[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\
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\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.
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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.
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\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.
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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.
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\5\ See, for example, D.P. O'Brien, The Classical Economists,
Clarendon Press, Oxford, 1975, pp. 245-259.
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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\
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\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).
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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\
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\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.
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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\
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\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.
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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.
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\12\ Several flat tax proposals, for example, remove the mortgage
deduction, which elicits strong opposition from the mortgage and real
estate industries.
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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.
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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:
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\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\
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\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.
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\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.
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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
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\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\
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\74\ Aaron and Munnell, 139.
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Elsewhere, Munnell has written:
The compliance, or more appropriately, the avoidance
costs of the transfer tax system may well approach the
revenue yield.\75\
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\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\
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\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.
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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.
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\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).
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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\
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\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.
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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\
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\82\ Joseph E. Stiglitz, Economics of the Public Sector, 1st ed.
(New York: W.W. Norton & Company, 1986), 487.
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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.
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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.
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\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.
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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\
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\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.
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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\
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\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.
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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.
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\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.
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\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.
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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)
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\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\
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\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.
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\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.
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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.
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\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.
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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.
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\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).
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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:
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\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\
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\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\
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\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.
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\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.
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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/.
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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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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.
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\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.
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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.
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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.