Government Policies and Capital Growth; C. Witzky and Rolf E. Wubbels

Christopher Witzky and RolfE. Wubbels Government Policies and Capital Growth ALTHOUGH many factors have con tributed to current U.S. economic problems, the subject of insufficient capital formation has received fore most attention in recent years. Sparked by the obvious failure of traditional Keynesian demand management policies, supplyside economics has captured the public imagination while eliciting ap proval from a broad spectrum of economists and politicians. The essence of the capital forma tion 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 Christopher Witzky is Business Technology Consul tant, Herbert K. Witzky and Associates, New Fairfield, Connecticut. Dr. Rolf E. Wubbels is Professor of Fi nance, New York University. with a perverse tax system have generated a consumption boom at the cost of chronic double-digit in flation, sluggish productivity and lackluster economic growth. Con sumer indebtedness helped finance the boom, rising from $188 billion in 1976 to $305 billion in 1980.

Disincentives to replacing our ag ing capital stock are resulting in widespread plant obsolescence and declining rates of capital utilization. Never as avid savers as their Eu ropean and Japanese counterparts, Americans have become one of the least thrifty peoples of the indus trialized world. The less a nation saves, the fewer are the resources to be devoted to the formation of capi tal necessary to insure healthy eco nomic growth and mitigate infla tion. The net supply of funds from household savings provides almost 579 580 THE FREEMAN October all of the net funds raised by the other primary sectors of government and business. Both government and business are net dissavers. DevelopingIncentivesfor Savingsand Investment In seeking to encourage future savings and investment, policymak ers are now scrutinizing the incen tive 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. Be yond such factors, a number of coun tries 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 in terest 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 in terest 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 sav ings accounts held for six or seven years. These accounts could take the form of bank accounts, life insur ance 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 depen dent child, in addition to accrued in terest. 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 gov ernment bonus of 30 to 40%, de pending upon family size. Individ ual annual interest income of up to $460 has been tax-free, and life in surance premiums are deductible under certain conditions. Such poli cies 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 elim1981 GOVERNMENT POLICIES AND CAPITAL GROWTH 581 inated many portions of the 14% bo nus scheme. Austria, with its relatively low in flation rate, provides similar incen tives to save and invest. A portion of interest on savings is exempt from tax, and numerous other deductions and tax privileges provide the Aus trian 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, includ ing 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 in come from stocks is tax-free under various conditions. The most recent French savings incentive is the popular 1978 Mon ory Act (after former Finance Min ister 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 addi tional child. The money must re main 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 port folio 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 in vestments in new plant and equip ment. "Loi Monory" has been an over whelming success. Mr. Monory was able to report to the Cabinet on Feb ruary 15, 1980 that in 1979 more than one million people took advan tage of the law, investing an addi tional $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 in come. Since the Monory Act is only a temporary four-year relief mea sure, some government officials are already worrying about the possible withdrawal of investors from the Paris Bourse when the Act expires i.n 1983. The election of Socialist President Francois Mitterrand in May of this year has placed the French economy in jeopardy and threatens to under mine many of these advances.

The problems of England's econ omy are well known. Although the Thatcher Administration has made major strides in curbing monetary growth and reducing inflation, gov582 THE FREEMAN October ernment policies have been largely oriented toward "tax-shifting" rather than real tax reductions. After taking over in April 1979, the Thatcher government cut per sonal taxes for middle and high-in come groups but soon found that the red ink was excessive. The adminis tration then nearly doubled the value-added tax, from 8% to 15%, raised gasoline taxes by 20 cents per gallon, and moved away from prom ises to cut corporate taxes. These factors, plus rising interest rates, led to an explosion in the re tail price level and an unfavorable economic climate. The nation's bond market had already virtually been destroyed in 1971 by the combina tion of inflation and high marginal personal tax rates. Equity markets, though also depressed, received some benefit from reductions in the de structive top marginal tax rate on investment income from 98% to 75%.

For many years the United King dom also had one of the highest cap ital gains taxes. All investment in come exceeding £5000 per annum was subject to an additional 15 per centage 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, how ever, it is likely that high inflation and falling productivity will continue to plague the United Kingdom unless both taxes and spending are further reduced. AdversePoliciesin U.S. What does the United States do to encourage savings and investment? Virtually nothing. In fact, most ex isting policies work to make con sumption a virtue and savings a risk. In the United States nominal in terest and dividend income has been taxed as unearned income at mar ginal rates up to 70%. This policy, combined with high inflation and interest-rate ceilings on bank depos its, 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 sav ings 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 per son 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 increas1981 GOVERNMENT POLICIES AND CAPITAL GROWTH 583 ing 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 rep resent very much smaller real gains (or possibly real losses). Thus, infla tion raises personal taxes by a much larger percentage than nominal in comes, 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 corpo rate profits and stock prices could manage to keep pace with inflation (an unlikely possibility) and main tain 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% infla tion rate would push the effective rate over 100%. Thus, capital gains taxes have actually been massively confiscatory. Similar inflationary ef fects on income tax rates result in confiscation of savings.

PenalizingCapitalGains Small investors nearly abandoned the American stock markets in the mid-1970s, partially due to exorbi tant taxes on capital gains pegged at a maximum of 49% for most of the decade. In addition to depressing eq uity market values and reducing new capital formation as measured by venture capital funds and new pub lic offerings, capital gains taxes tend to inhibit capital mobility. If a capi tal 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 tech nologies. Over the entrenched opposition of the Carter Administration, Con gress enacted the Steiger Amend ment to the Revenue Act of 1978, lowering the maximum tax on long term capital gains to 28%. Accord ing to a Treasury Department study, the net revenue loss in 1979 from this reduction was only $100 mil lion, far less than the forecasted loss of $1.7 billion. The rate cut was off set 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 mar ket duringthe latter part of the dec ade, perhaps in response to the Steiger Amendment. Even with the current surge, however, the 1980 shareholder total was still one mil lion less than the high of 30.8 mil lion in 1970, when 15.1% of the American population held stock. In 1980 that percentage was 13.6%, up 584 THE FREEMAN October considerably from 11.9% in 1975. These developments should be in terpreted 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 Ex change 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 histor ical cost of acquisition rather than on replacement cost, resulting in underdepreciation. Second, cost of goods sold from inventory is some times valued at current rather than replacement cost. These accounting procedures understate real current costs and hence overstate real prof its. Thus, taxation of inflated corpo rate profits effectively results in the net confiscation of capital. Tax Rates Outrun Inflation In summary, the federal govern ment's tax collections rise substan tially 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 in flation are not the only sources of our problems. Government rou tinely attempts to direct the flow of funds toward socially desirable goals. These attempts fall under the head ing of the social allocation of capital. Such intervention has become in creasingly popular in recent years through various means: 1) usury laws or interest rate ceilings; 2) govern ment loan guarantees; 3) interest rate subsidies; 4) government bor rowing and re-Iending, and 5) regu lations. Special interest groups see gov ernment intervention as a means for improving the condition of a partic ular sector of society, enabling it to borrow funds which might not oth erwise be available or might only be available at significantly higher in terest rates. Through such intervention, the 1981 GOVERNMENT POLICIES AND CAPITAL GROWTH 585 function of the financial markets is alteredo Funds no longer flow on the basis of expected return and risk.

When the government explicitly di rects funds to certain investments, it tampers with the workings of the marketplace. This tampering can lead to less efficient financial mar kets with the result that savings are allocated at higher cost and/or with greater inconvenience. Put another way, such interven tion produces the case in which in vestments are undertaken which are not optimal in terms of market effi ciency relative to market standards. As a result, there may be an adverse effect on real economic growth. Fi nancial markets simply become less efficient in channeling savings to in vestment opportunities on a risk-ad justed return basis. Clearly, cost es timates due to these induced distor tions should be included in any cost benefit analysis of capital gains tax ation. Unfortunately, such cost esti mates are nearly impossible to for mulate. Of course, government is not the only culprit causing our myriad cap ital formation problems. Manage ment and labor must share the blame. Often management contin ues to use nearsighted incentive programs which reward short-term results rather than long-term stra tegic thinking. As a result, execu tives have been slow to introduce re porting techniques that are in the best interests of the organization.

For example, two-thirds of Amer ican industries still use the First In First-Out inventory valuation method, resulting in an inflated bot tom line. American management has also failed to provide the work force with incentives for finding and ini tiating new ways of reducing the amount of labor in the production process. PoliticallyFeasible Measuresto EncourageGrowth Productivity and innovation are not solely management functions. Organized labor has complicated matters by locking management into Cost of Living Adjustments (CO LAs) and by resisting automation. In contrast, Japanese workers gen erally embrace technological changes which result in more efficient pro duction 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, re quiring one-fifth the number of workers that a conventional plant would need.

Given this operating environ ment, 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 586 THE FREEMAN married couples filing jointly) for new or additional investments in stocks and mutual funds of domestic cor porations. Patterned after the French Monory Act, the ~~Schulze Bill" would directly encourage savings and in vestment and would provide a needed incentive for our stagnating econ omy. 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 in dividuals 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 ~~ 10 5-3," provides for simplified acceler ated depreciation of capital invest ment. Because such changes only af fect the timing of after-tax cash flows, the effective reduction in the tax rate is merely the result of the time Leave the Markets Alone value of money. The effect is, there fore, somewhat illusory, since taxes will be even higher in later years when depreciation charges are ex hausted. Such taxes may only be avoided in future years if any tax savings are immediately recapital ized and depreciated.

The ultimate long-range solution to the capital formation problem hinges on concerted actions by all factors of production. Natural re sources 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 en couraged and productively em ployed, 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. ® IDEAS ON LIBERTY CAPITALISM is a viable economic system or it is not. An active policy of government intervention in a free market business system is a contra diction in terms. Trades of private property are either voluntary or they are not; one cannot legislate the free market or create competition. To have a free market the government must leave the markets alone; to have the state make markets "free" is again a contradiction in terms.

D.T. ARMENTANO, The Myths ofAntitrust John Semmens ESSENTIAL AIR SERVICE SUBSIDIES: JustPlaneFoolish ONE OF THE ARGUMENTS that is al ways offered in opposition to dereg ulation of transportation is that some remote, sparsely populated regions will be denied essential services. In order to neutralize this argument and get airline deregulation passed in 1978, Congress provided for sub sidies to support "essential air ser vice." Little thought was given to just exactly what constitutes "essen tial air service." Consequently, the "essential air service" subsidy pro gram is one of the most wasteful perpetrated by the federal govern ment. The major accomplishment of this subsidy program is to finance under utilized scheduled commercial air service. The ordinary person quite naturally imagines that "essential" Mr. Semmens is an economist for the Arizona Depart ment of Transportation. must mean necessary or indispens able. What is "necessary" or "indis pensable" about flying largely empty aircraft around various parts of the country? The official definition of what is "essential air service" is de termined in a completely arbitrary and silly fashion. If a point on the map had scheduled air service at some time during the 1968-78 base period, it is entitled to a subsidy for the provision of scheduled air ser vice until 1988.