CONCLUSIONS AND RECOMMENDATIONS

Tax Reform to Reduce the Cost of Capital and Lengthen Time Horizons in the United States

Tax policies affect the cost of capital directly as well as through their indirect effect on the cost of funds. The board believes that tax changes provide one of the most important direct means to alter the cost of capital. We recommend two approaches to reform: a broad direction for policy change and a more limited transitional tax change. 18

As a longer term goal, the board supports the adoption of a progressive, consumption-based tax system for three reasons. First, a consumption tax system will encourage saving and investment. Second, it will help to restore investment incentives for the broad class of investments for which part of the return is to society and not just the investing corporation. For example, the benefits of job creation and growth to communities and for federal, state, and local budgets go well beyond the private return to the firm. Third, by eliminating all investor-level taxation of capital income, a consumption-based tax could eliminate not only double taxation of corporate income flows but also the biases in favor of or against various categories of investment and investors. The difficulty of designing effective, nondistorting incentives for investment would vanish. The consumption tax should be made progressive, and there are several ways this could be achieved.19

The board recognizes that shifting to a broad-based consumption tax system is a major change and would entail a complex and lengthy process. On a shorter time horizon, we believe that the following steps should be taken to encourage productive investment.

First, Congress should progressively reduce the subsidy on residential real estate by eliminating the deduction for interest on future mortgages above an amount (e.g., $200,000 to $300,000) well below the current cap of $1 million. The national issue is not merely the amount of

18

In its deliberations on tax policy, the board first examined the concept of a level playing field for allocating capital among different classes of assets, partially introduced in the 1986 tax act, by reducing some of the remaining tax preferences. Some members of the board argued that a more neutral system would be the more efficient. Other board members pointed out that the tax act of 1993 restored some of these distorting incentives. The board supports the underlying philosophical thrust of the 1986 act but recognizes the need to live with some deviations from neutrality pending the substitution of a tax on comsumption for taxation of income.

19

Andrews (1974) and Bradford (1980) develop proposals for a consumption tax in some detail and discuss some of the issues that would arise in implementing such a tax.



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Investing for Productivity and Prosperity CONCLUSIONS AND RECOMMENDATIONS Tax Reform to Reduce the Cost of Capital and Lengthen Time Horizons in the United States Tax policies affect the cost of capital directly as well as through their indirect effect on the cost of funds. The board believes that tax changes provide one of the most important direct means to alter the cost of capital. We recommend two approaches to reform: a broad direction for policy change and a more limited transitional tax change. 18 As a longer term goal, the board supports the adoption of a progressive, consumption-based tax system for three reasons. First, a consumption tax system will encourage saving and investment. Second, it will help to restore investment incentives for the broad class of investments for which part of the return is to society and not just the investing corporation. For example, the benefits of job creation and growth to communities and for federal, state, and local budgets go well beyond the private return to the firm. Third, by eliminating all investor-level taxation of capital income, a consumption-based tax could eliminate not only double taxation of corporate income flows but also the biases in favor of or against various categories of investment and investors. The difficulty of designing effective, nondistorting incentives for investment would vanish. The consumption tax should be made progressive, and there are several ways this could be achieved.19 The board recognizes that shifting to a broad-based consumption tax system is a major change and would entail a complex and lengthy process. On a shorter time horizon, we believe that the following steps should be taken to encourage productive investment. First, Congress should progressively reduce the subsidy on residential real estate by eliminating the deduction for interest on future mortgages above an amount (e.g., $200,000 to $300,000) well below the current cap of $1 million. The national issue is not merely the amount of 18 In its deliberations on tax policy, the board first examined the concept of a level playing field for allocating capital among different classes of assets, partially introduced in the 1986 tax act, by reducing some of the remaining tax preferences. Some members of the board argued that a more neutral system would be the more efficient. Other board members pointed out that the tax act of 1993 restored some of these distorting incentives. The board supports the underlying philosophical thrust of the 1986 act but recognizes the need to live with some deviations from neutrality pending the substitution of a tax on comsumption for taxation of income. 19 Andrews (1974) and Bradford (1980) develop proposals for a consumption tax in some detail and discuss some of the issues that would arise in implementing such a tax.

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Investing for Productivity and Prosperity investment but also its composition. Although there may be social benefits of housing construction, as a result of the tax system’ s bias, approximately one-third of net private investment goes into owner-occupied housing, penalizing more productive corporate investment (Jorgenson and Yun, 1990; Poterba, 1992). To the extent international debt markets are integrated, reduced residential investment would not translate directly into increased investment in plant and equipment. Nevertheless, at least half of the value of residential real estate in the United States is equity financed, and a substantial part of the equity freed by reduced residential investment would be available for other investments, including plant and equipment. Moreover, given the tax system, investment in residential real estate has a highly favorable bias and plant and equipment are relatively disadvantaged. Reducing this disparity would eventually tilt the nation’s overall investment portfolio more in favor of the corporate sector. Reducing the maximum mortgage principal eligible for interest deductions to $300,000 would yield additional revenues, estimated at $4 billion to $5 billion per year according to the Joint Tax Committee and the Congressional Budget Office (1994). The board believes that, pending conversion to a consumption tax system, some of the revenues generated by this measure should be used to lower the taxes on the returns from corporate investment, thereby lowering the cost of capital. We favor two proposals. The first is elimination of the double taxation of corporate/divided income flows. Relative to other countries, the United States, through its double taxation policy, penalizes equity investment and increases the wedge between the cost of funds and the cost of capital, a condition that has prevailed for some time but attracted considerably more notice with the emergence of aggressive foreign competition and the decline in the growth rate of productivity.20 This double taxation is mitigated by three factors: corporations retain income, thus deferring the tax; financial investors can defer taxation of the capital gains portion of the return by holding the stock; and there is a class of tax-exempt or tax-deferred investors, primarily pension funds, that are in whole or in part relieved of the corporate income tax. Nevertheless, the double taxation penalty on taxable income flows at today’s higher marginal personal and corporate tax rates can be quite dramatic. Consider an individual investor who 20 This double taxation has led to an increase in corporate leveraging in buyouts (because interest is deductible but dividends are not) and hence to a reduction in government revenues. With the increase in marginal tax rates contained in the 1993 tax act, both at the corporate and individual levels, this double taxation became more of a hindrance to additional capital investment.

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Investing for Productivity and Prosperity demands a 6 percent after-tax rate of return on investments that are as risky as corporate equity. If this investor faces a combined federal and state/local tax rate of 40 percent on investment income, then stocks must yield a pre-tax return of 10 percent to deliver an after-tax return of 6 percent. If the corporation faces a marginal corporate tax rate of 36 percent, it must in turn earn a before-tax return of 15.6 percent to provide the investor with a 10 percent return net of corporate taxes or 6 percent after this tax. In this example the combined impact of the taxation of the firm and the investor is large. If the pre-tax return were taxed only once, at the corporate rate of 36 percent, the after-tax return to investors would be 9.36 percent, instead of the 6 percent in the case cited; conversely, the firm might have a before-tax return of only 9.36 percent to yield the 6 percent desired. As a U.S. Department of Treasury (1992) study describes in detail, there are several ways to remove this penalty on distributed corporate earnings.21 Manipulating the corporate income tax rate can raise additional tax revenue, be revenue neutral, or provide a further stimulus to investment. Our second proposal is to expand the favorable treatment of long-term capital gains on corporate equity in the 1993 tax legislation. The new tax law excludes from tax 50 percent of any gain on newly issued stock held 5 years in firms with no higher than $50 million capitalization. The preference applies to investments of $10 million or less and to stock that has appreciated 10 times or less. The board supports removing some of the limitations on this favorable treatment of long-term gains, for example, by extending it to gains on long-term holdings of newly issued stock in all firms regardless of size.22 This could encourage investment in firms with intangible and other assets with long-term payoffs and mitigate pressures to achieve short-term returns. For the investor who pays taxes, a targeted capital gains incentive for long-term equity investment would encourage a longer time horizon while it mitigates double taxation of corporate dividends. To influence the substantial pension and mutual 21 This thorough examination of four alternative integration approaches concludes that any of them can be designed to avoid loss of revenues. 22 In the short run, at least, this could be structured to raise revenue. The 1986 act had essentially eliminated the differential between capital gains tax rates and those for ordinary income by reducing the marginal rate on ordinary income. Because the 1993 act again widened this differential for all types of capital gains by raising the marginal rates, it is now justified to mitigate this by the particular type of targeted reduction for long-term holdings recommended in this report, to lengthen time horizons and thus help growth and risk taking. Furthermore, the limitations of such favorable deductions to longer-term holdings make the revenue effects small, even in the medium term and the overall progressivity of the code is little changed.

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Investing for Productivity and Prosperity fund assets for which taxes are deferred, this preference might be extended to taxes on the income paid out to distributees. The board generally favors broad-based rather than narrowly targeted tax-based investment incentives. Narrowly focused tax preferences lead to inefficiency, substitute government for the private sector in allocating resources for investment, and provide an opportunity for special interest pleading. Narrow investment incentives should be confined to areas in which there is a clear, measurable, significant public interest component to the return that is not captured by the private investor. Lengthening Managerial Time Horizons The board believes that managements and boards of directors can adopt practices that can, at least to some extent, mitigate the pressures to forgo longer term investments; bring the interests of investors, management, and other stakeholders in the corporation into closer alignment; and reduce investment hurdle rates without sacrificing the attractive features of U.S. capital markets. U.S. corporations can take steps to reduce perceived risk and many are doing so. These measures include communicating effectively about the goals and direction of the company to internal and external constituent groups, primarily stockholders, establishing close relations with suppliers and customers, avoiding excessive diversification, promoting significant employee ownership, and adopting more effective employment practices that reduce turnover and upgrade employee skill levels. A second class of reforms encourages managers and directors to focus on the long-term performance of their firms by increasing their long-term equity stakes in their companies. Many managers and directors now hold relatively little equity in the firms they control, and the equity that managers do hold results principally from the exercise of options. The brevity of most managers’ tenure also skews their incentives toward maximizing short-term rather than long-run financial performance. For outside directors, many of whom have virtually none of their own wealth invested in the firm, the incentive problem can be even worse. The board recommends that corporations and regulators permit greater use, in executive and director compensation, of restricted stock or options to acquire stock restricted from sale as a means of rewarding long-term performance.23 To encourage this practice, the accounting 23 Requirements that directors own substantial amounts of stock can be phased in so as not to limit inappropriately the pool of potential directors.

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Investing for Productivity and Prosperity and reporting treatment of restricted stock and contributions to stock options should be more favorable than that of unrestricted shares and options. These policies would strengthen links between the company’s long-term share price performance and managerial compensation. A number of corporations are well along in adopting these and similar measures. Developing a Cadre of Long-Term Investors A third class of reforms would create a distinctly American version of one of the most successful features of foreign competitors’ capital allocation systems—the presence of a class of long-term investors who are not highly sensitive to short-term fluctuations in share prices. The policy challenge is to preserve the openness and liquidity of U.S. capital markets overall while simultaneously providing substantial investors willing to be treated as insiders, with incentives to hold shares and with access and motivation to acquire and analyze specialized information on corporate investment decisions. There are several ways that capital market policies could encourage investors to seek and receive more information needed to develop confidence to support long investment horizons and to hold substantial equity stakes longer term.24 More flexible capital market policies could encourage the growth of investment institutions oriented to long-term, committed, active ownership of substantial equity stakes. Currently, several laws and regulations are quite rigid in limiting institutional investors to diversified small takes in companies. Mutual funds, for example, are strongly pushed toward diversification by tax incentives and are limited by the Investment Company Act of 1940 to owning no more than 10 percent of the stock of any firm. Pension fund managers are required by the Employee Retirement Income Security Act of 1974 to demonstrate prudent diversification, which in practice means holding small stakes in scores of companies. State regulations of insurance companies also generally require substantial diversification. Securities and Exchange Commission regulations raise the cost of holding significant stakes in companies by requiring extensive filings above a 5 percent threshold. 24 These proposals are discussed in more detail in Michael Porter’s paper in the forthcoming companion volume.