FEBRUARY 2000

BY JUDE WANNISKI

INSIDE: Government Surplus at The Expense of YOUR Savings.

hile it’s always nice to have some extra money (surplus in- come) left over at the end of the month, it does present some Wproblems—though they are nice problems. What should be done with the money? When determining the best use of surplus income, most people ALSO: do not have to be taught that credit card debt at an 18% interest rate Old Economy should be paid down first before paying down a 7% mortgage rate. Nor Wrestles with New does it make sense to pay off a car loan early if the house needs a new roof or if the kids are about to enter college. If there are better uses to which surplus income can be applied, it makes no sense to pay down debt. The bank that holds the debt will be perfectly to the nation over the next decade, the president and happy to accept timely payments of interest and the members of Congress must decide on how to op- principle. The bank would even be pleased to see a timize the return on the public investment of those new roof go on the house, since the bank has an in- resources. terest in the house it has collateralized. Creditors Should the monies be directed at increased will almost never object so long as they see that the public spending — for social programs, federal in- family is managing its finances in a way that frastructure or national defense? Or should tax rates makes it likely that it will be able to meet its future be reduced — to promote targeted social objectives debt obligations. In fact, it is often those families or expand the economy through supply-side effects? who are the deepest in debt who find it easiest to Or should the $3.5 trillion national debt be paid borrow more, because their future earning power down by running budget surpluses seems so secure. The same is true of businesses— — to clear the decks in order to more so long as the business is servicing its debt and easily finance public pensions and managing its finances well, its creditors health-care programs a generation are happy to grant even greater from now? levels of credit. Each of these questions How can this be? forces upon the elected officials It’s really quite simple. the question of return on invest- When a borrower (debtor) ment. At the end of the budget can persuade lenders (credi- “If there are better uses to process each year, the amount tors) that it will absolutely, of money authorized and ap- positively pay back dollars which surplus income can propriated for a specific line that will buy as much at some be applied, it makes no item represents the best guess future date as they can at pre- sense to of the government on its ROI sent, the creditors will bid in- — whether the investment terest rates down to the lowest pay down debt.” is in the National possible levels. If you have a good Endowment for the Arts or credit rating — based on your in- another aircraft carrier. come, wealth and history of debt The process is a messy repayment — you will be able to get one, but it is ultimately credit at low rates whether you are a much more efficient than the government or a household. methods employed by fascist or communist When do creditors get ner- dictatorships, which on the surface seem so much vous? When they see governments neater. who owe them money losing battles in war, when In our system, when there is no clear man- businesses whose paper they hold appear headed date from the people to the government on which of toward failure, or when breadwinners become un- the paths to take, the safest one is to pay down debt employed and the family begins missing pay- — at least until a new national election clears up the ments. Why then is there no more persistent snake- favored public choices. The Republican tax legisla- oil involving public finance than that which tion of 1999 was so poorly designed, for example, recommends a balanced budget? With the federal that the president’s veto seemed reasonable and the government now contemplating official estimates electorate sided with him. of a $2 trillion revenue surplus in the next decade, Classical (supply-side) economics has no why are both major political parties seemingly so opinion on spending priorities, for example, except transfixed with paying down debt? Surely there to note that on certain capital projects — fixing roads are better uses of our surplus national income than and bridges, for example — there may be a higher paying down low-interest debt? ROI than in lowering certain tax rates. In other The answer lies in the political realm. In words, higher federal spending and a bigger govern- every family — the nation’s basic political unit — ment can be compatible with a supply-side economic there are always discussions, at times arguments, system. That is, there is no reason why Democrats over how to spend current and future income. cannot embrace supply-side tax and monetary prin- Father or mother may manage the checkbook of ciples to promote economic growth in order to fi- household finance, but even the children partici- nance their favored social programs. Indeed, pate in the process of allocating the family’s re- President John F. Kennedy in 1963 proposed supply- sources. The national government — the executive side cuts in high marginal income tax rates despite a and legislative branches in this case — represent federal budget deficit. the opinions of a hundred million families. If there The GOP administrations of Harding and is a reliable estimate of resources becoming available Coolidge in the 1920s explicitly based their tax-cut-

2 ting plans on the idea that lower tax rates in certain cases would produce higher revenues and thereby re- duce the burden of the national debt. It was not until 1960 that this issue was addressed in a formal acad- emic setting. In the December 1960 issue of the Journal of Political Economy, the Canadian supply-sider Robert Mundell demonstrated in a Keynesian framework that a lower tax on corporate profits could lower interest rates on government debt even as the budget deficit in- creased. Mundell, the 1999 Nobel Laureate in eco- nomics, used similar proofs to provide the intellectual underpinnings for the Reagan personal income tax cuts of 1981. The tax cut need only produce sufficient economic growth so added revenues would be able to pay the interest on the bonds floated to finance the tax cut. In the 1980 cam- paign, George Bush called this “voodoo economics,” In 1902, a young American college student who but it is the same rationale used in private enterprise. If was to become one of the most influential econo- a business can issue debt to finance an expansion of a mists of the century wrote his doctoral disserta- product line, it need only sell enough at a profit to ser- vice the debt. Anything else is gravy, but the equity tion on the Union government’s financing of the markets will not punish it as long as it does well Civil War. Wesley Clair Mitchell propounded the enough to cover interest. view that the Lincoln administration should not Opponents of the Reagan policies to this day have left the gold standard in 1862 in order to pay blame the ensuing budget deficits on his tax cuts, but for the war with “greenbacks,” i.e., dollars whose one need only observe that the deficits were accompanied value was no longer guaranteed in gold by the by declining interest rates on government bonds to see the government. Mitchell demonstrated that in the in- wisdom of Mundell’s hypothesis. The investment made in lower tax rates in the Reagan years — and the flation that followed, it quickly took twice as bipartisan tax cuts of 1997 — produced the economic many greenbacks to buy an ounce of gold — and growth responsible for the “profits,” or budget sur- twice as much to buy the materials of war. In ad- pluses, that have emerged today. dition, interest rates doubled on the greenback To solve the longer-term problem of actuarial bonds the government floated, which meant the deficits in Social Security and Medicare, at least a por- taxpayers were burdened by much higher post- tion of the projected near-term surpluses should be de- voted to lowering those tax rates on capital and labor war costs of debt service. that are higher than they need to be. Only if the amount of capital available to labor is increased by Mitchell became a well-regarded professor of eco- 50% over the next 20 years will it be possible for two nomics at Columbia and a founder of the workers instead of three to provide for a pensioner. National Bureau of Economic Research. His ideas Merely paying down the debt will not accomplish that goal. about the financing of war debt became a fixture And if the U.S. dollar were fixed to gold in- stead of a floating greenback, interest rates on govern- in the decades that followed. They were in many ment bonds would be closer to 4% than 7%. The cost of ways responsible for the United States keeping debt service would decline by more than $80 billion a the dollar as good as gold, at $35 an ounce, as it fi- year over the average five-year maturity of the debt. nanced WWII, the most expensive war in its his- This is a policy that deserves far more consideration tory, at 2% interest rates. The public debt in 1945 than it is getting. was the equivalent of $2,400, or 68.5 ounces of These principles are not peculiar to the United States. They apply to every national or regional gold per capita. By contrast, today’s public debt is economy in the world. Unless our government takes $11,500 per capita. But after a half century of infla- the lead, though, chances are the world population will tion, the amount is equivalent to only 40 ounces continue to struggle under enormous public debts of gold. In other words, a much heavier debt in without realizing there are relatively easy and creative 1945 was being financed by the government’s ways to lighten that burden. creditors at a third of today’s 6% rate. Jude Wanniski is the author of the book The Way the World Works and teaches political economics at his virtual “Supply Side University,” www.polyconomics.com. 3 GOVERNMENT SURPLU ernment should not do our saving for us. Instead, it should cut the tax barriers that punish private saving and in- vestment. The country would be far better off with pro-saving and pro-investment tax cuts than with big budget sur- pluses. As Taxes Go Up, the Saving A PENNY Goes Down A key factor in the saving rate decline is SAVED … the fact that most Americans have less money to save with. Payroll IS A PENNY taxes, for instance, rose from 13.4% in 1983 to 15.3% in 1990, and the amount of in- come subject to the tax has risen TAXED each year. In addition, the income BY STEPHEN J. ENTIN tax has risen. As real incomes have 60 62 64 66 68 7 ost people instinctively understand the impor- grown, people have been pushed up tance of setting money aside for a rainy day, an through the graduated tax rate structure. In addition, there were emergency fund, college tuition and retire- Sources: M explicit income tax increases in ment. It has always been hard to save, but when the economy is growing at a healthy pace with both low 1990 and 1993. unemployment and low inflation, it should be easy to Taxes have been raised on corporations and on save money, right? After all, the stock market is owners of small businesses, keeping business saving booming and politicians tell us that the economy is in and investment from rising as much as they might terrific shape, what with the federal budget in surplus have. Business saving is usually about two-thirds of and all. What could be wrong with this picture? private-sector saving and is the chief source of funding for expanding capacity, productivity and wages. The Surpluses at the Expense of Savings tax bias against investment restricts the amount of Ironically, despite the economic growth of the capital formation in the United States, which de- past two decades, the personal savings rate (saving presses productivity, wages and employment. as a percent of disposable after- tax income) has plunged over the past 15 years. In the mid-1980’s, the rate was about 9%. The Blame Game Today that same figure is Politicians and some a mere 2.5%. Meanwhile economists blame the business saving has scarcely public for the low saving rate. changed. The result: Total private They claim that the public is saving (personal and business com- too shortsighted to save, or that bined) is in decline. it is taking advantage of the rising Many politicians and economists stock market to go on a spending spree. fret that this decline will retard eco- (Imagine the government accusing the nomic growth. They use the decline as public of going on a spending spree!) an excuse to hang on to large federal Even some economists theorize that government surpluses projected for the rapid rise in stock prices has the next decade, rather than cut lowered the personal saving taxes. They argue that govern- rate and encouraged con- ment surpluses add to na- sumption, because people tional saving and promote have seen their wealth in- growth. The truth is gov- crease without having to ernment surpluses do not save any current income. This raise national saving and in- theory makes individuals out to vestment. The excess taxes be opportunistic spendthrifts. The imposed to create the sur- assertion is twisted logic. The rise in pluses reduce private saving and dis- the stock market has increased the re- courage investment and growth. The gov- ward to saving and has probably

4 US AT THE EXPENSE OF PERSONAL SAVING

The Basics of Tax Biases Our current tax code is strongly biased against saving and investment. Under the ordinary “broad- based” income tax, income is taxed when earned. If it is used for consumption, there is generally no additional PERCENT OF GDP federal tax on the enjoyment of the goods and services. If the income is saved, however, there is a tax on the earn- ings of the savings. This is the basic income tax bias against saving relative to consumption. Additional tax biases against saving and invest- ment are created in other ways, such as taxing already- taxed corporate earnings a second time as dividends or as capital gains. The estate and gift tax on accumulated savings is also a bias against saving, as is denying busi- nesses a full and immediate accounting for certain busi- ness costs by requiring depreciation instead of imme- diate expensing, which inflates business taxable income and raises the effective tax rate. These multiple layers of tax on saving and investment were designed and advocated 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 by academics and social activists in YEAR Washington to redis- (quarterly data) tribute income Data from Bureau of Economic Analysis (incorporating Revised NIPA data). from rich

caused people to be more interested in saving and buying stock, not less. In fact, the Federal Reserve has just reported that the per- cent of families owning stock jumped from 31.6% in 1989 to 48.5% in 1998.

The Capital Gains Culprit capitalists to poor workers. However, the broad-based income tax retards investment, which reduces wages There are other ways, however, that the rising and employment, and penalizes saving, keeping those stock market may have cut the saving rate. People who who lack capital from getting any. It hurts the poor more have traded stock at a profit have had to pay substantial than the rich. capital gains taxes. In order to reinvest all the proceeds of their stock sales, so as not to eat into their accumu- Conclusion lated savings, they have had to pay the capital gains tax out of their current income. Their saving out of that Advocates of big government tell us that we are same income fell by roughly the amount of their tax pay- all spendthrifts, and that we would waste tax cuts on ments, and their saving rate as a percent of their current frivolous consumption, and that therefore we would all ordinary (non-capital gains) income dropped. be better off to let the government keep our money to re- In 1992, the Treasury collected nearly $29 billion duce the national debt. They lie. The truth is that we do in capital gains taxes. In 1997 (last available data), the save and invest when given the chance, that we would Treasury collected nearly $79 billion in capital gains save and invest more if government would cut the taxes taxes, a $50 billion, or 170% increase, over five years. that punish saving and investment. If government keeps (The jump in gains may have grown much larger since the money, it is far more likely to spend it foolishly than then.) That $50 billion increase was equal to 40% of the we are. personal saving done in 1997. Had that extra capital gains tax money been left for taxpayers to save, it would Stephen J. Entin is the Executive Director and Chief Economist of the have boosted the measured saving rate that year from Institute for Research on the Economics of Taxation, a non-profit Washington, 2.1% of disposable income to 3%. The culprit is the capital DC public policy think tank. Prior to joining IRET, he was Deputy Assistant gains tax, not savers. Secretary for Economic Policy in the Reagan Treasury Department.

5 ENTERING A DIGITAL DECISION The Old Economy Wrestles With the New BY BARTLETT CLELAND

In October 1998 Congress passed into law the deal with Congress to override constitutional precedent as Internet Tax Fairness Act. The intent of the legislation was determined by the Supreme Court in order to gain broader to stop new taxes on Internet access (taxes on the money taxing authority? spent for services such as AOL), as well as multiple, or dis- The Commission should consider the many issues criminatory taxes on electronic commerce (taxes not placed that are tough and that must be addressed as the national on another means of commerce, such as catalog sales). debate goes on. The most basic question does not even in- In addition, the new law required the creation of a volve a discussion of the electronic age: Does the current congressionally appointed commission to review the is- quilt of thousands of taxing authorities make any sense? sues related to electronic commerce and make a recom- Regardless of the answer, does the federal government mendation as to any actions that Congress should follow. have any role to play in how a state decides to tax? Where The appointed commission, called the Advisory does the physical transaction take place in our wired Commission on Electronic Commerce, will meet for the world? Are the definitions in tax law of dozens of years final time in Dallas, Texas, on March 20 and 21. In April ago or even five years ago of any use today? they will forward their findings to Congress. Don’t expect None of these questions are easily answerable and dramatic results. none of these questions will be any easier to answer in the From the beginning the Commission has been de- future. These questions are increasingly important — this fined more by politics than principled policy. Two camps past Christmas on-line sales continued their rapid in- of thought immediately crease. All predictions in- developed. The first dicate that electronic pur- group has argued that chasing will continue to sales transacted via the increase for the foresee- Internet should not be able future. taxed. The other side has Recently, some argued that without the members of the opposing tax of Internet sales, cities groups have begun to talk will crumble. Several about a compromise. commissioners have re- Importantly, the represen- mained non-committal to tatives from the business either mode of thought. world have put forth a Neither side has cornered detailed proposal in an at- the full story. tempt to find a reasoned The principled middle ground. and intellectually honest Without an exten- position falls somewhere sion of the current mora- between the Commissions torium the Commission rhetorical positions. Some will have to have its sug- simple questions demon- gestions to Congress in a strate this point. If sales matter of weeks. from within a state are Hopefully, Congress will taxable in the state, then take the time to explore why would the means of and understand these the sale change the tax? complicated issues. Does the recommendation Technology holds the create a simpler, more promise to make all of consistent tax philosophy? lives better, but not if gov- If remote sales (sales ernment uses it as an ex- across state lines) are not cuse to reach further into taxable, except through our lives. use taxes, then why should the involvement of Bartlett Cleland is the Director of a computer change the re- IPI’s new Center for Technology Freedom. sult? Can the states cut a

6 ON THE HILL… LOCALLY… C-SPAN Zooms in on IPI Sponsors Lewisville Aldona Robbins’ Chamber of Commerce Testimony Before House Luncheon IPI proudly sponsored its Ways and Means local Chamber of Commerce Subcommittee Luncheon for the month of February CSPAN caught IPI’s Senior 2000 by featuring guest speaker Bill Research Fellow Aldona Robbins on Murchison, senior columnist of The camera as she testified February 15, Dallas Morning News. 2000, before the Subcommittee on Murchison’s educational Social Security of the House Ways but entertaining perspective of po- and Means Committee. House Majority Leader Dick Armey, IPI litical responsibility imparted vision Chairman of the Board Dr. Michael E. Williams Dr. Robbins explained to the to Lewisville’s business and com- and IPI President Tom Giovanetti committee why the Social Security munity leaders. The lunch also pro- earnings test, a measure that heaps vided an opportunity to highlight IPI Supporters Team Up at unnecessary financial burdens upon IPI’s presence and hard work in and our retirees and ultimately forces around the Lewisville community. the Dallas Cowboys Game some out of the job market, is long The December 1999 Dallas overdue for its own retirement. Cowboy fundraiser was a winner! Friends and sponsors of IPI, in- cluding IPI founder House Majority Leader Dick Armey, kicked back and enjoyed themselves with great conversation, good food, and, of course, good ole’ Texas football. The event, hosted annually by IPI, provides a relaxing atmos- phere for folks to get caught up in touchdowns, touchbacks and field goals, while chatting about the policy issues that matter most and supporting the work of IPI.

Center for Technology IPI Unveils the Center for Technology Freedom and Freedom Debut Coincides Hires Bartlett Cleland as Director with E-Commerce Hearing IPI is proud to announce the creation of its Center for Technology IPI launches its Center for Freedom under the directorship of Mr. Bartlett Cleland. Technology Freedom at a March debut IPI understands that the rapid explosion of technology in all areas luncheon and press conference at the of life—health, education, commerce and entertainment—warrants a need Fairmont Hotel in Dallas. The Center for “hands on” understanding of today’s discussions regarding hot issues will also release its first two studies, Should We Tax the Internet?, by Merrill facing the technology industry. IPI and the Center for Technology Freedom Matthews, Jr., and Old Constitution @ will be the source for those who love freedom for how we should think New Economy, by Lawrence Hunter about government and technology. and George Pieler. Bartlett joins IPI with extensive experience within the technology The press conference precedes world, including serving as technology and policy counsel for Americans the last of four nationwide Advisory for Tax Reform (ATR) and prior to that for Senator John Ashcroft of Commission hearings on electronic com- Missouri. Bartlett received his MBA from St. Louis University and his J.D. merce, also hosted at the Fairmont. from the St. Louis University School of Law. Technology experts and press from You can join IPI’s venture into the e.conomy frontier. Just send your around the country will be exposed to IPI’s expertise and commitment to tech- email address to [email protected] and begin receiving the Center for Technology nology liberty. Freedom’s publications. Matthews and Pieler will par- Bartlett can be reached at IPI by email at [email protected]. ticipate, along with Center Director Bartlett Cleland. 7 WHY SHOULD YOU CARE ABOUT TAX REFORM? Here’s one reason: It would dramatically improve the return to your saving and invest- TAX- DEFERRED ment. Consider the advantage of tax deferred saving over saving that suffers under TREATMENT ordinary taxation. Let’s assume that a person

saves $1,000 per year from ages ASSETS 20 through 70 to build a retirement nest egg. Let’s also assume a tax rate of 20%, and a real rate of return of 7.2%. Under ordinary current taxation, the person’s (THOUSANDS OF DOLLARS) retirement nest egg would be $240,000, but in a tax deferred savings vehicle that same nest egg would be a much larger $400,000.This is why any tax reform plan that ends the double taxation of saving (i.e., gives all saving the same treatment as deductible pensions or Roth IRAs) would be an enormous ben- efit to everyone over his or her lifetime. ORDINARY (Biased)TAX TREATMENT

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IPI Insights South Dakota’s Governor Bill The IRS made $51 million in © 2000 Institute for Policy Innovation Janklow warns that a failure to tax the bookkeeping errors; made nearly $16 mil- lion in “potentially fraudulent”refunds Direct all inquiries to: Web might force his state to “disrupt inter- Institute for Policy Innovation state commerce.” He might, he says, have during the first nine months of last year; 250 South Stemmons, Suite 215 to begin “sending out the highway patrol and about 25% of the time takes longer Lewisville, TX 75067 to start pulling over little brown (UPS) than the law allows to remove tax liens on 972•874•5139 trucks,” sort out the Internet packages and property. Now the Treasury Department FAX: 972•874•5144 then “follow” them to their final destina- wants the IRS to ferret out what are being Email: [email protected] tions, where his men would collect the called “abusive tax shelters.” Unleashing Website: www.ipi.org “use tax” citizens owe on out-of-state pur- an agency with a record like that of the chases. IRS on U.S. business is cruelly ironic. Publisher……………Tom Giovanetti The Wall Street Journal Investor’s Business Daily Editor………………. Betty Medlock Design……………… S/Concepts The Census Bureau has just is- The prize for the most intrusive sued its annual poverty report, claiming and unnecessary government action has been won hands down by the Labor IPI Insights is published five times that nearly 35 million Americans (13% of per year by the Institute for Policy Department. It sent out an opinion stating the population) are ‘living in poverty.’ But Innovation (IPI), a non-profit public that if you work for your employer in just what does living in poverty mean? policy organization. Permission is Today, the typical American de- your own home, your employer is respon- hereby granted to reprint or other- fined by the government as poor has a car, sible for federal health and safety viola- wise use this material with appro- air conditioning, a refrigerator, a stove, a tions that occur at your home; i.e., the em- priate attribution. Nothing written VCR, a microwave, a stereo, and a color ployer must fix anything in your home here should be construed as an at- TV. He is able to obtain medical care. His that is deemed a safety hazard. tempt to influence the passage of any home is in good repair and is not over- [And] for the quickest back- legislation before Congress. crowded. By his own report, his family is down, [the] prize goes to the Labor not hungry, and in the last year he had Department, which recanted its opinion sufficient funds to meet all his essential two days after news of it hit the papers. The views expressed in this needs. While his life is not opulent, it is far Labor Secretary Alexis Herman, however, publication are the opinions of the from what the popular consciousness un- still says she wants to have a “national di- authors and do not necessarily re- derstands by “poverty.” alog” about it. flect the views of the Institute for Policy Innovation or its directors. Robert Rector in National Review Caspar Weinberger, Forbes

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