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Washington, D.C.
Friday June 3, 2005


Moderator, Tax Analysts

Cato Institute


Brookings Institution

















(9:09 a.m.)
MR. BERGIN: A little late start because of the rain. Good morning. Thank you all for coming on a rainy day. I'm Christopher Bergin, President of Tax Analysts, which is the nonprofit publisher of Tax Notes, Tax Notes Today, State Tax Notes, Tax Notes International, and many other print and online tax publications. Welcome to the second in Tax Analysts series of roundtable discussions on tax reform.

When President Bush said he would make tax reform a high priority in his second term and then appointed a panel to study the issue, we at Tax Analysts decided that we could provide a public service by highlighting the key issues that any serious reform effort would have to address. We decided to bring these issues to life through a series of roundtable discussions with people like you, leaders in the tax policy community. In our first roundtable in April we had a great discussion on the question of what lessons can we learn from the effort that produced our last major reform, the Tax Reform Act of 1986. Today we will ask what role tax reform can play in promoting economic growth.

For those of you who are new to our process here's how it works. I will open things up with some brief remarks to introduce our subject. I will then introduce our distinguished panel of four speakers. Each of them will address aspects of our topic for no more than 10 minutes. After that we will open up the discussion and you are encouraged, all of you, to participate, whether you are sitting around the table or anywhere else in the room. Just wave and I will find you.

We are recording this event and will post the transcript to our Web site as we did with our roundtable discussion in April. Also for media purposes we are on the record, so when I recognize you please state your name. Also please speak into a microphone. For those of you in the audience we have hand-held mics that we will get quickly to you. I will moderate the discussion and we will end at about 11:00 o'clock. We may go a few minutes over since we started late.

So let's get started. I like taxes as a subject. I'll tell you a secret. I am still having to live down the times when I get a little overexcited and say I think tax is sexy. See? When I served as the editor of Tax Notes I thought about taxation and tax policy a lot and, as any good editor would, usually from a cynical point of view.

And even though I now have more of an administrative job at Tax Analysts I am confident that I still think about taxes more than most Americans, though perhaps not more than the distinguished members of this group. But there are times when I don't think about taxes at all. For example, I bought a new car in 1987 right after Congress repealed the sales tax deduction which I knew about because I was writing about taxes at the time. That may have been poor planning on my part, poor tax planning anyway, but I bought the car not with the tax system in mind but because I had just received a pay raise that made my purchase possible.

When I got married the thought of the marriage penalty, at least the one in the tax code, never entered my mind. I cleared that with my wife. When my two children were born I did not think of them as little tax shelters and I promise you that the number of children we have was never influenced by considerations of the alternative minimum tax. And I have never ever heard a person say that he or she wasn't going to work the next day because it would move them into a higher marginal tax bracket. I don't know anyone who thinks that way and I've asked around.

Now, I'm not saying that taxes are never part of an economic decision. For example, I know and suspect most Americans know that from purely an economic point of view it's better to own a house than to rent because of the mortgage interest deduction. And it's obviously better to make a charitable donation than just leave your clothes and furniture to the trash man. I certainly think I benefit from lower tax rates on capital gains and investment and I do understand that tax cuts can help stimulate the economy over the short term. I just don't fully understand the role a tax system can play in spurring economic growth over the long term. I guess I still have a lot of the editor in me. I'm cynical.

So I'm sure that I personally will learn a lot today. We have assembled a distinguished panel to frame our discussion on what role tax policy and tax reform in particular can play in spurring economic growth. Let me introduce our panel in the order that they will appear.

Chris Edwards is the director of Tax Policy Studies at the Cato Institute and a former senior economist at the Joint Economic Committee. Drew Lyon is a principal at Washington National Tax Services of PricewaterhouseCoopers and a former assistant secretary for the Treasury for tax analysis. Isabel Sawhill is the VP and Director of Economic Studies at the Brookings Institution and a former associate director at OMB. And Rob Shapiro is chairman of Sonecon and former Undersecretary of Commerce.

We're going to start with Chris. Chris, how can tax reform help spur economic growth over the long term?

MR. EDWARDS: Well, thanks a lot, Chris, and I certainly learned a lot of what I know about taxes over the years from Tax Notes magazine so whatever I get wrong today I'll blame it on your publication. You often hear economists say that there's no free lunch in policy but when you think about it, that's a strange thing for an economist to say because certainly in tax policy the whole purpose of reform is to find the free lunch. By improving the efficiency of the tax system we can all have higher incomes. That's a free lunch.

Now, it's true when you're talking about tax cuts that are combined with increased spending as we've seen in the past few years the economic effects are certainly open to debate. But if taxes and spending are both cut in my view that clearly spurs growth because at the margin resources are used more effectively in the private sector than the government sector. In theory higher taxes might be used by the government for productivity-enhancing purposes but in practice the marginal federal dollar is spent wastefully in my view but anyway that's a bit aside from the point, though, because the President has called for revenue-neutral reforms. And there are four basic ways that revenue-neutral reforms can spur growth in my view, four ways to get that free lunch.

The first way we can get a free lunch is through reduced compliance costs. Various estimates of the income tax compliance costs range from about 10 to 20 percent of revenues collected so that's about 100 to $200 billion a year. Joel Slemrod and others think that the flat tax would cut compliance costs, for example, by about half so that would be a free lunch every year of about $100 billion.

The second free lunch we can get is from increased neutrality in the tax system. Economists support eliminating narrow tax provisions and loopholes and creating equal treatment for different economic activities. Nonneutralities cause resources to flow from high-valued to low-valued uses; that reduces output. One example of this is that the marginal effect of tax rates on investment in different industries can vary substantially. Jane Gravelle's data shows, for example, that the marginal tax rate on railroad equipment is 18 percent but the rate on engines and turbines is 36 percent. Those types of distortions cause capital to be misallocated. And there are many other nonneutralities in the tax code, as a lot of us are familiar with, the difference in treatment of debt and equity, residential and nonresidential investment, different types of compensation are treated differently, and corporate investment faces a marginal tax rate about twice as high as noncorporate investment.

The third type of free lunch we can get from tax reform is by cutting marginal tax rates. There are two types of efficiency gains you can get by cutting rates. The first is that the negative effects of all those distortions in the tax code are reduced so the negative effects of the mortgage interest deduction would be reduced if we have lower marginal tax rates and, secondly, lower marginal rates increase returns through productive activities such as working and investing. And to take one example, a series of papers by Doug Holtz-Eakin and his coauthors looked at the effects of changes in marginal income tax rates on small business investment. They found, for example, that a 5-percentage point cut in marginal rates, so from 40 to 35 percent, would increase small business investment by about 10 percent so that's a pretty substantial positive effect.

By the way, the economic damage caused by marginal tax rates increases by the square of the rate. To put that another way, as marginal rates rise the damage caused by taxes increases exponentially and that's why reducing the top marginal rates is such a high priority for tax reform.

The fourth free lunch we can get from tax reform is increased savings and investment. Economies with higher savings and investment grow faster. That's pretty straightforward. But the income tax throws a tax wedge in between the gross and net returns to savings and investment which discourages those activities.

There are disputes about how big the response to taxes is on personal savings but it is widely agreed that investment is quite responsive to taxation. And certainly in our globalized economy with hundreds of billions of dollars flowing over borders every year it seems to me that attracting investment capital is an increasingly important thing that we've got to look at in terms of tax reform.

In testimony to the president's tax panel a few weeks back Intel Corporation, to give one example, said that it costs more for them to build a chip plant in the United States than abroad in places like China and the key reason, they argued for their company, is taxes, not labor costs but taxes, even when you're talking about China. So cutting corporate taxes and making sure Intel continues to invest here seems to me is a free lunch for our economy and should be the highest priority of tax reform.

So the big reform option on the table is a flat-rate consumption tax like the Hall-Rabushka flat tax, and that would help give us those four types of free lunches. The Hall-Rabushka flat tax would cut compliance costs, it would end all those nonneutralities in the tax code such as the difference between debt and equity, it would create equal effective marginal rates across different industries, it would treat all different types of business organizations equally, and the distortion against savings and investment would be eliminated.

So how much of an economic gain would we get from a flat-rate consumption tax reform? Well, economists have two ways of measuring this. You can look at the gains to efficiency, in other words the reduction in dead-weight losses, from reform and a whole bunch of simulations have been done on that by Dale Jorgensen, who found, for example, that replacing the income tax with a flat-rate consumption tax would areate gains in the order of 2 to 4 or so trillion dollars, maybe 20 or more percent of GDP, so those are pretty big numbers.

Or you can look at the effects of tax reform on GDP and GDP growth. And a whole bunch of economic models have looked at the GDP effects of tax reform and they typically find that a flat-rate consumption tax would give you increased GDP in the long run of about 5 to 10 percent.

So to close it seems to me, though, that these economic models probably understate the benefits of tax reform because they abstract from certain important details. To give you some examples, some of these economic simulation models don't include the benefits of increased capital inflows from tax reform, some models don't have enough detail to estimate the benefits of eliminating distortions such as the debt-equity financing distortion and the different types of business organization distortions, models often don't take into account the full benefits of capital investment on technological change, and models don't measure the benefits of improved economic decision-making that we would have with a simpler tax climate.

I'm not a model expert and I'm speculating here and it would be up to other folks around the panel here to correct me on that and so with that I think I'll end.

MR. BERGIN: Thank you, Chris. I turn now to Drew.

MR. LYON: Well, there's a saying you can lay all the economists in the world end to end and they'll never reach a conclusion so hopefully we have enough economists to make that true but I am largely in agreement with Chris; I'm glad we have more economists.

So I'd like to focus more on the business side in terms of what tax reform could offer in increasing economic growth and I would point to the treatment of capital income as the most significant distortion today in the tax code. And within this broad category there are many distortions worth talking about but the largest one is the distinction between corporate and non-corporate forms of business activity.

And if you look at the amount of business income in noncorporate form principally earned by partnerships and S-corporations it's been growing at increasing rates throughout the '90s and as of 2001, the most recent data that I put together, there's actually more income earned by partnerships and S corporations than earned by corporations subject to the double tax. And I think that illustrates a couple of things.

First there's a direct efficiency loss to the economy because too much capital is flowing to the kinds of businesses that can operate in noncorporate form and too little to the large-scale businesses that depend on equity markets to raise capital from investors. It also shows the responsiveness capital has to seek out the lowest rates of taxation. It goes to where it's not taxed. There are other examples internationally where that occurs but we've got a very simple example right inside the United States. And so I think reforms aimed at integration where we don't have both an individual level tax on business income and the business level tax would result in significant improvements in economic efficiency.

Chris also alluded to the distortion between debt and equity. Debt financing is tax-favored. You may have corporations deducting debt at the corporate level and it being earned by nontaxpaying entities outside the corporate sector. And so you could also have reform that eliminates the distinction between those sources of financing at the business level.

Why do I focus on capital as the most significant distortion? Well, economists who've played around with the effects of compounding interest now being debated in part in the Social Security context just see the enormous rewards from long-term investment and if you take an example of an asset that earns 8 percent a year if that investment grows for 30 years $1 of initial wealth can grow to $10 by the 30th year. If that same investment is taxed at a 50 percent rate the $1 would be about three and a quarter dollars, one-third less, so the 50 percent tax reduces the returns to investment by two-thirds and you can quite easily get a 50 percent tax on capital today even with the 15 percent tax rates on capital gains and dividend income, the 35 percent federal tax rate on corporations, and then if you add in state taxes on both the corporate entity and individual entities. So there are just significant returns to the economy from greater amounts of investment that are currently discouraged by the tax system.

The other important distortion to eliminate under the current system is the inter-asset distortion that Chris mentioned with the example with the tax treatment of engines and turbines and I forgot what the other railroad example was but it's throughout the tax system, and I agree with Chris that the high-level economic modeling that people engage in probably doesn't begin to pick up the kinds of distortions that actually exist out there.

And when I testified to the tax reform panel one of the things I mentioned was in 1986 when we were trying to figure out the depreciation categories to put equipment in I was at the Joint Tax Committee, we were doing our very best job to minimize distortions among different assets, but we were limited in the scientific data that we had on what are true economic rates of depreciation for these different assets.

And at the time of the 1986 Tax Reform Act the most comprehensive and thorough study on depreciation rates of different kinds of investments had been done by Chuck Hulten and [Frank] Wykoff for the Treasury Department in the late 1970s. What they did was look at auction prices of used equipment to try to figure out how quickly equipment was depreciating and the problem was in the 1970s there weren't many sales of computers. In fact the personal computer wasn't invented until several years after their study was completed.

But, being good researchers, they looked at the asset category that the Commerce Department put computers in and, lo and behold, it was the same as typewriters. So the depreciation rate gathered by General Service Administration auctions of surplus government typewriters was used to assert the depreciation rate for computers and they thought they did a pretty good job. Subsequent studies have shown that I think computers depreciate about twice the rate of typewriters in the 1970s, perhaps not surprising but it's just one way of looking at here we're intentionally trying to do the best thing. We were free of political pressure on where to put certain assets, not all assets, and we're still way off base.

So achieving neutrality across the different kinds of business investments, I think, would go very far. There are two approaches to doing that. One is providing economic depreciation for every asset. As I mentioned, to do that you really need to rely on scientific studies to determine what economic depreciation is. The other approach is to provide expensing for all assets, the immediate write- off, and of the two you're much more certain to get neutrality through expensing just given the scientific uncertainty. Of course, it comes at a tax cost. You're giving up taxation of some amount of capital income by doing that.

The other major distortion is outside of the business sector but if we're to be serious about eliminating distortions we certainly need to look at the tax treatment of owner-occupied housing, which is not only untaxed currently but you can view as subsidized given the mortgage interest deduction.

The other aspect, again, as Chris mentioned, is lowering rates. Here I would really like to follow Michael Graetz's suggestion of lowering the corporate tax rate from about the current 35 to about 25 percent. If we had done this in 1986 it would have been an amazing change attracting worldwide attention. Today if we did it it would only keep us probably as uncompetitive as we were in 1986. Germany
has recently announced a 6-percentage point reduction in their corporate rate. The Netherlands has a similar rate. They already were below the US rate if you also include local taxes. So I think a reform like that would be necessary to try to attract the really highly profitable investments from intellectual capital and research. So that would be my third prescription.

In terms of the efficiency gains, what could we get from doing this, I looked at the same literature Chris points to. There's a great symposium the Joint Tax Committee did in 1997. One table gives 10 different studies, a full range of estimates that were done for them. I think the range of possibilities is probably larger than Chris mentioned just given the uncertainty.

My reading of the Joint Committee study is that within 10 years comprehensive reforms of these types could result in GDP growth from as much as 2 to 10 percent and I'd say there's a lot of uncertainty where within that range we'd fall but, again, those are pure gains to the economy and if you put them in relationship to the amount of taxes we're presently collecting they're very large. The corporate income tax itself is on the order of 2 percent of GDP so if we could get efficiency gains of 2 percent of GDP that's a tremendous amount by comparison. Or if you put it in comparison to the roughly 18 percent of GDP that all taxes are collecting from the economy it illustrates that there are currently significant efficiency losses relative to the taxes that are being raised.

So I'll stop here for now.

MR. BERGIN: Thanks, Drew. Belle?

MS. SAWHILL: Well, I want to shift gears a little bit and talk about what I think is the big elephant sitting in the middle of the room when we talk about tax reform and that is the deficit. I think it's fine to cut taxes and argue that that's good for growth and for the health of the economy but only under two conditions and the first is if the economy is already in recession or operating well below capacity and the tax cuts are designed to be temporary, in other words to be countercyclical. And the second is if the tax cuts are paid for, if they are financed, and I was glad to hear Chris mention this briefly at the beginning of his remarks, either by offsetting tax increases somewhere else in the tax code or by equivalent cuts in spending.

Neither condition characterizes the tax cuts that we have enacted in recent years and that are still being advocated. They have been permanent, not temporary, and they have not been paid for; instead, I think they're largely although certainly not solely responsible for the deficits we now face. We can debate this later around the table but I think the preponderance of expert opinion whether from the CEA or Joint Tax or various academics including some of my colleagues at Brookings is that on balance deficit-increasing tax cuts are not good for long-term growth or the health of the economy. Whatever positive effect they may have, for all of the reasons that the last two speakers have talked about, those positive effects are probably offset and even more than offset by the negative effect of rising deficits on long-term growth and standards of living. I think there is a free lunch, as Chris argued here, but there's also an eat your lunch other side of the coin if you have to do this by allowing the deficit to balloon.

Some people believe that the negative effects of deficits on long-term growth occur because of rising interest rates as the government competes with the private sector for savings and it's true there isn't much evidence to date that deficits have had much effect on interest rates and I think this is a puzzle to many of us. Some of the reviews of the wide literature, academic literature, on this suggest that an extra 1 percentage point of GDP deficit would lead to somewhere between 30 and 70 basis points on long-term interest rates. We certainly haven't seen that and that may be because in our global economy foreigners have been willing to lend us the money at current rates and many people believe and I think there's quite a bit of evidence now that there is a large supply of savings looking for very productive outlooks here in the United States from around the world.

But that's not good for the health of the economy long-term either because it means that our indebtedness to foreigners is going to rise and eventually we're going to have to earmark a growing proportion of our GDP to servicing that debt to people in other countries. So my bottom line, which is sheer conventional wisdom for many people, is that deficit-financed tax cuts are not good for the health of the economy but I'd be interested to hear more discussion on that.

Now, some of my friends on the right say don't worry; we can grow our way out of the deficit. That's possible in the shorter run. We did a calculation at Brookings on what it would take over the next 10 years to melt away current deficits. The answer was a sustained growth rate of real GDP of about 4.3 percent, and if you look at whether we've ever had an entire decade of growth rates at that level it's hard to find a precedent for that.

To be sure there's some good news on this front right now. Recently revenues have been coming in stronger than expected and the deficit is likely to be smaller this year than originally projected. But I think it's fair to say that it's impossible to grow our way out of the deficit over the longer run.

The reason is because a combination of an aging population and rapidly rising health care costs will if current policies are not changed in fairly drastic ways require either one of two main choices. Either we need to raise revenues to European levels, meaning at least a third higher than where they are now, or we need to make draconian changes in budgetary commitments to the elderly, asking them to take major responsibility for their own health and retirement costs. Those two choices are the theme in a new Brookings book called Restoring Fiscal Sanity and there's some literature about it if you're interested.

I think eventually we're going to end up having to do some of both but right now we're not facing up to the need to do either one and almost everything under current discussion involves either cutting investments in the younger generation or involves makings small changes in programs for the elderly that won't get the job done or, as in the case of the present Social Security proposals, will make deficits much worse for the next several decades.

So to do what we need to do, it seems to me, is going to require that Democrats accept the need for wholesale reform in entitlements and that Republicans accept the need for revenue increases, not just back to the 18 percent where we've been historically but probably to something considerably higher than that even if we cut spending in major ways. This is the arithmetic of an aging population and continued health care cost inflation.

Making those kinds of changes is going to require leadership from the President, a bipartisan effort on the Hill. Neither of these things is much in evidence right now. It seems to me that the guidelines for that effort should be to restore fiscal balance through a mixture of revenues and spending, to do so in ways that both enhance growth in equity in the way that the two previous speakers have suggested. I think when we get to the structure of taxes there are many, many opportunities for improvement along the lines that have already been indicated but I think we should make these changes both on the tax side and in the spending side with an eye to growth, efficiency, and equity.

It would be better, for example, to cut spending on the well-to- do elderly and preserve education programs for disadvantaged kids, to take one example, and it would be better to eliminate tax subsidies for affluent Americans. The mortgage interest deduction would be a good one although politically I can't imagine it ever happening than to raise income tax rates across the board. In other words base broadening I would totally support as opposed to rate increases.

As a final note I think it's highly unlikely that we can get the needed revenues from our current tax system alone. Some kind of consumption-based tax is almost inevitable, probably a VAT, and with this thought I want to borrow from something that Larry Summers once said which is that Democrats don't like the VAT because it's regressive and Republicans don't like it because it's a revenue machine and he said we'll get a VAT once Democrats realize it is a revenue machine and Republicans realize it hits the affluent very lightly.

So my question is how do we do revenue-neutral tax reform when we haven't been able to cut spending and have just had a Congressional budget resolution that actually increases the deficit over the next five years.


MR. BERGIN: Thanks, Belle. Rob?

MR. SHAPIRO: Thank you. First, as the cleanup batter here I agree with much of what's been said especially as technical issues. I also want to suggest that they may not necessarily be the most important things to say about the matter.

First, one matter I expected to be raised but which wasn't was the impact of a tax system on short-term growth. You have short-term growth, long-term growth. In thinking about short-term growth, at least, the tax system should be sensitive to income changes so it can assert a countercyclical force when the economy slows and when it heats, and monetary policy is usually a better way to do it than tax policy probably because it's easier for a body like the Fed that's not very accountable to take big steps especially when they increase costs for a lot of people.

But any tax system will have this effect in some form and to some degree. I can't help noting that if the key to the tax system's countercyclical role in fostering short-term growth is its sensitivity to changes in income that points to a little remarked- upon benefit of progressive tax rates and another problem with flat taxes.

In the same vein a consumption-based tax is also less sensitive than an income-based system for these countercyclical purposes since people tend to do whatever it takes to maintain their consumption even when their incomes fall.

For longer-term growth we've heard about the efficiency benefits of simplification especially when the simplification is tied to lower tax rates and, all other things being equal, lower tax rates are better for an economy than higher tax rates. Of course, all other things are never equal.

Lower tax rates in the absence of simplification, for example, or in the absence of some other approach that raises comparable revenues merely trades the efficiency benefits of a smaller tax wedge for the efficiency costs of increased government borrowing. That brings us to the deficits, which Belle has addressed very ably, and while I find it difficult to say with a lot of confidence what the impact on long-term growth is from deficits equal to a few percentage points of GDP for a few years if only because what we call the deficit is so sensitive to how we define and characterize the various transactions between the government and the private sector, what we can say with some confidence is that our extraordinarily low national saving rate has real implications for long-term growth not because it limits the quantity of capital available for private investment. As has been noted already that concern is largely addressed, at least for the United States, in this era by global capital markets. The issue for growth is that large deficits bring down national savings and ours is now so low that it's feeding current account deficits that are out of control, 6 percent of GDP and rising, and they may well bring on a dollar crisis that would dispose of growth in a hurry.

Even if the dollar continues to decline in what we like to call an orderly fashion it's still the case that domestic investment financed by domestic saving is better for long-term growth than domestic investment financed by foreign saving if only because the dividends, interest, and rents earned on those investments stay here. That's a real growth-related reason why we ought to be prepared to pay for at least most of what government spends and that, as Belle has noted, probably means more taxes.

That's all the quibbles I have. Now I want to talk briefly about paradigms. Let's start with a basic proposition. In order to come up with a tax policy or tax system that promotes economic growth you first have to recognize and take account of what factors drive that growth. Then hopefully you can use tax provisions to support those drivers.

For most public discussions about taxes and growth you would think that the most important factor for growth is physical capital since most of the debate revolves around how to encourage the private sector to create more financial capital and then to channel it to physical capital. It's all about saving and investment. Well, it is all about investment but not so much about physical capital.

Economists have generally agreed for at least 40 years, for example, that the largest single factor determining how fast an economy grows over the long run, that is, how much the long-term trend growth rate increases, is the pace of the development and spread of innovation. Figuring that out won Bob Solow his Nobel Prize. That kind of innovation isn't just about new technologies but also new materials, new ways of financing, marketing, and distributing goods and services, new ways of organizing a business, new ways of running a factory floor or an office.

Solow and others figured out that some 30 to 40 percent of U.S. growth over the last century, and we're talking about productivity here, can be traced to the development and spread of innovation, again broadly construed. After that the next most important factor for long-term growth is increases in human capital. They account for maybe 20 to 25 percent. Last, increases in the stock of physical capital contribute about 10 percent.

If you want to know why it probably won't matter much for long- term growth whether we ever expense all investments and plant and equipment at least beyond the efficiency gains, think of it this way. According to the BEA the American economy has about $25 trillion in plant and equipment. We spend about $2 trillion a year adding to that stock but we lose about $1.3 trillion in its depreciation. So on a net basis we add roughly $700 billion a year.

Say an ideal tax system would boost that by 20 percent. That's a lot. That would bring it up to $840 billion. Of course, depreciation would bring down that $140 billion figure pretty fast but let's set that aside for now. The $140 billion difference from an ideal tax system from the point of view of fixed investment represents a one- half of 1 percent increase in the total capital stock and that's what matters to growth.

Growth isn't possible without capital, but in an economy that's already highly capital-intensive, feasible increases make only a small difference and that's why the models say about 10 percent of U.S. growth over the last century can be traced to increases in the capital stock. So the long-term impact of the increase in fixed investment from this ideal tax system, which we've hypothesized at 20 percent, which is a lot, would be 10 percent of one-half of 1 percent.

There's not much question in economics about the role of innovation in growth but there is a huge debate over whether innovation responds to changes in costs and incentives, which is what the tax system would do. The question is whether innovation is exogenous to economic processes, which would mean you would get the same amount of it regardless of what you did with taxes or anything else or endogenous, which means you can affect it with policy changes.

That debate is not our subject today. For what it's worth I favor the endogenous argument enough so that I think it's sensible to say that the most important thing about a growth-oriented tax policy ought to be its impact on innovation and, following that, on human capital. From this perspective tax simplification makes a new kind of sense. It's not so much about efficiency as it is about the intensity of competition.

What's critical for growth is to expose every sector in business to the full force of competition, which means taking away all those special tax preferences because if innovation is endogenous competitive pressures are one of the most powerful factors driving it. And even if competition isn't why companies invest in R&D, at least those not in innovation-intensive industries like pharmaceuticals or software, competition is certainly a driving force in the spread of innovation to others.

Open trade also clearly matters to innovation and its spread both by intensifying competition and by exposing us all to all the innovations that are occurring everywhere else in the world. So any tax provision which has the effect of reducing the openness of the economy would be problematic in a growth-oriented tax program.

Certainly R&D matters here and I think everyone can agree that our current treatment is economically awkward at best. If R&D is as important as it might be, that is, if innovation is endogenous then perhaps we ought to bite the bullet, make the credit more generous, make it nonincremental, and make up the revenues by higher taxes on the profits it generates. From this perspective R&D's critical role in innovation and consequently in growth also justifies whatever taxes are required to support a greatly expanded public role in financing the basic research that the public sector usually avoids.

Clearly education matters a lot here too not only in the development of innovations but also in their successful spread since more education makes people more adaptable to new ways of doing things. And since increases in human capital are also their own separate and powerful factor in long-term growth, we may be able to conclude that expensing expenditures on education and training on both the individual and corporate side makes more sense than expensing those on plan and equipment.

As for plan and equipment, the issues become very complicated if innovation is endogenous. We want to favor the spread of new technologies over purchases of previous generation versions without discouraging companies or individuals from making whatever investments make sense to them. Suggestions on how to do that would be appreciated.

And it's also not clear to me why we shouldn't favor consumer purchases of new technologies as well as investments in their human capital. At the least I think we ought to have this discussion so we can move the debate beyond what it often has become in this era, a debate for preferences between different sectors of the economy and between one income group versus all the others.

MR. BERGIN: Thank you, Rob. We're now going to open this up for discussion. Again, wave your hand and I'll recognize you and I'm going to ask you your name if you don't offer it. So if we know each other don't be insulted. Any comments?

David. See, I already broke my own rule. I know him. State your name and save me.

MR. BRUNORI: David Brunori, I'm with Tax Analysts. It seems to me we're having a discussion on two different planes here almost. Belle and Rob talked a little bit about the problems of the deficit but, I mean, I view the deficit as a political budget problem. We could fix the deficit today easily by either raising tax rates or cutting services. I mean, that's not so much a systemic problem with the tax system, I don't think.

My question for Chris and Rob is, will reform itself without raising rates or cutting services help fix the problem of economic growth, I mean, just reforming how we collect taxes itself? Forget about the political will to either cut services or raise rates. Will reform of the system itself help?

MS. SAWHILL: Revenue-neutral reform.

MR. BRUNORI: Revenue-neutral reform.

MR. EDWARDS: It sounds like you're simply asking will revenue- neutral reform benefit growth. Is that what you're --

MR. BRUNORI: Right, I mean, I think that we recognize that the deficit is a problem and that is a question for the president and Congress and the electorate and everybody else to hash out over the coming years which to me is distinct from how we collect taxes in this country. I mean, the deficit could be a problem even with reform. If we spend more than we take in it's going to be a problem no matter what. The question is how we structure the tax system. Does it matter in terms of economic growth?

Well, certainly if one can imagine any kind of tax system there are tax systems which would be very adverse to growth and tax systems which at least theoretically would be very conducive to growth. We've had a discussion here about whether the most important factor is fixed investment in physical capital or other factors and, depending on what you think about that, it would lead you to a different ideal tax system.

One last point, and that is economists run projections based on theoretically perfect tax models. Of course, they do because that's the only way you can design the models or it's the easiest. It's the only reasonable way unless you have millions of millions of dollars to spend on the model.

But we all know that the tax writing process never approaches that. The transition issues, for example, in a flat tax are enormous, absolutely enormous, and some of its advocates have said well, if you address them you lose most of the benefits. Larry Kotlikoff has said that, for example. So apart from the paradigm issue I think we also need to focus on tax reform of the kind that we can reasonably expect to emerge from the American political process.

MR. EDWARDS: I just want to actually follow up a little up on what Rob said about capital investment. You probably know the literature a lot better than I but it does strike me that capital investment and innovation, technological advances, are so intricately connected that you really can't have one without the other. And if you look at Intel Corporation Intel would never go out and build a new plant that was the same as their old plant. Their new plant is the complete embodiment of the innovation of the company. So if you gave them expensing you gave them higher net returns from building a new semiconductor plant, the economy would get that innovation; it's intricately tied in.

So the Solow type of models that dumbly say that adding new machines that are exactly the same as the old machines gives you only 30 percent or whatever of GDP growth over long run, I think that's really wrong, and it misses what innovation is all about.

MR. LYON: I'd like to also just comment. I think, Rob, your figure was the capital stock might increase by one-half of 1 percent. The same joint committee symposium that I referred to for output gains put a range of capital stock growth between 5 and 20 percent so the range of economic uncertainty is even larger than I alluded to but also that the potential output gains are commensurately larger.

If we took these output gains of 2 to 9 percent those have been estimated for revenue-neutral reforms. I agree with Rob that the reforms are estimated cleaner than they would actually emerge but current law is also modeled cleaner than it actually is so I'm not sure how much is lost by the purity of the modeling.

And if you took 5 percent of GDP on a $12 trillion economy that's $600 billion. If there are 150 million workers that's about $4,000 per worker of extra income so I'd put that as a significant gain compared to the income of the average worker.

MR. WHITE: My name's Jim White from GAO. I've got a question that I think follows up on the discussion so far and the question is some of the efficiency gains from tax reform are one-time effects. The result would be a one-time increase in economic activity as opposed to a permanent increase in the rate of growth over time.

And so my question is to what extent would tax reform result in a one-time shift-up in the level of activity? And that shift-up you continue to operate at that higher level then forever. To what extent does it result in a one-time shift-up as opposed to a permanent change in the growth rate over time? And I think that gets back a little bit to this discussion about the impact of innovation, for example, too.

And I guess a related question is to what extent does this distinction matter? Is it important for the public to understand this difference?

MR. EDWARDS: I think yes, and Michael Boskin in his testimony to the President's panel touched on exactly that issue and discussed that a lot of the benefits of reform. We would get faster growth in short run but we'd reach that higher plateau, whatever it is, 5 or 10 percent higher than current GDP but then you're right. Then this goes to the issue of if increasing incentives for capital investment also leads to endogenous technological growth then you can get sustained higher growth over the long term so I think the benefits of tax reform would be both.

MS. SAWILL: Can I go back for a minute to Dave's question, which was what's the relationship between tax reform and the deficit? My question back to you and to other people here who follow this more closely than I do is where are we talking about paying for the tax reforms that everybody has alluded to? I think at our last roundtable discussion here there was mention, for example, of the exclusion of employer-provided health insurance, which is a huge item, and one could do that but my understanding is the president has already taken certain things off the table like the mortgage interest deduction, charitable contributions, et cetera.

In 1986 I think we heard last time from Joe and others that we had some money to play with and we were willing to raise corporate taxes in order to reduce individual taxes. Where's the money going to come from to do this in a revenue-neutral fashion particularly when we have these very large preexisting deficits that are slated to grow bigger and bigger over time, putting the next few years off the table?

MR. LOBEL: Martin Lobel. This discussion reminds me of the Joint Economic Committee in 1970 when everybody started their reports off assuming perfect competition, no taxes, the following will occur. You're overlooking the political aspects of this and the ability of sophisticated investors to game the system.

I heard a figure, about 35 percent effective tax rate on corporations. Balderdash. The only ones who pay that are the small businessmen who can't afford to hire PricewaterhouseCoopers or Bank of America, and if you've read the front page of the Wall Street Journal today, where they have learned to game the system by shifting profits abroad. Wednesday in the Wall Street Journal, there was an article that I found incredibly shocking saying that 70 percent of the cash flows were intracorporate cash flows from abroad to the United States. That means they're shifting a lot of profits abroad. They've gamed the system. The effective tax rate of large, multinational corporations probably is around 8 percent, far lower than the average person pays in the United States or the guy who cleans this room here.

And from a business perspective you're a fool if you don't try and buy a congressman because your rate of return on your investment in a tax loophole far exceeds anything you're going to get in the market. And it keeps going on and on and on.

In 1986 we did have real tax reform. Rob did a great job on that. And since then we've been slicing and slicing and slicing and opening each tax subsidy, each loophole. The one suggestion that was made is we go to a unitary tax system worldwide so you don't have to worry about all these arcane accounting issues of where you transferred the price to and they suggested that we just base the tax on what you report to your shareholders.

Well, guess what happened. Instant heart attacks all over the place. Richard Posner, the judge from the Seventh Circuit who writes widely on economic issues, said we could probably save 10 percent of the GDP if we got rid of the tax lawyers, a little exaggerating. All these economic models really are based on ephemera because it's all got to be based on the political will to do something.

You talk about impact on the public. Take a look at the stagnation of the middle class in terms of its economic status and look at the increase in income going to the top 1 percent or half of 1 percent in the United States. The best we can hope for, at least I'd like to throw this out as a question, is a tax collection system and worry about doing something for the good with appropriated funds where it's reviewed every year rather than stuck in the tax code and lost forever.

Anybody got a response now that I've opened the grenade and thrown it?


MR. MINARIK: I'd actually just like to join the chorus at this end of the table. Joe Minarik from the Committee for Economic Development. Relative to one of the points that Martin raised, Drew, when you speak again I wonder if you could tell us what the Hulten- Wykoff depreciation rate for a congressman is because if we're going to be investing in that area I think that it should be equal for engines and turbines, I think.

I think Belle in her opening hit the nail on the head and I'd just like to bang it again a couple of times. We are talking around the table in terms of benefits from "tax reform," which, of course, is one of the most misused terms in the Washington language. I think our august journal here once printed an article, and I never have been able to find it, a long time ago which I believe was entitled "The 10 Commandments of Tax Policy," and as I recall the first one was, whatever your tax proposal is call it reform. But when we talk about "tax reform" we are talking about in the metaphorical sense a lot of tiny little Harberger triangles that you get from equalizing marginal rates, this and that, and equalizing effective rates on different assets, reducing marginal rates somewhat, and, as one old wag said once a long time ago, you can fit a lot of Harberger triangles inside an Okun gap and we're talking here largely about macroeconomic phenomena pushing the results that we've been seeing in the last few years.

Belle pointed out a little bit the hole we're digging ourselves into. We have an enormous budgetary gap right now which is going to cause us problems either in terms of interest rates or in terms of our international financial balance or both so we've got a big, big gap to fill. We have seen that gap open and widen during a period of time when an administration and a Congress promised us fiscal responsibility solely through spending reduction.

I don't know where that spending reduction was, I don't see it coming right now, and one of the biggest fears I think we have to face right now is the possibility of either a tax reform bill or a Social Security reform bill that would be "paid for" by promised spending reduction in the future with no specifics. There's a tremendous risk that spending reduction is never going to show up so we ought to be very careful what we do on the revenue side.

On top of that, as Belle pointed out, people are talking about tax reform, which they construe as meaning removing the tax burden from capital, and Drew is absolutely right that if you want to get equal tax rates across all assets the easiest way to do it is to make all those tax rates zero. But if you do that you are losing revenue in the course of that action.

Put all that together, forget about or, if you're going to count money from spending cuts, show me what they are. You've got an enormous revenue gap and we are talking about making that up, it seems, almost entirely by increased taxes on consumption which, as we all understand, means increased taxes on middle-income working households. This does not seem to compute either politically or, it seems to me, with a reasonable sense about what the common good in this nation is.

We are not going to make that up by economic benefits in any reasonable sense. For purposes of perspective if we turn the clock back 50 years and look at where we were at the end of World War II and follow to where we are now we have had substantial reductions in effective tax rates and statutory tax rates. Individual rates, which in the top brackets were in the 90s at the end of World War II, are now in the mid-30s. Corporate tax rates have come down about 20 percentage points.

Inflation at current levels does not distort effective tax rates on capital income nearly as much as they did before. In looking at that continuum we have probably already obtained most of the benefit of taking the immediate post-World War II tax system to an effective tax rate on corporations of zero. We've probably already gotten most of the benefit.

If you look at the economic history of that period it seems to me very hard to see where that benefit was. The changes in economic performance have been very subtle. If you look at economic performance over relatively large chunks of history you see much better economic performance in the 1990s when tax policy went in the other direction than you did in the 1980s when there was a substantial reduction in statutory and effective tax rates. I have a very hard time understanding how we are going to make up this tremendous revenue loss that we're talking about from giving away the tax collections on income from capital through economic performance so we are talking about all of it coming down on moderate- and lower- income households.

In terms of looking around the world to see what the models are I don't want to be flip but the notion of imitating Germany in its tax system and the performance therefrom strikes me at this point to be less than promising with certain very limited exceptions looking at the German economy. There was a claim earlier, I'm not sure quite from whom, about increases from "tax reform" in small business investment. It's worth keeping in mind that because of section 179 of the tax code virtually all investment by anything that could conceivably be called a small business is already expensed so that doesn't seem to me to be a likely outcome.

I'm skeptical.

MR. BERGIN: Let me ask maybe a simple question. Staying away from using the word "reform" and going back to the principles that I learned back in the early '80s, can we really build a tax system that's fairer, simpler, promotes economic growth, and is revenue neutral? Is the general consensus no? We should let the president's panel know that, I think. Can't be done?

MR. EDWARDS: I don't think there's a conflict. In my view fairness means neutrality and, I mean, to talk about corporations for a minute, there are angry comments down here about the low effective corporate tax rate. Claimed to be 8 percent, I think it's more like 20 percent or so but, I mean, the problem there is that corporations have widely varying effective rates.

Sure, if you take companies with highly mobile types of activities, pharmaceutical companies, financial companies, sure, they're able to lower their effective tax rates. On the other hand if you look at companies like Wal-Mart corporation it pays an absolutely enormous amount of taxes, a very high effective tax rate, so the problem there is both fairness and it's distortion and you can fix them both at the same time by creating a more neutral corporate tax code, it seems to me.

MR. SHAPIRO: I don't know. I find it hard to accept that what's really wrong with the American economy is that corporations pay too much taxes when corporations today are reporting the highest profits in their history and they are providing the smallest share of revenues as a share of GDP of any time in 60 years.

MR. LYON: Not this year. Corporate taxes are up 50 percent.

MR. SHAPIRO: Last year. Last year.

MR. LYON: So we're in a recession. I mean, it's unfair to point to recession.

MR. SHAPIRO: Well, actually it's an interesting notion that to say that we're in a recession today. Gene Steuerle some years ago made the calculation that 80 percent of all saving and investment received some form of tax preference. And he made that analysis, I don't know, 10 or 15 years ago. The percentage today is greater than that and the degree of preference is much greater than that. The notion that this is what's wrong with the American economy I just find a wonderland notion.

I agree with you that the variation in the treatment of investment is a significant problem for reasons different than those I think you believe. I think it insulates sectors from competition, makes them less innovative, less efficient, because of that. And so I would like to see a radical simplification particularly along the business side but the notion that that is tied to a tax burden which is inordinate in the face of large and rising deficits and a current account deficit related to those deficits which could, yes, really bring on a recession, again, seems to me otherworldly.


MR. LYON: What I'm amazed at is we're in a roomful of economists and we're referring to corporations as if they're somewhere at the upper tier of the individual income scale. Corporations don't pay tax. They pay tax on behalf of individuals including, perhaps, the janitor who sweeps the floor in this room. It's through the improved productivity that the capital brings and so I think we have to be very careful about talking about the incidence of the corporation as if they're a wealthy individual.

I agree with Joe that we've made tremendous improvements in the tax systems by lowering rates; unfortunately, the world has changed since 1986 as well and since the decades earlier. There's much greater international mobility of capital and this is in part that Martin was alluding to, the opportunities to move profitable investments to attractive locations.

So in some sense we've got more severe competition for the location of capital but the same ability that companies have today to move capital also gives them the opportunity to sell around the world and so we also have greater opportunities for multinationals headquartered in the United States to reach broader markets than they ever could have in the past.

So I think we've got these opposing tensions which make the importance of tax reform in some ways more important than when we had walls around our economy and the capital was locked within. Individuals on their own can invest in foreign companies that are subject to lower taxes so that's a somewhat offsetting effect.

I also want to point out that in moving to expensing we have to be careful about calling it a zero rate on capital income. It's a zero rate on the marginal investment, the last investment undertaken, which is really giving up the return from waiting, the ordinary return. Some people pegged it at maybe a 4 percent return. The extraordinary return to capital, all the inframarginal return to capital, still gets taxed at the statutory rate and that's also the problem with the analogy. The problem today, perhaps we have a
35 percent statutory rate so at the margin profits are taxed at that rate even though the average rate might be much lower.

MR. TODER: Hi, Eric Toder. I wanted to make a few comments about the environment in which tax reform is being considered and how that affects how we think about capital income taxes in particular. The first was touched on by some others in terms of the deficit but really can also be thought of in terms of demographic projections coming forward in coming years and I've just been reading a horror novel on the train but it wasn't by Stephen King. It was by Larry Kotlikoff, who was talking about the coming generational storm. Two things came out of that in my mind that are relevant.

One is the real problem we have in this economy is on the labor supply side, not on the capital side. And the other thing is if we're thinking about what he's talking about is the transfer of resources away from future generations to current generations the deficit is not the only thing you want to look at. You also want to look at the tax system and particularly how the tax system affects people in different age groups, in different generations. And so the one thing I would say that's relevant is that the transition effects of moving toward a consumption tax is terribly important and particularly anything that would reduce taxes on the return to existing capital by itself is not a good thing in terms of those generational impacts.

The second point I want to make is political. The president in introducing the tax reform commission said that he would not allow any changes in the mortgage interest deduction, that that was off limits. I assume he was not disembling when he said that; however, one thing to point out is if we keep interest deductions and reduce the tax on investment income we're not moving toward a consumption tax. We're basically moving toward no tax in the sense that we're allowing all income to be arbitraged away so that's something we need to be very mindful of in designing a reform.

Third question is the increased internationalization. Marty has referred to that and Drew and one aspect of that, however, has not been mentioned. We've been talking about saving and investment a lot and what I learned 30 years ago is in order to get investment you have to have saving. Well, that's really not true any more. If you save you can save anywhere in the world and you can get your investment capital from anywhere in the world.

So I think the lesson to me is as we look at reform as it deals with people and the corporate issue, as Drew said, corporations are intermediaries and it's very, very complicated in the international world to impose an effective tax on corporations. My view is that in terms of taxing capital income certainly the location of capital income, particularly financial capital, is much more mobile than the location of people who are earning the capital, that we should be moving toward taxing capital income as much as we can on a basis of residence and not on the basis of the source or the location of the income.

And that really says something about corporate integration and my concern that by taking the tax off at the individual level you're doing it at the wrong place and also in terms of the Hall-Rabushka proposal, which is eliminating interest deductions, which will have the effect of raising the cost of capital located in the United States.

The final point I want to make is about new research developments in the field of economics and particularly the field of behavioral public finance, which I don't know that much about but I gather it's a challenge to the assumption that people are behaving rationally and trying to look at how people actually behave. There's been limited work done but there's been some very interesting work done looking at saving and in particular the fact that it appears when firms make the 401(k) acceptance the default rather than inviting people to contribute you get a lot more participation in these plans. There's also been some new plan that Professor Richard Thaler has worked on where you're actually getting people to sign up to have successive increases in future years in their saving and the early returns suggest that that's very effective.

So I think that coupled with the fact that we never really have gotten very much attraction from studies that have looked over time, and I know there've been a few that have shown positive results but by and large they haven't is my understanding of the literature, on the relationship between people saving and the after-tax rate of return from saving we might really want to rethink tax reform that's designed to raise the after-tax rate of return from saving, whether that's going to promote economic growth or whether there may be better ways to produce saving, and in particular tampering with provisions in the current code which encourage corporations to offer pension plans to their employees by effectively making a return to all saving tax-free may paradoxically be counterproductive.

MR. BERGIN: Thank you, Eric.

MR. GLECKMAN: Howard Gleckman with BusinessWeek. I'd like to follow up on something that Rob Shapiro raised and actually this is a mechanical question. If we do believe that human capital and education are as important as physical capital how do you make that fit? How do you make that concept fit in a consumption tax? Chris, I don't know, or, Drew, if you want to take a shot at that?

MR. EDWARDS: Let me just make a quick comment. I mean, education is already enormously subsidized on the spending side of the budget. I'm not in favor of extending any further tax subsidies to education. Part of what you do when you do that, you actually are not subsidizing investment. You're subsidizing consumption. Some share of university spending and other types of education spending seems to me is actually consumption spending; it's not investment. It doesn't create long-term benefits. Again, we enormously subsidize universities, K-12 education, already on the spending side of government budget so I don't see any reason to further increase the subsidies.

MR. LYON: I think the traditional view of the tax treatment of education might go back to Michael Boskin in the 1970s when he noted that education really is already on consumption tax treatment. The biggest cost of education really is the foregone earnings that you otherwise would have had so you're not taxed on those foregone earnings. So that's equivalent in the modeling to immediately writing off the cost now. Perhaps since then the cost of college tuition has escalated relative to wages but the basic argument is that it's still essentially a tax-free investment.

MR. GLECKMAN: Rob, you want to respond?

MR. SHAPIRO: Well, it's interesting on the one hand the models treat what is from the point of view of people's behavior, I think, a fairly theoretical aspect of the tax treatment of education as powerful and there was a passing reference to the cost of college tuition. The cost of college tuition is equal to almost the median family income at leading private institutions.

So I think there's a great deal more we can do. I think there's a great deal more we could do with respect to the cost of continuing education which individuals bear as opposed to those which corporations bear. And I certainly don't agree that if in fact we are already spending more than enough on education at state, local, and federal levels then we're not spending it very well by the results. And yes, there are consumption aspects to education; there are consumption aspects to corporate operations as well, not only lunches and cars and gyms and all the other things which we do in order to make life a little more pleasant for most workers and a lot more pleasant for executives. That's all consumption, and it's all nontaxed.

So the notion that there's some distinction between the way we treat consumption expenses in education and consumption expenses by corporations, I think, is not valid.

MR. GLECKMAN: Rob, can I just follow up quickly? Is there any particular reason why these subsidies or these incentives should be generated through the tax code and not through direct spending by the government?

MR. SHAPIRO: Well, that's an interesting question, yes. If you believe, for example, that if we had a policy of actively promoting post-graduate training by current workers, efforts by people to improve their skills, a tax treatment would get the government out of the business of choosing what is the best form that should take and who are the best people to provide it. And so competitive forces and the private sector would be able to compete for that business if it were heavily tax-preferred.

That doesn't mean we don't need to spend more on a lot of aspects of education. I'm thinking more of adult advanced training which ultimately, I think, is if you're thinking about growth in the lifetimes of most of the people at this table, not all, a couple of young people, is just as important as what we would do with public education.

MR. BRUNORI: A quick follow-up if I may. Isn't the tax code already replete with all kinds of incentives for education purposes? I mean, Chris had mentioned that we're expending a lot of money on education and whether we're expending enough is a matter of opinion, obviously, but the last time I checked there are five or six different code provisions providing all kinds of incentives for education, right?

MR. SHAPIRO: Well, there are and all of them came in the 1990s when there was more of a focus on human capital. I think this is an area in which simplification would be very useful. We have too many, they're very complicated, I think we could simplify it and in my view probably expand it as well.

MR. EDWARDS: A quick follow-up on that, I mean, the topic of the forum is economic growth and when the government intervenes for it to create a positive benefit for economic growth it should only intervene when there's a market failure. As far as I have read there's no proof really that there's a market failure that creates a need for government to come in with tax incentives on education.

Young folks know that investing in education creates a high rate of return; everyone knows that. There are newspaper stories on that all the time. Everyone knows that they'll earn more money in the long run if they have a college education, if they get continuing education. So as far as I know, I mean, it's not clear that there's a market failure there that we need government intervention for.

MR. RAINES: Frank Raines, just a couple of comments from an old budgeteer. First it's good to hear some humility about how any one thing can affect this very large economy, including tax reform, because I think humility is really necessary and something you learn going through the federal budget a few times is how little you can predict what the outcomes will be of decisions that you make either on the revenue side or the expenditure side.

The first thing in terms of overall economic growth, by far more important than any of the things talked about today, is the overall size of government. And if you do any international comparisons, the United States has one of the smallest governments of any developed country in the world by far. Our total spending on government is roughly 30 percent and is highly favorable compared to almost any country and as the developing countries fully develop their infrastructures I'm sure it will be competitive there. So a lot of our angst about the impact of either taxes or spending on economic growth, I think, in comparison to other countries has to be tempered by the fact we have a relatively small government.

Second, I think we need to have some humility in talking about the federal tax system because we're really talking about a relatively small part of the tax system of the country. If you take out state and local taxes, relatively 10 or 11 percent of GDP, you take out employment taxes, we're now getting down to the individual tax and the corporate tax to a relatively small part of a relatively small government and we're now getting into the nuances of that relatively small part. What is the impact on capital? What is the likelihood of any of the predictions of impact on the economy and particularly on economic growth being large seems to me has got to be wrong.

Having looked at in great detail on several occasions at the time it was a $1.7-trillion budget, it's over $2 trillion now, the likelihood of any of the benefits happening on the expenditure side that were promised I took to be quite small. Applying the same test on the revenue side, I think we can also expect in reality relatively small impacts.

And I'll just give you one example. Rob talked about the relatively small impact of physical capital on the economy and we debated what the impact would be if you changed different rates, all of which can be washed out by state tax policy, all of which can be wiped out by franchise taxes, other things that are basically taxes on capital. And we can be moving around the chessboard here and not see any of this happen in a real complicated economy out there that either other entities are operating in the opposite direction or by careful tax planning you can avoid.

And just as it's very difficult for us to capture all the benefits on the spending side and have them all hit exactly where we'd like them to be it's probably harder on the tax side because there are probably even more people and more money going into the effort to defeat whatever it is that you're trying to achieve. So I think some humility here is quite appropriate and at least as much humility on the tax side as we have on the expenditure side even though we give far more scrutiny to the expenditure side than we do to the tax side.

The last thing I'd say is that if, taking into account Belle's point that we do have to remember why we have a tax system, it's not just because. It's because we'd like to make expenditures and there ought to be some relationship between the two. And merely because some people believe that all spending is wasted and therefore any spending on interest can go over in the wasted side and therefore deficits don't matter because it's just offsetting spending and so if you can fill it all up with interest maybe you've done a generally good thing but, putting that aside, it strikes me that getting the fundamentals on economic growth straight that we have a small government. If we're going to spend 18 to 20 percent we ought to probably tax 18 to 20 percent on average over the business cycle.

Within that 18 to 20 percent that we are taxing we ought to do it in the most economically efficient way but we ought to also have our spending programs in the most economically efficient way and we ought to just admit that my preference on the revenue side is no different than my preference on the spending side. It's my preference and what we really will have is a democratic debate, small d, about that.

But the idea that economic theory is going to answer that question I think is no more likely than economic theory answering any other question about values or priorities or any of the others and it's quite interesting since I first came to Washington how the discussion of revenues and tax policy has totally moved from being a social and legal discussion. I think everybody here who's in the discussion is an economist, which is one value, certainly an important one to consider, but not one that's going to answer this question for us any more than it answers the question about how much we should spend on education, how much we should spend on the military, and whether within the military innovation is something we ought to be spending on or whether we should be trying to maintain the old [system] and keep it going for another 20 years.

MR. BERGIN: Belle?

MS. SAWHILL: I was going to say something about education but now that Frank has spoken I have to add a couple of footnotes there, one on the size of government and this goes back to something Joe said about how much tax rates have come down over the last few decades as well. If you look at the United States versus other advanced countries, I think almost everybody here knows this, our total tax burden including federal, state, local, is 31 percent of GDP. There are 17 other advanced countries where the total tax burden is more than 10 percentage points above that, in other words above 40 percent, and it includes France, Germany, the UK, Belgium, the Netherlands, et cetera. I'm not arguing that we should go to where they are but it does seem to me that the size of our government and revenue burden we currently have have got to be part of this debate.

On the interest costs of allowing deficits to just continue to add to the national debt I did a calculation that if we don't do anything about the deficit 10 years from now just the increase in interest payments on the national debt, just the increase, will absorb all corporate income taxes. So if corporations are concerned about the level of their burden this is a little bit of a provocative or a cute way of saying they ought to start worrying about these deficits. And I think one of the reasons they don't, which Frank has alluded to, is they consider all spending wasteful, not just interest, which is money we wouldn't otherwise have to pay if we could get the deficit under better control.

If I can go back to education for a moment I agree with those who have suggested that current education spending is not necessarily optimal and I think, by the way, we devote far too many resources to education amongst older kids and adults and not enough to the youngest age group. I think the evidence is quite strong that the rate of return on the right kind of spending at an early age, talking about early childhood education and the primary grades as opposed to adolescence and college age, has a rate of return from at least the better programs that have been experimented with that way exceeds the rate of return on private capital.

So we could debate that. If Gene Steuerle were here he would make the usual point that if we're worried about marginal tax rates we should worry about the fact that every time we income-relate something on the spending side of the budget, which is good to do for a variety of reasons, we create implicit marginal tax rates that probably do bite on lower middle income and middle income families and may affect their behavior although I go back to what you said at the beginning, Chris. I think we way over-estimate the effects of most tax provisions on behavior and I agree with Eric that we ought to look at the research from the new behavioral literature on this.


MR. LYON: To also invoke Gene Steuerle, I think he'd also point out the loss of older workers that our Social Security system encourages.

Bob Goulder with Tax Analysts, I think that the international dimension of the debate is very interesting. Certainly we folks here in the United States are not the only people wrestling with these issues so rather than focus on some theoretical model of what a particular tax system might or might not accomplish, other countries can function as a living lab so let's look at what's going on around the world and I think we heard some discussion before that maybe there are certain aspects of the German tax system that we don't really admire but, that said, who's doing it right?

And I was particularly interested in what Chris might have to say because I know you spent some time in the international area. What do you think about the flat tax systems in Eastern Europe and Russia? Have they got it right?

MR. EDWARDS: Well, a lot of those aren't flat taxes the way we think of a flat tax here like the Hall-Rabushka consumption tax plan. A lot of those, I understand, are not consumption tax systems. And I must say there's also probably a difference between developed and more corrupt countries. They have an even bigger need and drive to create a simple, efficient tax system in order to get the revenues that they need.

I wanted to go back actually to the main point of Mr. Raines and with all due respect here's why I think you're wrong about the point that taxes are a fairly small share of GDP. The thing is that we put taxes on profits, on income, and profits are a very small share of GDP -- they're a small floating part on top of corporate revenues. But they're the tail that wags the dog. They drive the economy. Corporations, small businesses, they try to maximize their profits. Profits are the driver that pushes resources into different activities in the economy.

The corporate tax rate, the statutory rate is 35 percent. That's a third of all profits. That's huge and that's why it is such a big driver. So it's because we tax the thing we tax that looking as a share of GDP is not really the right metric, I don't think.

MR. DIEFENDERFER: My name's Bill Diefenderfer. I presently run a small software company that gets smaller by the day. In the past I had a role in 1986 tax and was Deputy Director of OMB. People often asked me if I was an economist and I said it was one of the few public embarrassments I spared my mother.

Economists do have a role to play but the role ends someplace. I can remember them telling us in the Reagan years that the deficit was going to crush us by the late '90s and it didn't. And I'm not saying that Reagan caused the boom in the '90s. That's for economists to figure out but they're seldom particularly right.

As for tax reform I think the answer to the question is can tax reform help spur economic growth. I think absolutely it can. I think being revenue neutral is important but, remember, the revenue neutrality is estimated by economists who sometimes depreciate computers like typewriters and it's not their fault. They're more in an art then they are in science but they're moving toward a science.

In '86 is tax reform possible? People were discussing about the political problems that one would encounter. In the Senate we essentially broke it down into principles and Hall-Rabushka was an important part of the principle, which was the market should allocate capital and not the tax code. I believe that's one of the strengths of the American economy.

I can remember in 1990 or '89 being the lowest highest person at the White House. I had to meet with Mr. Morita, the founder of Sony, and, listening to a half-hour lecture about how they were going to essentially bury us, the Japanese economy. Well, they had a managed economy. It wasn't a state-run economy but a managed economy and they've come down a few pegs since then. The allocation of capital and the efficiency of the allocation of capital, I came to believe, is key and now we're going to be faced with China, which is a huge challenge, much bigger than Japan, much bigger than Russia, and I believe that the allocation of capital can be improved. Maybe it's marginal but it can be improved by reform in the code.

Allocation of capital is one. Fairness was another. We had six million people who were on the tax rolls who were below the poverty level in 1986 and we took them off. Didn't make it a political issue. Republicans, Democrats looked at that and said it was wrong and they acted.

Reducing the attractiveness of debt was another issue. It was a principle and some simplicity, not a whole lot. Simplicity was at war with fairness in a lot of instances. But if principles are used and you have people of good will and a fair amount of intelligence, and we had a very good committee then, Republican and Democrat, think back to that committee. You had guys like Moynihan, Bentsen. You had Packwood, Danforth, very committed politicians and were also very bright. If you assemble that kind of group and we can agree on broad principles we can make progress. It won't be perfect progress.

I was reluctant to say this but I'm starting to feel very negative about what people are saying about tax reform. It's getting back to Republican versus Democrat. We can agree on principles. I think these principles are still valid. There may not be as much left on allocation of capital, getting rid of tax shelters, although a lot of that's come back. So that's my two cents and I'm sorry if I offended any economists; I was just joking.

MR. BERGIN: I think economists and lawyers have thick skins on this front.

MR. LORENZEN: Ed Lorenzen with, I just wanted to return again to the point that Belle made in her presentation about the importance of looking at tax reform within the context of the overall fiscal policy and the deficit so I think it's important for two reasons.

One, there's been a lot of talk about tax reform should be revenue-neutral, which seems like a simple term but in light of the last few rounds of tax cuts exactly what do we mean about revenue-neutral in tax reform? Is it revenue-neutral at what the current tax laws are now and the current tax rates today or revenue- neutral at what the law provides when the tax cuts expire in 2010? And so if we are doing a tax reform is it assuming that those lower rates are permanent and that over the long term makes a huge difference.

And if we're talking about revenue-neutral at the lower rates made permanent that the fiscal gap becomes huge whereas if it's revenue-neutral assuming that those tax cuts expire then the fiscal gap is not nearly as huge. So that's, I think, a very important question that when the president said tax reform should be revenue- neutral wasn't really discussed.

I think the other reason why it's important to look at it is regardless of the decision on revenue-neutral there's still going to be a fiscal gap remaining and there are going to be issues in deficit reduction and increased revenues and the decisions on tax reform need to be made of will the political consensus and economic rationale for whatever tax reform proposal is enacted be sustainable if we need to collect more revenues.

If, for example, there was a reform deal that had lower rates with a broader base but then we had to come back and increase those rates as part of a deficit-reduction package would the consensus for the broader base still hold? Conversely, if we move to a consumption tax is there a consensus that a consumption tax at a certain level is okay but that changes that would need to be made to that consumption tax as part of a deficit reduction deal would cause that to fall apart? I think arguably that was one of the problems that caused the '86 reform to slowly unravel, that the consensus behind the '86 deal had the rates at a certain level and as we had to go throughout the '90s with deficit reduction packages to make changes in that structure to get more revenues that some of the consensus fell apart and I think that that needs to be very carefully considered. If we want to make whatever we do in tax reform sustainable, it has to be done in light of what are the revenues going to be going forward.

MR. BERGIN: That's a good point.

MR. ROSENTHAL: I'm Steve Rosenthal, a tax lawyer at Miller & Chevalier. I'm also the chair of the tax section of the DC Bar so I thought it was worth chiming in to make sure that people did not underestimate us tax professionals. I am struck by the estimates of the hoped-for savings to shifting to a tax reform or new system and I can tell you that right now we have a very highly developed delivery model for tax services. There are global firms of nimble tax professionals who can exploit loopholes in a second and I've been at both sides of the table.

I've helped draft tax rules for the Congress and I've also helped clients and others interpret tax rules and use tax rules to their benefit and I must say that in light of the developed information market and the delivery of tax services, hoped-for savings from reductions in distortions in the tax system and shifting to tax neutrality as well as savings on compliance costs strike me as overestimates. And perhaps you might label those mere transition issues in trying to plug the loopholes that are created as you shift from one system to another but I'm reminded as I sometimes do tax research that goes back into the 19th century that our income tax system has evolved for over 100 years in basically the same structure and if we were to try to create a new tax system, a shift to major a consumption-based system, for our tax revenue and expect as a transition matter to plug the holes and get it right in a short period I would be surprised.

MR. BERGIN: That's a good point. I see a hand back here.

MR. O'NEIL: My name's John O'Neil, I'm with Deloitte Tax. My impression following the issue has been that broad reform is probably not likely. I mean, the one bit of reform that has seemed to have any traction is VAT and my thinking is it's perhaps because no one can see it coming. I mean, it's essentially a hidden consumption tax. So my question for you guys is does anyone think that there is a likelihood of broad reform whether it's flat tax, VAT, et cetera, and, absent that, whether anyone has an interest in identifying the areas where there is political consensus between the competing sides that you might see marginal reform done whether it's in capital or in

MR. EDWARDS: I think there might be consensus just as quickly to look at upper middle-class and higher-income folks and do a simple trade-off, lower statutory rates and eliminate the state and local tax deduction, limit the home mortgage interest deduction. I don't think Bush said limiting the deduction is off the table. So it seems to me you can do a swap for high-income folks where most of the money is and where most of the complexity is and that I think you could get both sides on board for.

MR. SHAPIRO: I'm more skeptical. I think the likelihood of major tax reform, particularly in our current political environment is nearly nil. In environments that were more conducive to the two parties working together these reforms have not been able to establish real traction. The flat tax, large corporations have opposed it consistently because of the loss of the interest deduction and the impact that would have on their stock price.

So I agree with whoever said we ought to approach this issue with a lot more humility not only with respect to what tax reform can achieve but also with respect to what tax reforms we could achieve on both sides of it. It'd be very hard for me to imagine George Pataki and Arnold Schwarzenegger and Mitt Romney. I mean, it's interesting that most of the high-tax states are led by Republican governors today who would all strenuously oppose any change in the state and local tax deduction.

MR. BERGIN: With that being said I'd like to go back to a question that came in the beginning from David. If that's true then is it more important for economic growth to deal with the deficit than to worry about reforming a tax system?

MS. SAWHILL: Just to weigh in briefly here, it seems to me that, as several people have suggested, I think Ed most recently, if you've got to wrap the two together I think that's what's going to happen politically. I don't think the chances of us doing revenue-neutral tax reform by itself is going to happen but if you do something of the sort that Bill Thomas, interestingly, seems to be talking about, which is to put everything on the table together, we might make some very rough progress on several fronts at the same time if we're lucky. I think the politics of that right now are poisonous and not good but that would be the only way it could happen as I can see it.


MR. MINARIK: Joe Minarik. Speaking to Belle's last point, there is one thing that makes me nervous about the scenario of putting all these issues together and that is the possibility that the unified budget benefits of fixing Social Security would be spent on income tax reductions so that by the time we were done we would have a deficit-neutral change in our overall fiscal position where Social Security is finished and now we have the remaining demographic problem left and no place to go to solve it.

I do recall, if those of us of a certain age look back about 20 years ago, one of the things that we were saying is we knew that the Social Security fix of 1982-'83 was going to turn over at some point and we used to say to each other well, at least we'll get out of this unified budget problem to some extent when we do fix Social Security for the long haul. If we fix Social Security and we still have a budget problem we're in trouble.

I think Rob made my point but in a slightly different way to Chris's tradeoff. Capping the mortgage interest deduction and in particular getting rid of state and local tax deductions in a deficit-neutral trade for rate reduction is a regional shift of income from high-income states to lower-income states and the high- income states know that.

And I'd like to make one last point putting together two things that were said before and particularly my former long-distance colleague Bill Diefenderfer. I think if we tried to have a consensus around this table that I think everyone might agree to, taking the title of this session and changing it slightly, if the title of this session were Can Tax Reform, no quotation marks, Facilitate Economic Growth I think the answer is yes. If the question is Can "Tax Reform," with quotation marks, "Boost Economic Growth" I think the answer is no.

MR. BERGIN: I think that's a good place to end. Thank you, everybody, this was very great.

And thanks to our four panelists. You guys did a great job. Thank you.
(Whereupon, at 11:01 a.m., the PROCEEDINGS were adjourned.)