders cut back on construction activity to work off 
recent growth in inventories of unsold homes.


    According to the house price index compiled by the Office 
of Federal Housing Enterprise Oversight, year-over-year home 
price appreciation has slowed from the double digit rates 
observed between the fourth quarter of 2004 and the second 
quarter of 2006 to 7.7% in the third quarter of 2006. Year-
over-year growth in the National Association of Realtor's 
measure of median prices of existing homes has shown price 
declines in three consecutive months through October of 2006, 
in contrast to double digit increases observed throughout most 
of 2005.


             LOW INFLATION DESPITE RUN-UPS IN ENERGY COSTS

    Consumer price inflation, measured by the year-over-year 
percent change in the CPI, has remained low by historical 
standards throughout most of the ongoing economic expansion. 
Accelerating energy prices caused acceleration of overall CPI 
inflation, pushing inflation above 4.0% during some months of 
2005 and 2006. Recent easing of energy prices has helped pull 
overall CPI inflation from a recent peak of 4.3% in June of 
2006 to 1.3% in October. Inflation in core consumer prices, 
which exclude volatile energy and food prices, has remained low 
throughout the current expansion. Core CPI inflation and core 
PCE inflation began 2006 at around 2.0% but those inflation 
measures rose, to close to 3.0% in September for the core CPI 
and around 2.4% for the core PCE. Those core measures of 
consumer price inflation eased in October of 2006, and the Fed 
anticipates further easing as effects of recent favorable 
energy developments and of recent slowing of economic activity 
take hold. The Fed remains, however, alert to upside risks for 
future acceleration of inflation. 


         RISING SHORT-TERM INTEREST RATES, LOW LONG-TERM RATES

    While the Fed has raised its target for overnight interest 
rates from 1.00% at the end of June 2004 to the current 5.25%, 
long-term interest rates have barely moved on balance. The 
nominal yield on a 10-year constant maturity Treasury note, for 
example, averaged 4.73% in June of 2004 and averaged 4.60% in 
November of 2006. The persistence of relatively low long-term 
interest rates is an ongoing area of economic research to 
establish the important contributing factors.


    To some extent, the low long-term rates could reflect 
reductions in term and inflation-risk premiums demanded by 
investors, perhaps a partial reflection of gains in Federal 
Reserve credibility for keeping inflation low and less volatile 
than in the past. To some extent, the low long-term rates could 
reflect what Federal Reserve Chairman Ben Bernanke has called a 
global ``savings glut,'' with investors in some economies, such 
as in Asia and oil-exporting countries, having an excess of 
savings relative to investment. Those investors then, perhaps, 
decide that the best opportunities for the excess savings lie 
in the strong, liquid, and relatively low-risk financial 
markets of the United States. The relatively strong demand for 
U.S. assets exerts upward pressure on the prices of those 
assets and, correspondingly, downward pressure on their rates 
of return.
    Whatever the reason for the relatively low long-term 
interest rates, they have been carefully analyzed by economic 
analysts because longer-term interest rates have been below 
short-term interest rates, a phenomenon known as an ``inverted 
yield curve.'' Analysts are alert in the presence of an 
inverted yield curve because, in the past, such a condition has 
presaged recession. To the extent that Fed Chairman Bernanke's 
``global savings glut'' hypothesis holds true, current 
conditions do not carry the signal of a possible recession 
ahead as like conditions have in the past. Some support for 
Bernanke's position comes from observing that inversion of the 
yield curve is not currently unique to financial markets in the 
United States. Similar conditions currently hold in a number of 
industrialized economies.

                       INTERNATIONAL DEVELOPMENTS

    From the beginning of 2001 through early December of 2006, 
the trade-weighted value of the U.S. dollar has depreciated by 
around 12.5%. Vis-a -vis the euro, the dollar has depreciated 
by 37.5% during the same period; vis-a-vis the yen, the dollar 
has not changed significantly in the period.
    Many believe that further depreciation of the dollar will 
be necessary given that the U.S. trade deficit is large and 
growing relative to GDP. A declining dollar makes imports more 
costly and less competitive in U.S. markets and makes U.S. 
exports more competitive in world markets.
    Trade deficits have helped fuel historically high U.S. 
current account deficits. The current account deficit, after 
hitting a near-term low as a percent of GDP of 3.5% in the 
fourth quarter of 2001, rose to 7.0% of GDP by the fourth 
quarter of 2005, and has since retreated to around 6.6% of GDP. 
The current account deficit means that U.S. savings are not 
sufficient to fund U.S. investment; on the other hand, it also 
reflects the fact that investors abroad continue to view the 
U.S. as a particularly attractive place to invest.
    Prospects for U.S. exports of goods and services have 
improved recently, with a pickup in growth in the euro-zone, 
after years of tepid growth, along with seven consecutive 
quarters of growth in Japan's economy through the third quarter 
of 2006.

                           THE FEDERAL BUDGET

    The federal government recorded a total budget deficit of 
$248 billion in fiscal year 2006, $71 billion below the deficit 
incurred in 2005. The 2006 deficit was 1.9% of GDP, down from 
2.6% in 2005. Federal government receipts in fiscal year 2006 
rose by 11.8% relative to fiscal year 2005, the second highest 
percentage increase since 1981. In fiscal year 2005, receipts 
rose by 14.6%. Receipts as a share of GDP rose to 18.4% in 
fiscal year 2006, above the average of 18.2% experienced since 
1965. Outlays, too, rose in 2006--by 7.4% over their 2005 
levels. Outlays reached a 10-year high in 2006 at 20.3% of GDP, 
just slightly below the long-run average of 20.5% between 1965 
and 2005.
    Despite the recent favorable swings in the government's 
fiscal position, the threat to stability in longer-term 
government finances comes from projected runaway growth in 
mandatory spending, including Social Security, Medicare, and 
Medicaid. The relatively certain demographic outlook involves 
large-scale retirement of the ``baby boom'' generation, meaning 
fewer workers per beneficiary in Social Security. Currently, 
3.25 workers contribute to the Social Security system per 
beneficiary. The number of beneficiaries by 2030 will have 
doubled and the ratio of workers to beneficiaries will have 
fallen to 2.00. At the same time, Medicare spending per 
beneficiary is expected to rise with increases in the costs of 
medical care. In fiscal year 2005, federal outlays for Social 
Security, Medicare, and Medicaid amounted to around 8% of GDP. 
Projections by the Office of Management and Budget suggest that 
this share will rise to 13% by 2030.
    The nation faces important questions as it examines whether 
promises imbedded in the Social Security system, Medicare, and 
Medicaid are sustainable, given budget and social priorities. 
Many fear that these systems may have committed more resources 
to the baby boom generation than they can realistically deliver 
without imposing massive burdens on younger generations. If 
those commitments are untenable, then making changes to the 
promises should come sooner rather than later, giving people as 
much time as possible to plan their work, savings, and 
retirement plans.

                              The Outlook

    Recent economic data show that economic growth has slowed 
over the course of 2006, partly reflecting a cooling of the 
housing market. Looking forward, most forecasters see a gradual 
return to annualized growth of around 3.0% by the end of next 
year. Inflation pressures have been easing, assisted by lower 
energy prices, contained inflation expectations, and cumulative 
effects of monetary policy actions and other factors 
restraining the aggregate demand for goods and services in the 
economy. Unemployment and long-term interest rates remain low 
by historical standards, and job and compensation growth 
continue.
    Of course, some risks and uncertainties remain. The extent 
to which the housing market correction is behind us or has a 
way to go remains uncertain. Continued rapid growth in China, 
India, and other countries may continue to put upward pressure 
on prices of key inputs such as oil and commodities. The global 
risks of terrorism and unrest in the Middle East also remain. 
There are uncertainties concerning effects of near-term budget 
pressures that will increasingly be felt from the demographic 
tidal wave of baby-boomer retirees in conjunction with existing 
entitlement promises.
    Despite our nation's challenges, we maintain our confidence 
in the economy's ability to expand and provide improved job 
opportunities for all Americans. We must work to insure that 
fiscal and regulatory burdens do not hinder economic growth and 
job creation and we must continue to fight efforts toward 
protectionism against our trading partners that would prevent 
Americans from benefiting from the gains of free and fair 
trade.
                                 Senator Robert F. Bennett,
                                                     Vice Chairman.

                                  
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