Taxes and Capital Formation (National Bureau of Economic Research Project Report)

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Taxes and Capital Formation

A National Bureau of Economic Research Project Report

Taxes and Capital Formation

Edited by

Martin Feldstein

The University of Chicago Press Chicago and London

MARTIN FELDSTEIN is the George F. Baker Professor of Economics at Harvard University and president of the National Bureau of Economic Research. He is the author of Inflation, Tax Rules, and Capital Formation, and editor of The American Economy in Transition, Behavioral Simulation Methods in Tax Policy Analysis, and The Effects of Taxation on Capital Accumulation, all published by the University of Chicago Press.

The University of Chicago Press, Chicago 60637 The University of Chicago Press, Ltd., London 0 1987 by The National Bureau of Economic Research All rights reserved. Published 1987 Printed in the United States of America 96 95 94 93 92 91 90 89 88 87 5 4 3 2 1

Library of Congress Cataloging-in-PublicationData

Taxes and capital formation. (A National Bureau of Economic Research project report) Includes index. 1. Taxation-United States. 2. Saving and investment-United States. 3. Taxation. 4. Saving and investment. I. Feldstein, Martin S. 11. Series. HJ2381.T395 1987 336.2’00973 87-5898 ISBN 0-226-24079-7

National Bureau of Economic Research Officers Franklin A. Lindsay, chairman Richard N. Rosett, vice-chairman Martin Feldstein, president

Geoffrey Carliner, executive director Charles A. Walworth, treasurer Sam Parker, director of fhzance and administration

Directors at Large Moses Abramovitz Andrew Bnmmer Carl F. Christ George T. Conklin, Jr. Jean A. Crockett Morton Ehrlich Martin Feldstein Edward L. Ginzton David L. Grove

George Hatsopoulos Walter W. Heller Saul B. Klaman Franklin A. Lindsay Roy E. Moor Geoffrey H. Moore Michael H. Moskow James J. O’Leary Robert T. Parry

Peter G. Peterson Robert V. Roosa Richard N. Rosett Bert Seidman Eli Shapiro Stephen Stamas Donald S. Wasserman Manna v.N. Whitman

Directors by University Appointment Marcus Alexis, Northwestern Charles H. Berry, Princeton James Duesenbeny, Harvard Ann F. Friedlaender, Massachusetts Institute of Technology J. C. LaForce, California, Los Angeles Paul McCracken, Michigan James L. Pierce, California, Berkeley

Andrew Postlewaite, Pennsylvania Nathan Rosenberg, Stanford James Simler, Minnesota James Tobin, Yale John Vernon, Duke William S. Vickrey, Columbia Burton A. Weisbrod, Wisconsin Arnold Zellner, Chicago

Directors by Appointment of Other Organizations Edgar Fiedler, National Association of Business Economists Robert S . Hamada, American Finance Association Robert C. Holland, Committee for Economic Development James Houck, American Agricultural Economics Association David Kendrick, American Economic Association Douglass C. North, Economic History Association

Rudolph A. Oswald, American Federation of Labor and Congress of Zndustrial Organizations Douglas D. Purvis, Canadian Economics Association Albert T. Sommers, The Conference Board Dudley Wallace, American Statistical Association Charles A. Walworth, American Institute of Cert$ed Public Accountants

Directors Emeriti Arthur F. Burns Emilio G. Collado Solomon Fabricant

Frank W. Fetter Thomas D. Flynn Gottfried Haberler

George B. Roberts Willard L. Thorp

Relation of the Directors to the Work and Publications of the National Bureau of Economic Research 1. The object of the National Bureau of Economic Research is to ascertain and to present to the public important economic facts and their interpretation in a scientific and impartial manner. The Board of Directors is charged with the responsibility of ensuring that the work of the National Bureau is carried on in strict conformity with this object. 2. The President of the National Bureau shall submit to the Board of Directors, or to its Executive Committee, for their formal adoption all specific proposals for research to be instituted. 3. No research report shall be published by the National Bureau until the President has sent each member of the Board a notice that a manuscript is recommended for publication and that in the President’s opinion it is suitable for publication in accordance with the principles of the National Bureau. Such notification will include an abstract or summary of the manuscript’s content and a response form for use by those Directors who desire a copy of the manuscript for review. Each manuscript shall contain a summary drawing attention to the nature and treatment of the problem studied, the character of the data and their utilization in the report, and the main conclusions reached. 4. For each manuscript so submitted, a special committee of the Directors (including Directors Emeriti) shall be appointed by majority agreement of the President and Vice Presidents (or by the Executive Committee in case of inability to decide on the part of the President and Vice Presidents), consisting of three Directors selected as nearly as may be one from each general division of the Board. The names of the special manuscript committee shall be stated to each Director when notice of the proposed publication is submitted to him. It shall be the duty of each member of the special manuscript committee to read the manuscript. If each member of the manuscript committee signifies his approval within thirty days of the transmittal of the manuscript, the report may be published. If at the end of that period any member of the manuscript committee withholds his approval, the President shall then notify each member of the Board, requesting approval or disapproval of publication, and thirty days additional shall be granted for this purpose. The manuscript shall then not be published unless at least a majority of the entire Board who shall have voted on the proposal within the time fixed for the receipt of votes shall have approved. 5 . No manuscript may be published, though approved by each member of the special manuscript committee, until forty-five days have elapsed from the transmittal of the report in manuscript form. The interval is allowed for the receipt of any memorandum of dissent or reservation, together with a brief statement of his reasons, that any member may wish to express; and such memorandum of dissent or reservation shall be published with the manuscript if he so desires. Publication does not, however, imply that each member of the Board has read the manuscript, or that either members of the Board in general or the special committee have passed on its validity in every detail. 6. Publications of the National Bureau issued for informational purposes concerning the work of the Bureau and its staff, or issued to inform the public of activities of Bureau staff, and volumes issued as a result of various conferences involving the National Bureau shall contain a specific disclaimer noting that such publication has not passed through the normal review procedures required in this resolution. The Executive Committee of the Board is charged with review of all such publications from time to time to ensure that they d o not take on the character of formal research reports of the National Bureau, requiring formal Board approval. 7. Unless otherwise determined by the Board or exempted by the terms of paragraph 6, a copy of this resolution shall be printed in each National Bureau publication.

(Resolution adopted October 25, 1926, as revised through September 30, 1974)

Contents

I.

Acknowledgments

ix

Introduction Martin Feldstein

xi

INDIVIDUAL RESEARCH PROJECTS

1. Individual Retirement Accounts and Saving David A. Wise

3

2. Rates, Realizations, and Revenues of Capital Gains Lawrence B. Lindsey

17

3. Corporate Capital Budgeting Practices and the Effects of Tax Policies on Investment Lawrence H. Summers

27

4. The Tax Treatment of Structures

37

James R. Hines, Jr. 5. Tax Reform and the Slope of the Playing Field Patric H. Hendershott

6. Tax Rules and Business Investment Martin Feldstein 7. Tax Policy and the International Location of Investment

Michael J. Boskin vii

51

63

73

viii

Contents

11. SUMMARIES OF ADDITIONAL STUDIES

8. Anticipated Tax Changes and the Timing of Investment Alan J. Auerbach and James R. Hines, Jr.

85

9. Tax-Loss Carryforwards and Corporate Tax Incentives Alan J. Auerbach and James M. Poterba

89

10. Tax Asymmetries and Corporate Income Tax Reform Saman Majd and Stewart C. Myers

93

11. Consumer Spending and the After-Tax Real Interest Rates N. Gregory Mankiw

97

12. The Impact of Fundamental Tax Reform

on the Allocation of Resources Don Fullerton and Yolanda Kodrzycki Henderson 13. The Value-added Tax: A General Equilibrium Look at Its Efficiency and Incidence Charles L. Ballard, John Karl Scholz, and John B. Shoven

14. The Cash Flow Corporate Income Tax Mervyn A. King

101

105

109

List of Contributors

111

Author Index

113

Subject Index

114

Acknowledgments

This volume presents seven relatively nontechnical papers that were prepared as part of a research project by the National Bureau of Economic Research (NBER) on the effects of taxation on capital accumulation. Brief summaries of seven additional studies are also included in the volume. The volume is designed to distribute the results of the NBER’s research beyond the usual audience of professional economists and policy specialists. As part of that same effort, the seven papers in this volume were presented at a conference for government and corporate officials in Washington, D.C., on 28 May 1986. Technical versions of the fourteen studies described here are being published separately in The Effects of Taxation on Capital Accumulation, edited by Martin Feldstein (NBER volume published by the University of Chicago Press, 1987). The NBER research on taxation and capital accumulation has been discussed at regular meetings of the bureau’s tax program and at special meetings focused on this project. The collaborative research in this project is made possible by the ongoing activities of the NBER’s tax program under the guidance of program director David F. Bradford. National Bureau Directors Andrew Brimmer, Walter W. Heller, and James L. Pierce reviewed the entire manuscript. National Bureau staff members Mark Fitz-Patrick, Deborah Mankiw, Kathi Smith, Annie Spillane, Gail Swett, and Kirsten Foss Davis contributed to the overall effort.

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Introduction Martin Feldstein

It has long been recognized that there is an important effect of capital accumulation on productivity and economic growth. In fact, more than fifty years ago the pioneering studies of capital accumulation that were done at the National Bureau of Economic Research by Nobel laureate Simon Kuznets began the process of developing quantitative knowledge about capital formation and its link to economic performance. In the years since Kuznets began his work, many other researchers at the NBER have studied capital formation. In the 1950s, Milton Friedman and Raymond Goldsmith made important contributions to the subject. The list of researchers and the range of issues studied grew rapidly in the 1960s and 1970s. The NBER is currently engaged in several related studies of the accumulation and financing of capital in the United States. One of these is a study of the effects of taxation on capital accumulation, including the effects on saving, risk taking, and corporate investment in the United States and abroad. The papers presented in this volume summarize seven of the individual research projects within that study. Longer technical reports on these research projects will appear in a separate volume, The Effects of Taxation on Capital Accumulation, edited by me. That volume will also contain technical reports on seven additional studies that are summarized more briefly in the second part of the current volume. We hope that these summary papers will be of interest to a wide audience of policy officials and staff, members of the business community, and others who are concerned about the effects of taxation on capital formation. In keeping with the NBER’s tradition, these papers do not make any policy recommendations. Even when the researcher is convinced that a particular type of tax change will have an undesir-

xii

Martin Feldstein

able effect on capital formation, he or she does not offer an overall evaluation of any of the recent tax proposals because the effect on capital formation is only one of many criteria by which the desirability of a tax proposal should be judged. A researcher might conclude, for example, that eliminating the investment tax credit would reduce investment in equipment but might nevertheless favor doing so because the revenue raised in that way could be used to help the poor by raising the zero-bracket amount or to stimulate work effort by reducing personal marginal tax rates. The papers in this volume make no attempt to assess these other aspects of the recent tax proposals and therefore should not and do not make any recommendations with respect to the alternative policy proposals, The emphasis in these studies is on developing a better understanding of how the economy works and how specific policies would affect particular aspects of the economy. We hope that these analyses will contribute to the formulation of better economic policy in the years ahead.

I

Individual Research Projects

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1

Individual Retirement Accounts and Saving David A. Wise

Individual retirement accounts (IRAs) were established in 1974 as part of the Employee Retirement Income Security Act to encourage employees not covered by private pension plans to save for retirement. The Economic Recovery Tax Act of 1981 extended the availability of IRAs to all employees and raised the contribution limit. The legislation emphasized the need to enhance the economic well-being of future retirees and the need to increase national saving. Now any employee with earnings above $2,000 can contribute $2,000 to an IRA account each year. An employed person and a nonworking spouse can contribute a total of $2,250, while a married couple who are both working can contribute $2,000 each. Recent tax proposals have contemplated substantial increases in the limits (the current House bill is an exception). The tax on the principal and interest is deferred until money is withdrawn from the account. There is a penalty for withdrawal before age 59 f, which is apparently intended to discourage the use of IRAs for nonretirement saving. Whether IRAs are an important form of saving for retirement depends on how much is contributed. Whether they serve as a substitute for private pension plans depends on who contributes. The short-run tax cost of IRAs also depends on how much is contributed and on the marginal tax rates of contributors, since contributions are not taxed. Possibly the most important question, however, is the relationship between IRA contributions and other forms of saving. What is the net

David A. Wise is the John F. Stambaugh Professor of Political Economy at the John F. Kennedy School of Government, Harvard University, and a research associate of the National Bureau of Economic Research.

3

4

David A. Wise

effect of IRA accounts on individual saving? That is the primary focus of this paper. Two central questions arise in considering the effect of newly available IRAs on net saving. The first is the extent to which IRA contributions are made with funds withdrawn from other saving accounts. Presumably such substitution would be made by taking funds from existing liquid asset balances, such as other saving accounts. A second question is whether new saving would have been placed in other accounts were it not for the availability of IRAs. Would the new saving have been made anyway? This paper is based primarily on my work with Steven Venti, with some comparisons drawn from my analysis of Canadian Registered Retirement Saving Plans (RRSP). 1.1 The Incentive Effects of IRAs

Two characteristics of IRAs provide an incentive to increase saving. First, it costs less in terms of current consumption to save through an IRA. To save $1,000 in a regular saving account requires that $1,000 less be spent for current goods and services. But for a person in the 30% marginal tax bracket, for example, $1,000 can be saved by reducing expenditure for current goods and services by only $700, $1,000 less the $300 in tax that does not have to be paid on the $1,000 IRA contribution. Second, while tax must be paid on the interest that accrues in a regular saving account, the interest that accrues in an IRA is not taxed. Suppose, for example, that the interest rate is lo%, the marginal tax rate is 30%, and that a dollar saved at age twenty-five is not withdrawn until age sixty-five. Assume also that the marginal tax rate when the dollar is saved is the same as the marginal tax rate when it is withdrawn. Then at age sixty-five the accumulated value of the IRA contribution after taxes would be 3.32 times the value of a contribution to a conventional saving account. It would be worth 1.82 times the value of a conventional saving account if the dollar were saved at age forty-five. The IRA advantage increases with the interest rate, the marginal tax rate, and the number of years that the money is left in the account. If $2,000 were placed in an IRA account each year beginning at age twenty-five, the after-tax value of the account by age sixty-five would be $789,000; placed in a regular saving account, the value would be only $320,000. Again, the IRA advantage increases with the interest rate, the marginal tax rate, and the number of years over which contributions are made. On the other hand, once money is placed in an IRA account, there is a 10% penalty for withdrawal before age 591/2.In this sense, the IRA

5

Individual Retirement Accounts and Saving

is less liquid than a regular savings account. Of course some persons may consider this an advantage; it may help to ensure behavior that would not otherwise be the case by being a means of self-control. However, if the funds are to be withdrawn before age 591/2, whether it would be better to save the money in an IRA or a regular account depends on the interest rate, the marginal tax rate, and the length of time that the money will remain in the account. At an interest rate of 10% and a marginal tax rate of 30%, funds would have to be left in an IRA for 5.6 years to break even. At an interest rate of 2% and a marginal tax rate of 30%, the funds would have to be left for 26.1 years. At an interest rate of 10% and a marginal tax rate of 50%, they would have to be left for 4.8 years. The number years to break even is lower with higher interest rates and with higher marginal tax rates. Thus, the incentive to save through IRAs because of their higher return should be greater for persons in higher tax brackets, and the disincentive because they are less liquid should be less as the tax bracket is higher. There is an additional reason why total saving might be less with the availability of IRAs. Because of the greater return on IRA contributions, the amount of saving necessary to achieve a given level of retirement savings is less if the saving is done through IRAs. For example, again at an interest rate of 10% and a marginal tax rate of 30%, to achieve $1 million in retirement saving by age sixty-five would require giving up $4,377 per year in expenditures for current goods and services beginning at age twenty-five if saving were through a regular account, but only $1,775 if the saving were through an IRA. Thus, to attain the same level of consumption after retirement, one need forgo less consumption before retirement if saving is done through IRAs. This is what has led some to argue that there could in principle be less saving with than without IRA accounts. Finally, the promotion of IRAs may have a substantial effect on their use. They are advertised widely and are available through almost any bank and through many other financial institutions. Their promotion has typically emphasized the avoidance of current taxes through IRA contributions, as well as the importance of prudent planning for future retirement. Of course, the ultimate effect of IRAs on saving is the net result of all these factors. To put the subsequent discussion of findings on that issue in perspective, it is useful first to consider summary data on IRA contributions and on other forms of saving. 1.2 Descriptive Data Sixteen percent of families with wage earners had IRAs, according to the recently released 1983 Survey of Consumer Finances (SCF).

6

David A. Wise

Although the likelihood of contributing to an IRA is much greater for high- than for low-income families, almost 70% of contributors have incomes less than $50,000, as shown in table 1.1. Almost no families with incomes under $10,000 have them, and only about 7% of families with incomes between $10,000 and $20,000 do. Slightly more than half of those with incomes above $50,000 contribute to IRAs, based on the SCF. In addition, older persons are considerably more likely than younger ones to contribute. Yet because there are many fewer highincome than middle-income families, the preponderance of contributors is at the middle-income levels. The results of the formal analysis discussed here rely in part on the relationship between 1982 IRA contributions on the one hand and on changes in “overall savings and reserve funds” on the other. Only 32% of respondents to the SCF survey reported an overall increase in savings and reserve funds in 1982. But those who made IRA contributions were much more likely than noncontributors to report an increase. Table 1.2 shows the proportion with an increase (by income interval) Table 1.1

IRA Contribution by Income

Income Interval ($ Thousands)

% with

% of

IRAs

Contributors

0- 10 10- 20 20- 30 30- 40 40- 50 50-100 100+ All

1 7 14 25 34 51 65 16

2 15 17 20 15 24 8 100

Table 1.2

Income Interval ($ Thousands) 0- 10 10- 20 20- 30 30- 40 40- 50 50-100 loo+ All

Increase in Savings and Reserve Funds by Income and by IRA Contribution Status % with an Increase in Savings and Reserve Funds

(% of IRA Contributors with an Increase) i (% of Noncontributors with an Increase)

14 26 35 44 50 56 54 32

1.54 1.77 I .68 1.47 1.40 2.19 2.10

...

7

Individual Retirement Accounts and Saving

and the proportion of IRA contributors versus noncontributors with an increase. Suppose that IRA contributions were typically taken from savings and reserve fund balances. If savings and reserve funds include IRAs, there would be no change in overall savings and reserve funds. If the latter were interpreted to exclude IRAs, contributions to IRAs would be associated with a decline in savings and reserve funds. Apparently neither is true. Persons who contribute to IRAs are much more likely to indicate an increase than those who do not. Overall, contributors are more than twice as likely as noncontributors to indicate an increase, although this number in part reflects different distributions of contributors and noncontributors by income and age. The average of the ratios over groups defined by income and age is 1.77 (see Venti and Wise 1987). Thus, these numbers suggest that there are savers and nonsavers and that savers contribute both to IRAs and to other savings instruments; the positive relationship reflects an “individual-specific” saving effect. To put the level of IRA contributions in perspective and to help to interpret the analysis here, it is useful to know the magnitude of individual wealth holdings. The median wealth of families in the sample is $22,900, excluding pensions and Social Security wealth (as shown in table 1.3).l Most of this wealth is nonliquid, the preponderance of it being housing. Consistent with other evidence, a large proportion of individuals have very little wealth other than housing; they save very Table 1.3

Assets by Type and by Income ($ Thousands)

Income Intervals

Total Wealth

Nonliquid Assets

All Financial Assets

Financial Assets Excluding Stocks and Bonds

0- 10 10- 20 20- 30 30- 40 40- 50 50- 100 loo + All

.5 10.0 28.3 50.5 80.6 123.6 279.0 22.9

.07 .1 24.5 44.2 64.9 92.5 197.5 18.7

.1 .7 1.9 4.0 8.5 20.0 38.0 1.3

.1 .7 1.7 3.5 5.5 12.8 30.4 1.2

1 . The following breakdown of wealth is used throughout this paper: liquid assets: checking accounts, certificates of deposit, savings accounts, money market accounts, savings bonds; other financial assets: stocks, bonds, trusts; IRAs and Keoghs: balances; other assets: value of home, other property, receivables; debt: mortgage and consumer debt. Total wealth is the sum of the first four categories minus debt. Wealth does not include the cash value of life insurance, the value of motor vehicles, and pension and social security wealth.

8

David A. Wise

little. The median for all families i s $1,200. For families earning $30,000$40,000 with a head forty-five to fifty-four years old, the median is only $4,600. While most people have some liquid assets, only about 20% have financial assets in the form of stocks or bonds. Therefore, it is clear that most people have not been accumulating financial assets at a rate close to the $2,()00 per year that an IRA allows. While IRA contributors have larger holdings of financial assets than noncontributors, even their holdings are much lower than the assets that would have been accumulated had their annual savings equaled the typical IRA contribution. The average IRA contribution (of SCF families who contributed) was about $2,500. (There were two wage earners in many contributing families.) The median of family liquid asset holdings among IRA contributors by income interval is shown in table 1.4. Recall that almost 70% of contributors have family incomes of less than $S0,000.2 It is clear that these families typically have not been saving close to $2,500 per year in financial assets. Thus I982 IRA contributions seem large relative to apparent past saving. As would be expected, and as was demonstrated by the relationship between IRA contributions and changes in savings and reserve funds, IRA contributors tend to be savers. Not only do they make IRA contributions, but they are also more likely to report an increase in overall savings and reserve funds; and, because they are savers, they have accumulated more assets. I t is sometimes implied that, because many IRA contributors have previously accumulated other savings and coutd have funded IRA contributions by withdrawals from these balances, they did in fact do that. But our data provide no evidence of that. Even responses to survey questions that ask where the funds for IRA contributions came from are difficult to interpret. Since most people do not carry $2,000 in cash, Table 1.4

Financial Ametr nf IRA Contributom ($ Thousands)

Income Interval

0- 10 10- 20 20- 30 30- 40 40- 50 50-100 100+ All

Financial Asset:. Excluding Stocks and Bonds

2.46 3.10

4.00 7.10 8.75 16.10 35.00 8.51

2. Fifty percent of contributors have less than $8,510 in liquid asset