What kind of recovery package will help the United States escape recession? There is pressure for a tax cut -- many politicians are afraid to oppose middle-class tax relief -- but most analysts believe that promoting such consumption is a bad idea. What America really needs, they argue, is investment.
Increasing investment would benefit the economy in almost every respect. In the short run, it could help drive a recovery. In the 12 months following the 1981-82 recession, for example, demand rose 8.6 percent, but investment rose 40 percent. In the long run, investment could help boost productivity. Over the past 20 years, the United States has been the world's champion job creator, increasing employment more rapidly than Europe or Japan. But America's jobs haven't been good ones. Real wages have slid almost steadily since 1973, and sluggish productivity growth is behind the decline. The United States has consistently invested a smaller share of gross national product than almost any other industrial nation. Over the past 30 years, Japan has invested 31 percent of output and achieved productivity growth of more than 5 percent per year. Germany and France have invested about 23 percent of output and achieved annual productivity growth of more than 3 percent. But America has invested just 18 percent and averaged slightly more than 1 percent in productivity growth.
Costly capital. American investment has lagged primarily because of higher capital costs. Investment requires funds, which are ultimately supplied by savings. In the 1980s, however, tax incentives for investment were offset by sharp declines in national savings. Households saved less, but Washington also chalked up record deficits. As a result, private savings were used to finance public deficits instead of new investment. This reduced national savings from 9 percent of GNP in the late 1970s to only 2 percent in 1987.
The United States was able to compensate for part of this savings collapse by borrowing abroad. Without capital from Europe and Japan, American investment would have fallen sharply. But to attract these foreign funds, the United States had to offer high rates of return. During the 1980s, real interest rates rose to unprecedented levels, and these soaring rates discouraged many Americans from investing.
Today, the problem is how to stimulate American investment. Conservatives and liberals have very different visions. Conservatives want to use the same strategy as the first Reagan administration. That means boosting investment by increasing incentives for the private investor. To accomplish this, they support a cut in the capital-gains tax. Conservatives argue that if this levy is sliced, investors will buy stocks of companies that retain earnings. They believe this will lower the firms' cost of capital while providing incentives for saving. Taxes on investment income encourage consumption at the expense of savings, according to conservatives. If a citizen earns a dollar and spends it, he pays income tax once; if the funds are profitably invested, however, they are taxed again.
Critics of this argument fear that the main beneficiaries of a lower capital-gains tax will be short-term financial operators rather than long-term investors. And, even if a lower capital-gains tax does raise real investment, will it provide the right kind of investment? In the past, when capital-gains-tax rates were much lower than the income-tax rates paid by wealthy Americans, there was a proliferation of tax shelters that converted ordinary income taxable at 70 percent to capital gains that were taxed at much lower rates. Most of these shelters involved commercial real estate, which will be in excess supply for the foreseeable future.
Liberals want to raise taxes, not lower them. Indeed, they want to tax upper-income families who would gain the most from a capital-gains cut. The liberals point out that incomes of the very well-off have soared since the 1970s while those of most Americans have stagnated. Why not take back the Reagan tax cuts for the top 1 percent, ask liberals, and use the money to reduce the budget deficit?
Conservatives reply that higher taxes will discourage enterprise. And they scoff at claims that the deficit will be reduced, arguing that tax increases will quickly be dissipated by higher spending. In fact, many liberals do advocate higher federal spending, although they favor future-oriented spending on education and infrastructure.
The conservative conviction that a cut in capital-gains taxes can work magic is hard for most economists to swallow. But just because the conservatives are wrong doesn't mean the liberals are right. A middle-class tax cut will probably be enacted this election year. And some cut in capital-gains taxes -- which will create new tax shelters but little investment -- will also be passed. The sad part is that everyone agrees that America needs to increase investment, but nothing significant will be done to achieve this goal.
Originally published, 2.24.92