[Economic Report of the President (2007)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 3

Pro-Growth Tax Policy

The word "investment" has different meanings to different people. In
finance, investment means the purchase of financial products or other
assets, such as mutual funds or gold, with an expectation of
favorable future returns. For businesses, it can mean the purchase of
a physical good, such as a durable machine or inventory, with the
hope of improving future business. In economics, investment is
defined as any use of resources intended to increase future
production output or income. In particular, capital investment is
money spent on physical capital such as buildings, equipment, or
machinery, or on human capital such as education or job training.
Because a larger capital stock makes labor more productive,
investment is a primary driver of greater economic growth and higher
standards of living.
If governments pursue policies that involve the least amount of
government interference necessary for a well-functioning capital
investment market, this will encourage an efficient amount of
investment. One type of policy that is key to encouraging an
efficient level of investment is pro-growth tax policy. One of the
goals of pro-growth tax policy is to finance government services in a
way that minimizes the effect of taxes on the capital investment
decisions of households or businesses. By taxing investment returns
too heavily or by providing tax advantages to certain types of
investment, a tax system can discourage overall investment, as well
as prevent capital from being used efficiently. A tax system that
affects investment decisions in these ways is called "distortionary"
because it creates incentives for people to base their saving and
investment decisions on taxes, rather than making those decisions
based solely on where they can use their resources most productively.
This chapter discusses the advantages of adopting a more pro-growth
tax system. It reviews recent changes that have reduced tax
distortions on capital investment decisions, and evaluates options to
further reduce such distortions. It draws the following four main
conclusions.
 The goal of pro-growth tax policy is to reduce tax
distortions that hamper economic growth. Most
economists agree that lower taxes on capital income
stimulate greater investment, resulting in greater
economic growth, greater international competitiveness,
and higher standards of living.
 The current tax code contains provisions that discourage
investment and create distortions that affect the level,
structure, and financing of capital investment. These
distortions dampen capital investment and contribute
to an inefficient allocation of capital throughout the
economy.
 Estimates from research suggest that removing these tax
distortions to investment decisions could increase real
gross domestic product (GDP) by as much as 8 percent in
the long run.
 Since 2001, temporary changes in the tax code have
reduced the tax on investment. These pro-growth policies
have stimulated short-run investment and economic growth.
However, the temporary nature of the provisions
eliminates desirable long-run economic stimulus.


Rationale for Pro-Growth Tax Policy

All societies must decide on the amount of government services that
best provides for the welfare of the citizenry. When deciding how to
finance a given amount of government services, two features of the
tax system must be determined--the appropriate tax base and the
appropriate tax rate. The goal of pro-growth tax policy is to define
a tax base and choose tax rates that finance government expenditures
with the least distortionary effect on the economy. A tax system is
distortionary when it creates incentives for people to make spending,
saving, or investment decisions that are different from the decisions
they would make in the absence of taxes. For example, by taxing the
sale of apples and not oranges, a tax system would encourage people
to consume more oranges and fewer apples than they otherwise would.
Similarly, by taxing a family's out-of-pocket health spending but not
employer-paid health insurance premiums, the tax system encourages
inefficient consumption of health care by households. (See Box 4-1
in Chapter 4, The Fiscal Challenges Facing Medicare, for a discussion
of the President's proposal to reform the tax treatment of health
insurance.) By comparison, a tax system that taxes investment can
create incentives that favor consumption over saving, investment in
certain types of capital over others, or certain methods of financing
capital investment. In the absence of distortionary taxes, people
would have made those decisions based solely on the best and most
productive use of those resources.


Defining the Tax Base

Most economists agree that the choice of the appropriate tax base
is between taxing some measure of income or taxing some measure of
consumption. Broadly defined, income is the increase in an
individual's ability to consume during a period of time. Income can
include labor earnings (both cash and benefits), interest payments,
rents, royalties, dividends, increases in asset values, alimony, and
pension payments. An important dimension of income taxation is that
saving and investment are included in the tax base. Using income as
the tax base is equivalent to taxing potential consumption. In effect,
this taxes all resources that people put into the economy. A tax system with an income base is distortionary because taxes affect decisions on when, how, and how much to save and invest. For example, in taxing household saving,
future consumption (financed by saving) becomes relatively more
expensive compared to current consumption. As a result, households
tend to consume more and save less than they otherwise would if
saving were not taxed.
By contrast, consumption is defined as the actual amount that
people and businesses spend buying goods and services today. When a
tax system has a consumption base, it only taxes what people take out
of the economy. While there are several possible measures of a
consumption tax base--retail sales, value-added, and consumed income,
among others--all of these measures share the attribute of excluding
saving and investment from the tax base. Such a tax system is
considered "neutral" and efficient because it neither encourages nor
discourages savings and investment decisions; it allows people to
decide whether to consume now or to invest in the future based on
market prices instead of on how to avoid paying taxes. Relative to
an income tax, the consumption tax base results in a larger, more
efficient stock of capital, which in turn makes workers more
productive. Output and wages rise, resulting in higher standards of
living. As a result, many economists feel that consumption is a
better base for pro-growth tax policy.
Our current tax system has a hybrid tax base, with elements of both
income and consumption tax bases. Some, but not all, of the return to
saving and investment is excluded from the tax base through various
provisions. For example, individual retirement accounts (IRAs),
employer-sponsored retirement savings plans, lower tax rates on
capital gains and dividends, and accelerated depreciation for certain
types of investment are some of the provisions in the current tax
code that provide at least a partial consumption tax base. Recent
estimates suggest that about 65 percent of the return to house-hold
financial assets is taxed under an income tax base, with the
remainder receiving consumption tax treatment.


Choosing the Tax Rates

A marginal tax rate tells how much tax is paid on an additional,
or marginal, dollar of income. When assessing the effect of marginal
tax rates on investment, it is the effective tax rate rather than the
statutory tax rate that matters. A statutory marginal tax rate is a
legal definition of the amount of extra income needed to pay taxes
due from an additional dollar of taxable income in any year. By
contrast, an effective marginal tax rate estimates the extra share of
the total return from an investment needed to cover tax liabilities
over an investment's useful life. A tax system with high effective
tax rates on labor and capital income will dampen economic growth by
reducing incentives to work and invest in capital formation.


Pro-growth tax policy, whether through adopting a consumption base,
lowering statutory tax rates on saving and investment, or allowing
individuals to fully deduct the cost of investment from taxable
income, stimulates new investment by lowering the effective tax rate
on investment income. Individuals and businesses will undertake more
projects because lowering the effective marginal tax rate reduces the
pretax rate of return necessary to make new projects profitable. In
addition, lowering the effective tax rate on the return to capital
investment enhances the competitive position of the United States in
today's increasingly global economy. This is because a lower
effective tax rate raises the after-tax return to U.S.-based
investment relative to foreign investment, making U.S. investment
relatively more attractive to both domestic and foreign investors.


The U.S. Tax System--
Previous Distortions and Recent Reforms

The United States tax system has become increasingly distortionary
and inefficient, with hundreds of highly targeted tax provisions that
erode the potential for tax system neutrality and greater economic
growth. A major source of inefficiency is the treatment of capital
investment, both for physical capital and for human capital. The
profusion of provisions has resulted in a system where taxes can be
the primary determinant in whether to undertake new investment, what
form the investment should take, and how to finance the investment.
Since 2001, several pro-growth tax policy changes have been enacted
which have reduced the distortionary effect of taxes on investment
decisions. This section discusses investment distortions in the tax
system prior to 2001 and analyzes how changes since that time have
reduced distortions and stimulated economic growth. Overall, the
pro-growth policies enacted since 2001 have helped lessen the impact
of the recession and have led to greater investment and overall
economic growth.


Tax Treatment of Physical Capital Investment

This section discusses how two features of the tax system result in
"tax wedge" distortions that contribute to physical capital
investment inefficiency: depreciation schedules that result in an
inefficient level and allocation of capital, and the double taxation
of corporate profits that affects the level, form, and financing of
business investment.


The Tax Wedge
The tax system creates a "tax wedge" for investment, making the
pretax return on investment higher than the after-tax return on
investment. This is important because investors require the pretax
return to cover both the opportunity cost and the tax cost of
investment. If the tax wedge is large, fewer projects will be
undertaken because the after-tax return for some projects will be
below the opportunity cost of investment. For example, consider an
investment with a pretax return of 10 percent and an after-tax return
of 7.5 percent, meaning the tax wedge is equal to 25 percent of the
pre-tax return. If investors decide they require an 8 percent
after-tax return in order to cover the opportunity cost of the
investment, taxes will stop the otherwise profitable project from
being undertaken. By lowering the effective tax rate on investment,
the pretax return is unaffected but the after-tax return will rise.
For example, if the effective tax rate is reduced to zero, then the
tax wedge is eliminated and the after-tax return rises to 10 percent.
Note that the tax wedge does not need to be eliminated for our
hypothetical project to be financed--the effective tax rate only
needs to be reduced to the point where the after-tax return is 8
percent. However, completely eliminating the tax wedge removes taxes
from the investment decision. Two main contributors to the tax wedge
on investment returns are depreciation schedules and the double tax
on corporate profits.


Depreciation Schedules

A primary source of the inefficiency created by the tax wedge is
the depreciation schedules that treat investments very differently
depending on their business sector, asset life, and source of
financing. Depreciation schedules tell how much of an investment's
acquisition cost can be deducted from the taxpayer's taxable
investment income in any year. There are two distortions associated
with the tax depreciation system. First, spreading the deduction for
the acquisition cost over a number of years lowers the present value
of the total tax deduction relative to fully deducting the cost in
the year purchased. By lowering the present value of the deduction,
the depreciation system raises the tax cost and the total effective
cost of investment. This makes some projects unprofitable and reduces
the economy-wide level of investment. Second, the depreciation system
distorts the allocation of investment among various sectors of the
economy because the depreciation schedules lead to sectoral
differences in effective marginal tax rates. Under an income tax
system, the amount of investment cost counted each year should
ideally equal the true economic depreciation of the asset. For
example, if an asset loses 10 percent of its useful value per year,
then an ideal income tax depreciation schedule would allow 10 percent
of the cost to be excluded from income each year. When tax
depreciation is not the same as economic depreciation, the tax system
distorts investment decisions regarding the allocation of capital
investment.
A common method of measuring the relative distortions caused by the
depreciation system is to calculate the effective marginal tax rates
on different types of investment. Under current law, different types
of investments are depreciated under various depreciation schedules
ranging from 3 to 39 years. Because acquisition costs are deducted
from taxable income at different rates, the amount of tax paid--and
the effective marginal tax rate--varies by depreciation class. Table
3-1 shows the effective tax rates on different assets for different
types of investments, with computer investment facing the highest
effective marginal tax rate and petroleum infrastructure investment
facing the lowest. Because marginal investments should provide the
same after-tax rate of return, the depreciation schedule distorts
the allocation of capital by discouraging investment in assets with
high effective marginal tax rates.
Even if we adopted a tax system with tax depreciation equal to
economic depreciation, there would still be a notable tax wedge that
would distort investment decisions. To completely remove the
investment distortions of depreciation schedules would require
adopting a consumption tax base. With a consumption tax, all
investment costs are fully deducted (fully expensed) from taxable
income in the period in which the acquisition occurs. This has the
effect of reducing the tax wedge to zero if there are no other taxes
on investment returns. This means that the tax system is neutral to
the level and allocation of capital investment because taxes do not
affect the decision to invest and all types of investment are treated
equally.


The Double Tax on Corporation Profits

The double tax on corporate profits--which is inconsistent with
either an income tax or a consumption tax--also has a pronounced
effect on investment



decisions. First, corporations pay tax on net corporate earnings at a
maximum marginal rate up to 35 percent. Second, individual investors
are taxed on the returns they earn on corporate equity. These returns
can take the form of a capital gain, the difference between the
purchase price and the sale price of an asset, or a dividend, which
is a share of corporate profits distributed to share-holders after
corporate income tax has been paid.
The total tax on corporate income is calculated by combining these
two layers of tax. Prior to 2001, the tax on individual investment
returns (capital gains and dividends) created incentives for
investors to favor projects that paid returns in the form of capital
gains or interest payments instead of dividends because long-term
capital gains were taxed at a maximum statutory rate of 20 percent,
while dividend payments were subject to a maximum individual
statutory rate of 39.6 percent (both tax rates do not take state and
local taxes into account).
For corporate income distributed to shareholders as dividends, the
double tax on corporate profits could approach the level of
confiscation. For example, given a maximum statutory marginal tax
rate of 35 percent for corporations and 39.6 percent for individuals,
the combined effective marginal tax rate on distributed corporate
profits could have been as high as 61 percent! Instead of paying out
corporate profits as dividends, a corporation could retain and
reinvest the after-tax profit, leading to an increase in its stock
value. Prior to 2001, when a long-term capital gain was realized, the
combined effective tax rate on corporate profits was about 42
percent, after accounting for the deferral of tax on the accrued
gains. All else equal, investors tended to favor investment returns
in the form of capital gains.
The high effective tax rate on equity-financed investment also
created incentives that favored debt (taking out loans or issuing
bonds) when financing new projects. As shown in Chart 3-1, while the
economy-wide effective tax rate prior to 2001 was 20.4 percent, the
effective tax rate on business sector investment was 29.8 percent.
Chart 3-2 shows that the effective tax rate on equity-financed
investment was 45.2 percent and the effective tax rate on
debt-financed investment was almost zero. The reason for this large
difference in effective rates is that corporations can deduct
interest payments for loan and bond payments from taxable income,
but must include dividend payments and retained earnings in taxable
income. Individual investors then must pay taxes on the interest
payments from their debt holdings and the investment returns (capital
gains and dividends) from their equity holdings. This tax treatment
results in a system where the return to corporate debt is taxed once
but the return to corporate equity is taxed twice. The resulting
overreliance on debt-financed investment could lead to greater
bankruptcy risk during temporary industry or economy-wide downturns,
as well as to a misallocation of resources in the economy.





Tax Treatment of Human Capital Investment

Human capital investment (such as education and worker training) is
an important input in the production of final goods and services, and
investing in human capital is a cost of earning income. Prior to
2001, the tax treatment of education and training expenses was mixed.
Some costs were fully deducted against taxable income, while others
were subject to varying degrees of taxation. In addition, the
treatment varied depending on whether the investment was paid for by
businesses or households.
At the household level, most human capital investment was fully
deducted because the tax system does not tax the opportunity cost of
education--the foregone wages of working instead of attending school.
For other human capital investment costs, there was a complicated set
of rules, with the tax treatment primarily determined by the income
of the individual taxpayer undertaking the investment. Some costs
could also be deducted under both income and payroll (Social Security
and Medicare) taxes.
The opportunity cost of working was fully deductible under both the
income and payroll tax. Other costs fully deductible under both
taxes were scholarships, fellowships, and reduced tuition. Costs
that were fully deductible under just the income tax included
education costs paid through Coverdell Education Savings Accounts
(Coverdell ESAs), interest payments on student loans, and Treasury
bond interest. These costs were excluded from income tax so long as
they were used for tuition and related expenses such as fees,
books, supplies, and the equipment required for courses of
instruction.
At the firm level, human capital investment received more efficient
tax treatment than physical capital investment. Consider a $50,000
investment in office equipment. For many businesses, this cost was
not fully deductible. Instead, the cost was recovered through
depreciation provisions, with a fraction of the cost deducted
from taxable income over a 7-year period. Alternatively, the firm
and workers could have agreed to reduce cash compensation by
$50,000 and invest the money in job training. In this case, the firm
would have deducted the cost of training from taxable income as an
ordinary business expense and workers would not have claimed the cost
as taxable income for income or payroll taxes. In this way, the
investment cost was fully deductible in the year the training
occurred, resulting in no tax distortions to the firm's human capital
investment decision.
In addition to allowing partial deductibility of human capital
investment, the tax system had two human capital investment tax
credits available for use by households. In 2000, the Hope credit
provided a tax credit of up to $1,500 per eligible student for the
first 2 years of post-secondary education. To qualify for this credit
the student had to be pursuing a degree or other recognized
educational credential. The Lifetime Learning credit provided a tax
credit of 20 percent of the first $5,000 in household education
expenses peryear. This credit was available for any post-secondary
education investment for an unlimited number of years, regardless
of whetherthe student was pursuing a degree or educational credential.
Tax credits differ somewhat from tax deductions. A tax credit
directly reduces the amount of tax you have to pay. By contrast, tax
deductions reduce the amount of income subject to tax. Tax credits
can provide investment incentives that are equivalent to partial or
full deductions and can also be more generous than full deductions.
For example, consider a person who has qualified education expenses
of $5,000 and receives a $1,000 Lifetime Learning credit. If this
person is paying taxes at a 20 percent effective marginal tax rate,
then the credit is equivalent to being able to fully deduct the
education cost from taxable income. If the person is paying taxes at
a higher marginal tax rate, then the credit is equivalent to a
partial deduction. For example, if the student is paying tax at a 31
percent marginal tax rate, then the credit is equivalent to being
able to deduct about $3,200 of the investment cost. Similarly, if the
student is paying tax at less than 20 percent, then the credit
provides more than a full deduction (i.e., a tax subsidy).
Overall, the tax system in place prior to 2001 can be characterized
as relatively inefficient with respect to investment in physical and
human capital. Changes to this system were and are still necessary to
eliminate distortions that keep the economy from reaching its full
potential.

Pro-Growth Changes Since 2001

A number of pro-growth tax initiatives have been proposed and
signed into law by President Bush since 2001. The initiatives
enacted include provisions aimed at reducing the double taxation of
corporate profits by lowering the tax rate on dividends and capital
gains; temporary bonus depreciation; expansion of deductibility of
higher education costs; and several smaller provisions aimed at
encouraging investment. Taken together, these reforms reduced the
effect of taxes on investment decisions.


Reducing the Double Tax on Corporate Profits

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA),
proposed and signed by President Bush, reduced the double tax on
corporate profits by lowering the top individual tax rate on
dividends and capital gains to 15 percent through 2008. These changes
promoted economic growth by increasing capital in the corporate
sector and improving the allocation of capital throughout the
economy. As shown in Chart 3-3, in the 9 quarters preceding JGTRRA,
real private nonresidential investment fell at an average annual
rate of about 7.5 percent and annual real GDP growth averaged
1.1 percent. In the 13 quarters after JGTRRA was enacted, real
private nonresidential investment grew at an average annual rate of
about 6.9 percent, with annual real GDP growth averaging 3.6 percent.
While it is too early to estimate the full effect of pro-growth tax
policy on GDP, recent estimates suggest that without the tax cuts the
economy would have had as many as 3 million fewer jobs and real GDP
would have been as much as 3.5 to 4 percent lower by the end of 2004.
Several studies indicate that prior to JGTRRA, corporations had
been steadily reducing dividend payments. The reason is that the tax
system resulted in a strong tax bias in favor of retained earnings
and capital gains. Since passage of JGTRRA, there has been an
increase both in the average amount of corporate dividend payments
(Chart 3-4) and in the percent of firms paying dividends (Chart 3-5).
Reducing the double tax on corporate profits also slightly reduced
tax-motivated incentives for debt finance because it reduced the
effective marginal tax rate on equity finance. As seen in Chart 3-2,
the effective marginal tax rate on equity-financed corporate
investment is now about 40 percent, a drop of about 12 percent from
the pre-2001 effective tax rate. While this rate is still
substantially higher than the effective tax rate on debt-financed
corporate investment, the relative reduction reduced the distortion
between debt and equity finance.
A major challenge facing this pro-growth change is the impermanence
of the capital gains and dividend tax reductions. Originally
scheduled to expire at the end of 2008, both provisions were recently
extended until the end of 2010 in the Tax Increase Prevention and
Reconciliation Act of 2005 (TIPRA). For



these changes to have lasting effects on investment and economic
growth, these pro-growth policies should be made permanent.



Increasing the Deductibility of Capital Investment

Another pro-growth change proposed and signed into law by President
Bush was the Job Creation and Worker Assistance Act of 2002 (JCWAA).
This act included a provision for temporary bonus depreciation, which
allowed taxpayers an additional first-year depreciation deduction of
30 percent from taxable income. In 2003, JGTRRA included a
modification to the JCWAA bonus depreciation provision, allowing
taxpayers to take a first-year depreciation deduction of 50 percent
from taxable income. Both provisions were temporary and expired at
the end of 2004 because the purpose of these provisions was to
provide a temporary investment stimulus to speed economic recovery
and promote short-term economic growth. By allowing investors to
deduct more of the cost of investment from taxable income in the year
of acquisition, these provisions had the effect of lowering by
one-half or more the effective marginal tax rate on qualifying
investment.


Removing Distortions to Human Capital Investment

President Bush proposed and signed into law a number of provisions
that reduced tax distortions affecting human capital investment
decisions. Among these provisions were statutory changes that allow
households to deduct (within limits) higher education costs; an
expansion of the deductibility of student loan interest payments;
and an expansion of the full deductibility of employer-provided
education expenses to include workers pursuing graduate school
education. Other changes include an increase in the amount of money
a household can contribute to a Coverdell ESA; the removal of tax
considerations from higher education costs paid through qualified
tuition programs (Section 529 plans); an increase in the amount of
costs eligible for the Lifetime Learning credit; and an expansion of
eligibility for these various education provisions.


Other Changes

Other changes that have been signed into law by President Bush over
the past 5 years are tax credits aimed at encouraging research
investment; an expansion of full deductibility of the acquisition
cost of tangible property for small business (called Section 179
expensing); full deductibility of brownfields projects; and full
deductibility of certain oil exploration costs. Some of these changes
stimulated investment and greater short-run economic growth.
Unfortunately, the temporary nature of many of these provisions
reduces their potential to stimulate long-run efficiency gains to
investment and economic growth.



Incremental Approaches to a
More Pro-Growth Tax System


Many economists agree that adopting a broad-based consumption tax
would benefit the economy. There is a substantial body of research
that estimates the economy-wide growth effects of this broad
pro-growth tax reform. The estimated effects can vary widely
depending on the type of model used and the policy change considered.
For example, when considering the transition to a pro-growth
consumption tax, estimates of the short-run increase in the capital
stock range from about 1 percent to about 14 percent, with estimates
of the long-run increase in the capital stock ranging from about 0
percent to about 32 percent. As a result of capital deepening (the
increase in capital per worker), the long-run increase in real gross
domestic product is estimated in the range of about 2 percent to
about 8 percent (about $260 billion to about $1.1 trillion in 2006
GDP).
In the absence of such broad reform and the transition to a
consumption tax base, there are two primary alternatives for adopting
a more pro-growth tax system. One is to allow investors to completely
deduct (fully expense) or substantially deduct (partially expense)
the cost of their investments in the year in which the investments
are made. The other alternative is to lower the statutory tax rate
on investment income by reducing or eliminating the tax rate on
corporate income, capital gains and dividends, or a mixture of both.
Both of these approaches would reduce the amount of tax paid on an
investment return, lowering the pretax rate of return necessary to
undertake new investment. If one of the objectives of pro-growth tax
policy is to move incrementally to a more efficient,
consumption-based tax system, then expensing does a better job than
rate reductions of meeting this objective. Indeed, full expensing of
investment is a necessary component of a consumption tax base. By
contrast, reducing the statutory corporate tax rate or eliminating
the tax on capital gains and dividends could be accomplished under
the existing hybrid tax system.
There are a number of reform options that contain elements of
these approaches. One option is a value-added tax (VAT) that replaces
all or part of the corporate income tax; another, the Growth and
Income Tax (GIT), proposed by the President's Tax Reform Panel, would
lower effective marginal tax rates on new investment. Other options
focus on household saving as a means to remove investment
distortions. However, compared to a VAT or the GIT, these options
would provide relatively less stimulus for domestic growth within a
rapidly expanding global market. The reason is that focusing on
savings incentives tends to ignore the full effects that capital
has on the economy. By reducing taxes on investment, the economy
develops more capital, increasing labor productivity and wages.
In addition, reducing effective tax rates on investment attracts
more foreign investment because U.S.-based investment would offer
relatively higher after-tax rates of return. (See Chapter 8,
International Trade and Investment, for a discussion of the
benefits to the U.S. of foreign investment.) Expanding savings
incentives can provide capital deepening, but it will not encourage
greater investment by foreign investors who do not
receive the benefits of the reform. This section focuses on
pro-growth options that would have the greatest impact on economic
growth.


Expensing of Investment

Allowing investors to fully deduct the cost of an investment from
taxable income is called full expensing of investment. As shown in
Box 3-1, in the absence of other taxes, full expensing reduces the
tax paid on the normal return to capital investment to zero,
completely removing taxes from the investment decision. This happens
for two reasons. First, all assets face the same effective tax
rate--zero--so that taxes no longer influence the decision about
where or in what to invest. This results in a more efficient
allocation of capital. Second, with full expensing there is no
difference between the pretax and after-tax rates of return to
investment. As a result, taxes do not discourage capital formation.
It is important to note that full expensing is equivalent to not
taxing the ordinary, normal return (or opportunity cost) of new
investment. As shown in Box 3-1, the reason is that full expensing
is equivalent to an interest-free loan on the value of foregone tax
liability. To see this result, consider the example in Box 3-1.
Under the income tax, the firm pays $35 in tax on the cost of the
investment, whereas under full expensing the tax liability on the
cost of the investment is zero. Assuming that the pretax return of
10 percent equals the normal opportunity cost of funds, the deferral
of tax liability is worth $3.50 to the firm, which is exactly equal
to the tax on the investment return. Because the opportunity cost of
this loan is equal to the normal return to the investment, full
expensing of investment costs is equivalent to excluding the normal
return portion of capital income from taxation. However, returns in
excess of the opportunity cost (called supra-normal returns) are
still subject to taxation. For our example, if the total return of
10 percent is composed as a normal return of 6 percent and a
supra-normal return of 4 percent, then the deferral of tax liability
is worth $2.10 to the firm. This is equivalent to the firm paying
$1.40 in tax, which is a tax of exactly 35 percent on the $4.00
supra-normal return.
Partial expensing of investment occurs when something less than
100 percent of an asset's purchase price is excluded from taxable
income in the year the asset is purchased. Partial expensing reduces,
but does not eliminate, the amount of tax paid on the return to
capital investment because costs


_____________________________________________________________________
Box 3-1: Investment Returns Under Different Tax Systems:
A Numerical Example

Suppose a firm undertakes an investment in a new machine that costs
$100 and that earns a pretax rate of return of 10 percent. Assume
that the machine does not depreciate in value and that the firm
sells the machine for $110 after 1 year. Under a system with a
corporate income tax and no expensing, the after-tax cost of the
machine is $100 because the firm receives no deduction from taxable
income when it purchases the machine. At the end of the year the firm
deducts the cost of the machine from the firm's total income and has
a net income of $10. With a corporate tax rate of 35 percent, the
firm pays $3.50 (35 percent of $10) in tax to the government. This
leaves the firm with $6.50 in after-tax income, and results in an
after-tax rate of return of 6.5 percent on its investment of $100.
The corporate income tax creates a 3.5 percentage point tax
wedge between the pretax rate of return (10 percent) and the
after-tax rate of return (6.5 percent) on the investment.
With full expensing, the firm deducts the cost of the machine from
taxable income at the time of purchase. This means the firm's
after-tax cost of the machine is only $65. As before, the firm then
sells the machine at the end of the year for $110. Under full
expensing, the entire $110 is included in taxable income because
the firm deducted the cost of the machine when it was purchased.
This means the firm pays $38.50 (35 percent of $110) in taxes and
makes an after-tax profit of $6.50. The firm earns an after-tax
rate of return of 10 percent on the $65 investment, which equals
the pretax rate of return. Because the firm is not taxed on the
investment's return, the result is an effective marginal tax rate
of zero.
In contrast, consider what happens when the government lowers the
corporate tax rate to 25 percent but allows no expensing. The firm
sells the machine at the end of the year for $110 and pays tax of
$2.50 (25 percent of $10). As such, the firm's after-tax rate of
return is 7.5 percent and the tax wedge between the pretax and
after-tax rate of return is 2.5 percentage points. Lowering the
corporate tax rate reduces the disincentive to invest but does
not eliminate it unless the statutory tax rate is reduced to zero.
By comparison, reducing the statutory corporate marginal tax rate
to 25 percent would be equivalent, in terms of the effective tax
rate, to about 38 percent partial expensing of investment costs.

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Income Tax versus Pro-Growth Tax: A Numerical Example


Cost of machine                                    $100
Pre-tax rate of return                              10%
Value of asset in 1 year                           $110
Corporate rate tax                                  35%


Income tax:

Net taxable income
= Selling price - Cost of asset            $110 - $100 $10
Taxes owed
= Corporate tax rate * Profit                35% * $10 $3.50
After-tax return
= Net income - Taxes owed                  $10 - $3.50 $6.50
After-tax rate of return
= After-tax return / Cost of machine        $6.50 / $100 6.5%
EMTR on investment income*
= Tax paid / Investment income                $3.50 / $10 35%



Pro-growth tax:
Expensing
New cost of machine
=Old cost of machine * (1 - corp rate)        $100 * (1 - 35%) $65
Net taxable income                                             $110
Taxes owed                                        35% * $110 $38.50
After-tax return                            $110 - $38.50 - $65 $6.50
After-tax rate of return                            $6.50 / $65 10%
EMTR on investment income                               $0 / $10 0%



Corporate rate cut (new rate=25%)
Net taxable income                                  $110 - $100 $10
Taxes owed                                          25% * $10 $2.50
After-tax return                                  $10 - $2.50 $7.50
After-tax rate of return                          $7.50 / $100 7.5%
EMTR on investment income                           $2.50 / $10 25%


*Note: EMTR refers to the effective marginal tax rate.

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in excess of those expensed are still subject to the tax depreciation
schedules, resulting in an inefficient allocation of capital.
There are several advantages to adopting full expensing as part of
the current tax system. First, full expensing reduces the tax wedge
between the pretax and the after-tax rates of return on investments,
resulting in a more efficient level and allocation of capital
throughout the economy. Second, if coupled with the repeal of capital
gains and dividends taxes, full expensing completely removes taxes
from equity-financed investment decisions. Third, full expensing
reduces distortions that affect the financing of new investment by
reducing incentives to debt-finance investment. Fourth, expensing is
an integral part of many major tax reform proposals, such as a
transition to a VAT, a consumed income tax, or the GIT. Overall,
full expensing greatly simplifies the tax system and is an important
step in the transition to a full consumption tax.
There are two important issues that must be resolved when adopting
expensing as part of the tax system. The first issue is transition
costs, which pertain to how the tax system will treat existing
capital, called "old capital," at the time of the change. This is
important because expensing can place a potentially heavy tax burden
on the owners of existing capital. This tax burden arises because of
the difference in the treatment of new capital (which can be
expensed) and old capital (which does not benefit from expensing).
As shown in Box 3-1, the after-tax rate of return on new investment
rises with full expensing. The increase makes new investment projects
relatively more attractive to investors than purchasing existing
capital projects. Consequently, the relative value of the existing
capital at the date of the change must fall in order for old capital
to earn the same after-tax rate of return as an investment in new
capital. The decline in value is equivalent to an unavoidable tax on
existing capital and is considered a transition cost of full expensing.
The second issue is the treatment of interest payments under full
or partial expensing. If expensing is to result in taxes being
neutral in investment decisions, interest payments must be taken
out of the tax system. Otherwise expensing could result in negative
tax rates and overinvestment in capital. Removing interest from the
tax base means that borrowers cannot deduct interest payments from
taxable income. Similarly, lenders would not include interest
payments in taxable income. The elimination of interest
deductibility would help to equalize the tax treatment of different
types of financing and would reduce tax distortions in investment
decisions. However, excluding financial transactions from taxation
could create difficulties for financial services businesses and
result in opportunities for tax arbitrage--forming or consolidating
businesses to take advantage of the difference in tax rates as the
basis for profit. The taxation of financial services under a
consumption tax is a perennially thorny problem that has yet to
admit of an easy solution.


Reducing Statutory Tax Rates

An alternative to expensing of investment is to reduce statutory
tax rates on investment income. Unless the tax rate is reduced to
zero, however, lowering the statutory tax rate will not completely
eliminate distortions affecting capital investment decisions. As
discussed in Box 3-1, the effect of lower statutory rates on
investment is similar to that of partial expensing of investment.
Lowering the statutory tax rate on investment can take many
forms--lowering the corporate tax rate, lowering individual tax
rates, reducing or eliminating the tax rate on capital gains and
dividends, or some combination of these. All of these alternatives
have the effect of reducing tax distortions on investment decisions,
but the economic effects will differ according to which tax rates
are reduced.
One of the biggest misconceptions about pro-growth tax policy is
that reducing the statutory corporate tax rate only benefits
corporations. The main problem with this argument is that
corporations are pure legal entities that cannot themselves bear
the burden of taxes. It is households, in their role as owners and
users of corporate capital, who benefit from the reduction in
corporate tax rates. As discussed in Box 3-2, corporate tax burdens
are distributed across all households. The long-run effect of
reducing the corporate tax rate is to increase the capital stock,
making labor more productive. Ultimately, reducing corporate taxes
benefits labor through higher wages and benefits capital owners
through higher after-tax returns.
An important goal of pro-growth tax policy is to promote a tax
system that does not create distortions that affect the structure
of business formation or business investment. By reducing statutory
tax rates for corporations or households in an uncoordinated way, the
tax system can create incentives that favor certain forms of
business. For example, consider reducing the maximum effective
corporate tax rate below the maximum effective individual tax rate.
This would make it relatively more attractive for businesses to
incorporate rather than form as a sole proprietorship or partnership
(which pay tax using individual rate schedules). Consolidating the
business and individual tax bases would reduce or remove taxes from
consideration in business decisions.
Reducing individual tax rates can also reduce tax considerations
from capital investment decisions. Perhaps the most direct way to
stimulate greater individual saving and investment is to reduce or
eliminate the tax rate on capital gains and dividends. This is
important because even with full expensing, the effective tax rate
on investment is positive as long as there are taxes on capital
gains and investment income. Consider two effects from the recent
reduction in taxes on capital gains and dividends. First, there was
an overall reduction in taxes on corporate income, which stimulated
greater investment. Second, the changes reduced the tax distortion
that favored returns in the form of capital gains. Prior to JGTRRA,
the double tax on corporate income was as high as 42 percent and 61
percent for corporate


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Box 3-2: Who Bears the Burden of Corporate Taxes?


One key tenet of public economics is that businesses do not pay
taxes, people do. Businesses organize capital and labor to produce
goods and services used throughout the economy and consumed by
households. But businesses are owned by individuals, hire individuals
as workers, and sell to individual consumers. While firms remit
business taxes to the government, it is individuals who bear the
burden (or incidence) of business taxes. Investors may bear the
burden through lower after-tax returns to investment, workers through
lower wages, and consumers through higher prices.
Tax law provides no insight as to who bears the burden of the
corporate tax. A corporation can be viewed as an institution
comprised of its owners and creditors, wage earners, and customers.
In this sense, everyone belongs to the institution, so everyone
consequentially bears some portion of the tax burden. An important
question is whether the tax burden is primarily borne by owners of
capital or by labor. In analyzing the incidence of the corporate
tax between capital and labor, it is important to distinguish
between the short-run versus the long-run burdens. In the short
run, increases in the corporate tax are borne by current owners
of corporate capital through a drop in asset values and by
investors through lower after-tax rates of return. In the long run,
labor bears most of the burden of the corporate tax. This is because
for taxes on capital income, an increase in the effective tax rate on
new saving and investment leads to a reduction in capital
accumulation. The resulting decline in the capital-to-labor ratio
decreases labor productivity and leads to a fall in wages.

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income distributed as capital gains and dividends, respectively.
After JGTRRA, the double tax on corporate income fell to about 40
percent and 45 percent for capital gains and dividends, respectively.
As shown in Charts 3-3 to 3-5, following JGTRRA, real private
nonresidential investment rose substantially, and there was an
increase in the average amount of dividend payments and the percent
of firms paying dividends.


Comparison of Effects of Different Pro-Growth Policies

The primary objective of pro-growth tax policy is to stimulate new
investment. New investment leads to a larger capital stock,
increases in productivity, higher wages, and economic growth.
Full expensing of investment does a better job than rate cuts in
meeting this objective. As noted above,rate cuts reduce but do not
eliminate the effect of taxes on newinvestment decisions. In
addition, a tax rate reduction applies to all investments, new and
old alike. By contrast, full expensing is carefully targeted towards
removing tax considerations from new investment decisions.
One method of comparing policies is to estimate "bang for the buck"
measures that show the amount of investment stimulus per dollar of
tax cost. These measures are derived by using sophisticated
macroeconomic models to simulate the effect of pro-growth policy
changes, assuming that each policy change has the same budget effect.
As shown in Table 3-2, full expensing provides investment incentives
that are 3.5 times as large per dollar of revenue cost compared to
reductions in corporate tax rates. The reason for this difference
is that much of the revenue cost from statutory rate reductions is
from reducing taxes on existing capital. Because expensing applies
to new capital only, the potential for economic growth is much
greater with expensing than for reductions in the statutory tax rates
that have the same revenue cost.
As discussed above, a major issue with expensing is the transition
cost imposed on existing capital. It is possible that during the
transition to full expensing, the government could provide tax relief
to the owners of existing capital. However, the revenue cost of
providing this type of transition relief would require rate increases
or other tax changes that could reduce the incentive to invest in
new capital projects. Estimates of the cost of transition relief
range from about 1 percentage point to about 6 percentage points of
the long-run increase in real GDP, depending on how and for how long
transition relief is paid. Thus it is possible that providing
transition relief to owners of existing capital could eliminate all
of the efficiency gains from adopting a more pro-growth tax system.

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Conclusion

The goal of pro-growth tax policy is to finance a given level of
government services in a way that minimizes the drag imposed on the
economy by tax distortions on investment decisions of households and
businesses. Of particular importance is the effect a tax system may
have on capital investment decisions. Taxing capital in a way that
distorts investment decisions can affect the level, allocation, and
financing of new projects. Reducing the tax on capital income will
lead to a larger capital stock and higher standards of living. With
more capital available, labor becomes more productive and real wages
rise.
An incremental approach to pro-growth tax policy would be a
transition to a tax system that allows full expensing of capital
investment. Research indicates that we could expect up to a
8-percent increase in long-run real GDP from adopting the pro-growth
policy of full expensing. Full expensing provides relatively more
bang for the buck because it targets new investment, whereas rate
cuts benefit old and new capital alike.
Reducing or eliminating distortionary capital taxation leads to a
more efficient level and allocation of capital throughout the
economy. This increase in efficiency in turn results in higher
productivity, GDP, and standards of living. While there have been
recent changes to a more pro-growth tax system, the temporary nature
of the provisions reduces the long-run impact of these policy changes
on investment and economic growth. Making these changes permanent
would ensure a tax system that minimizes tax distortions to
investment decisions that can keep the economy from reaching its
long-run potential.