Freeman

ARTICLE

Government Policies and Capital Growth

OCTOBER 01, 1981 by CHRISTOPHER WITZKY, ROLF E. WUBBELS

Christopher Witzky is Business Technology Consultant, Herbert K. Witzky and Associates, New Fairfield, Connecticut. Dr. Rolf E. Wubbels is Professor of Finance, New York University.

Although many factors have contributed to current U.S. economic problems, the subject of insufficient capital formation has received foremost attention in recent years. Sparked by the obvious failure of traditional Keynesian demand-management policies, supply-side economics has captured the public imagination while eliciting approval from a broad spectrum of economists and politicians.

The essence of the capital formation problem is that an insufficient portion of national income is saved for investment, while too much is spent for government and private consumption. Decades of fiscal and monetary mismanagement coupled with a perverse tax system have generated a consumption boom at the cost of chronic double-digit inflation, sluggish productivity and lackluster economic growth. Consumer indebtedness helped finance the boom, rising from $188 billion in 1976 to $305 billion in 1980.

Disincentives to replacing our aging capital stock are resulting in widespread plant obsolescence and declining rates of capital utilization.

Never as avid savers as their European and Japanese counterparts, Americans have become one of the least thrifty peoples of the industrialized world. The less a nation saves, the fewer are the resources to be devoted to the formation of capital necessary to insure healthy economic growth and mitigate inflation. The net supply of funds from household savings provides almost all of the net funds raised by the other primary sectors of government and business. Both government and business are net dissavers.

Developing Incentives for Savings and Investment

In seeking to encourage future savings and investment, policymakers are now scrutinizing the incentive systems developed by America’s trading partners. Although savings rates and consumption patterns are partly a cultural phenomenon, the U.S. tax system is effectively biased against savings and investment, while foreign countries tend to rely much more on consumption- based levies such as the value-added tax. The United States also depends more heavily on capital gains taxes. Beyond such factors, a number of countries have adopted clearly positive investment and savings-oriented tax policies.

The Japanese have a tradition of saving, which is reinforced by a tax policy that exempts virtually all interest income earned by Japanese citizens. This exemption includes interest on deposits of up to $13,300 in both postal savings accounts and banks, interest on up to $13,300 worth of government bonds, and interest on as much as $22,000 held in employee payroll savings accounts. In this way, a maximum of $62,000 in savings can be sheltered from taxes on interest income. On average, the Japanese now save about 26% of their disposable income.

Since the 1960s a cornerstone of the West German policy to increase savings had been a government tax-free bonus program for special savings accounts held for six or seven years. These accounts could take the form of bank accounts, life insurance policies, building society shares, and stocks and bonds. Any adult with a taxable income of less than $13,700 could deposit up to $475 per year into such an account, which would earn an annual tax-free bonus of 14% a year plus 2% for each dependent child, in addition to accrued interest. Deposit and income ceilings were doubled for married couples.

Furthermore, an employee could set up a special account to service regular payroll deductions of up to $357 annually and qualify for a government bonus of 30 to 40%, depending upon family size. Individual annual interest income of up to $460 has been tax-free, and life insurance premiums are deductible under certain conditions. Such policies have helped to generate an im pressive savings rate of 14%.

The cost of these tax rebates and savings programs amounted to $4.1 billion in 1980, about 3.5% of West German federal spending. Facing a projected 1981 public sector deficit of some $32 billion due to rapidly mounting costs for social-welfare programs, the government has eliminated many portions of the 14% bonus scheme.

Austria, with its relatively low inflation rate, provides similar incentives to save and invest. A portion of interest on savings is exempt from tax, and numerous other deductions and tax privileges provide the Austrian investor with a positive rate of return. Austria is also well-known for its banking secrecy laws which are more stringent than those in Switzerland.

France Offers Advantages

In France all individuals, including children, are allowed to earn tax-free interest of 7.5% on deposits of up to $10,840 in mutual savings banks. The first $723 of dividend income from stocks is tax-free under various conditions.

The most recent French savings incentive is the popular 1978 Monory Act (after former Finance Minister Rene Monory) which became effective May 1978. The law allows individuals who invest in French equities to deduct up to 5000 francs (about $1200) from their taxable in come each year for four consecutive years. The deduction limit is raised 500 francs for the first and second child and 1000 francs for each additional child. The money must remain invested for a minimum of three years, though not necessarily in the same securities. Investments may be made in mutual funds, provided that at least 60% of the portfolio is devoted to stock of French companies.

Observers regard passage of the Monory Act as an important factor in the resulting boom on the Paris Bourse. French industry has also benefited from over $1.95 billion in new equity offerings, spurring investments in new plant and equipment.

“Loi Monory” has been an overwhelming success. Mr. Monory was able to report to the Cabinet on February 15, 1980 that in 1979 more than one million people took advantage of the law, investing an additional $1.8 billion in equities since its enactment. Since 1978 French production has risen by more than 17%; and in 1979 the French saved approximately 17% of disposable income. Since the Monory Act is only a temporary four-year relief measure, some government officials are already worrying about the possible withdrawal of investors from the Paris Bourse when the Act expires in 1983.

The election of Socialist President Francois Mitterrand in May of this year has placed the French economy in jeopardy and threatens to undermine many of these advances.

The problems of England’s economy are well known. Although the Thatcher Administration has made major strides in curbing monetary growth and reducing inflation, government policies have been largely oriented toward “tax-shifting” rather than real tax reductions.

After taking over in April 1979, the Thatcher government cut personal taxes for middle and high-in-come groups but soon found that the red ink was excessive. The administration then nearly doubled the value-added tax, from 8% to 15%, raised gasoline taxes by 20 cents per gallon, and moved away from promises to cut corporate taxes.

These factors, plus rising interest rates, led to an explosion in the retail price level and an unfavorable economic climate. The nation’s bond market had already virtually been destroyed in 1971 by the combination of inflation and high marginal personal tax rates. Equity markets, though also depressed, received some benefit from reductions in the destructive top marginal tax rate on investment income from 98% to 75%.

For many years the United Kingdom also had one of the highest capital gains taxes. All investment income exceeding £5000 per annum was subject to an additional 15 percentage point tax over and above the maximum individual rate of 60%. The maximum tax rate on capital gains thus amounted to 75%. The capital gains tax now stands at 30% on any gains above £3000.

Even with these reforms, however, it is likely that high inflation and falling productivity will continue to plague the United Kingdom unless both taxes and spending are further reduced.

Adverse Policies in U.S.

What does the United States do to encourage savings and investment? Virtually nothing. In fact, most existing policies work to make consumption a virtue and savings a risk.

In the United States nominal interest and dividend income has been taxed as unearned income at marginal rates up to 70%. This policy, combined with high inflation and interest-rate ceilings on bank deposits, has made savings a guaranteed-loss proposition. As a percentage of disposable income, the U.S. savings rate dropped from 7.4% in 1970 to 6.9% in 1976, reaching a low of 3.4% in the first quarter of 1980. (In 1981, the Commerce Department issued a new statistical measure of the savings rate. Although the new savings rate statistics are nominally higher, the declining trend remains.) Thanks in part to this decline, productivity growth slowed to an annual average of only 1.2% in the 1970s, down from 2.5% in the 1960s. Between 1963 and 1973 American output per person rose by 1.9%, the slowest of any major industrial country.

Under current tax law, taxable income is not adjusted for inflation. As a result, during an inflationary period, individuals advance into higher tax brackets due to increasing nominal money incomes, while real incomes are rising much less or may even be declining. In addition, capital gains computed in dollar terms enter into the tax base, even though such nominal gains can represent very much smaller real gains (or possibly real losses). Thus, inflation raises personal taxes by a much larger percentage than nominal incomes, causing the average tax rate to rise and tax payments to increase in real terms.

According to Martin Feldstein, president of the National Bureau of Economic Research, even if corporate profits and stock prices could manage to keep pace with inflation (an unlikely possibility) and maintain traditional rates of real growth, a 20% tax on nominal capital gains would mean an 80% tax on real gains given a 7% inflation rate, depending on the holding period. An 8% inflation rate would push the effective rate over 100%. Thus, capital gains taxes have actually been massively confiscatory. Similar inflationary effects on income tax rates result in confiscation of savings.

Penalizing Capital Gains

Small investors nearly abandoned the American stock markets in the mid-1970s, partially due to exorbitant taxes on capital gains pegged at a maximum of 49% for most of the decade. In addition to depressing equity market values and reducing new capital formation as measured by venture capital funds and new public offerings, capital gains taxes tend to inhibit capital mobility. If a capital asset appreciates substantially, the accumulated capital gains tax liability upon realization can deter the asset’s sale. This is referred to as the “lock-in” effect. It is difficult to measure the opportunity cost of this capital immobility in terms of diminished exploitation of new technologies.

Over the entrenched opposition of the Carter Administration, Congress enacted the Steiger Amendment to the Revenue Act of 1978, lowering the maximum tax on long-term capital gains to 28%. According to a Treasury Department study, the net revenue loss in 1979 from this reduction was only $100 million, far less than the forecasted loss of $1.7 billion. The rate cut was offset by $2.5 billion in new revenues from higher turnover rates.

An extensive 1980 survey of stock ownership by the New York Stock Exchange has shown that the small investor returned to the stock market during the latter part of the decade, perhaps in response to the Steiger Amendment. Even with the current surge, however, the 1980 shareholder total was still one million less than the high of 30.8 million in 1970, when 15.1% of the American population held stock. In 1980 that percentage was 13.6%, up considerably from 11.9% in 1975.

These developments should be interpreted with caution, however, for the average portfolio size has shrunk. In addition, during the 1970s there was a great increase in the rate of inflation and a serious decline in the prices of common stocks, measured in constant dollars. In fact, the total return on common stocks for the whole period, in constant dollars, was negative. Between the end of 1969 and the end of 1979, the value of common stocks on the New York Stock Exchange declined by about 42%. This drop is far greater than that of the 1930s when the value of stocks on the New York Stock Exchange fell by about 31%. Thus, investors in high tax brackets tended to experience losses greater than those of the Great Depression, since dividends were taxed at higher rates in the seventies than in the thirties.

The decline in real stock prices was probably made worse by market adjustments in response to two types of inflationary tax-raising effects which arise from standard methods for computing business costs and profits. First, depreciation expenses are computed on the basis of historical cost of acquisition rather than on replacement cost, resulting in underdepreciation. Second, cost of goods sold from inventory is sometimes valued at current rather than replacement cost. These accounting procedures understate real current costs and hence overstate real profits. Thus, taxation of inflated corporate profits effectively results in the net confiscation of capital.

Tax Rates Outrun Inflation

In summary, the federal government’s tax collections rise substantially as a share of both corporate and personal income as individuals and corporations are exposed to the effects of inflation. In fact, taxes have risen in the United States at almost twice the rate of inflation since the late 1960s.

Inappropriate tax policies and inflation are not the only sources of our problems. Government routinely attempts to direct the flow of funds toward socially desirable goals. These attempts fall under the heading of the social allocation of capital. Such intervention has become increasingly popular in recent years through various means: 1) usury laws or interest rate ceilings; 2) government loan guarantees; 3) interest rate subsidies; 4) government borrowing and re-lending, and 5) regulations.

Special interest groups see government intervention as a means for improving the condition of a particular sector of society, enabling it to borrow funds which might not otherwise be available or might only be available at significantly higher interest rates.

Through such intervention, the function of the financial markets is altered. Funds no longer flow on the basis of expected return and risk. When the government explicitly directs funds to certain investments, it tampers with the workings of the marketplace. This tampering can lead to less efficient financial markets with the result that savings are allocated at higher cost and/or with greater inconvenience.

Put another way, such intervention produces the case in which investments are undertaken which are not optimal in terms of market efficiency relative to market standards. As a result, there may be an adverse effect on real economic growth. Financial markets simply become less efficient in channeling savings to investment opportunities on a risk-adjusted return basis. Clearly, cost estimates due to these induced distortions should be included in any cost-benefit analysis of capital gains taxation. Unfortunately, such cost estimates are nearly impossible to formulate.

Of course, government is not the only culprit causing our myriad capital formation problems. Management and labor must share the blame. Often management continues to use nearsighted incentive programs which reward short-term results rather than long-term strategic thinking. As a result, executives have been slow to introduce reporting techniques that are in the best interests of the organization. For example, two-thirds of American industries still use the First-In First- Out inventory valuation method, resulting in an inflated bottom line. American management has also failed to provide the work force with incentives for finding and initiating new ways of reducing the amount of labor in the production process.

Politically Feasible Measures to Encourage Growth

Productivity and innovation are not solely management functions. Organized labor has complicated matters by locking management into Cost of Living Adjustments (COLAs) and by resisting automation. In contrast, Japanese workers generally embrace technological changes which result in more efficient production processes. Fujitsu Fanuc Ltd. is now operating a $38 million plant that uses robots and numerically-controlled machine tools to help build other robots and machine tools, requiring one-fifth the number of workers that a conventional plant would need.

Given this operating environment, what can realistically be done to restore adequate capital growth? Congressman Richard Schulze has introduced H.R. 63, the Individual Investors Incentive Act. This bill would provide a 10% tax credit up to $1000 for individuals ($2000 for married couples filing jointly) for new or additional investments in stocks and mutual funds of domestic corporations. Patterned after the French Monory Act, the “Schulze Bill” would directly encourage savings and investment and would provide a needed incentive for our stagnating economy.

New York’s Republican Senator Alphonse D’Amato has introduced the Family Savings Incentive Act. This Act would raise the exemption for interest income to $1000 for individuals and $2000 for those who file joint returns. This concept has been endorsed by the Savings and Loan Foundation.

The Jones-Conable Capital Cost Recovery Act, better known as “105-3,” provides for simplified accelerated depreciation of capital investment. Because such changes only affect the timing of after-tax cash flows, the effective reduction in the tax rate is merely the result of the timevalue of money. The effect is, therefore, somewhat illusory, since taxes will be even higher in later years when depreciation charges are exhausted. Such taxes may only be avoided in future years if any tax savings are immediately recapitalized and depreciated.

The ultimate long-range solution to the capital formation problem hinges on concerted actions by all factors of production. Natural resources must be allocated by the market. Management must once again seek to innovate, along with the active cooperation of labor and government. Savings must be encouraged and productively employed, and obstacles to the market allocation of capital flows must be abolished. The Kemp-Roth program, though a step in the right direction, is only a band-aid remedy. More substantial action will be needed in the future.

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October 1981

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