Thank you Mr. Chairman, it is my pleasure to be here today to discuss the future direction of federal tax policy. Your letter of invitation suggested that I discuss a good number of topics in this complex field; including the record tax burden, unanticipated revenue growth, prospective future changes in the tax code and consequences of tax reform. I shall try to touch on all of these areas, but would like to stress in my remarks what I view as an urgent short run need. Allow me to say first however, that these views are my own and do not necessarily reflect the views of the American Enterprise Institute.

At present, macroeconomic policy is placing an excessive reliance on monetary policy to sustain the current economic expansion. Fiscal policy has proven to be quite tight: much tighter than the Administration or the Congress intended when the budget agreements of 1993 and 1995 were enacted. While that unexpected tightness has produced some good news, a budget surplus, it is creating strains in the larger economy that are putting the present expansion at risk. I believe that the most important single action the present Congress could undertake would be to help alleviate some of those strains with a major across-the-board reduction in tax rates.

Such an action would significantly ease the intense pressure now placed on monetary policy to sustain the current American economic expansion, and indirectly, the growth in global output. In so doing, it would restore a much more prudent and balanced mix of fiscal and monetary policy to our nation. It should be viewed as an insurance policy designed to preserve the current expansion until such time as global economic conditions improve.

An across-the-board tax cut is not a substitute for much needed reform of our tax system. I would hope that this Congress might begin that process. But given the long lead time involved in preparing and enacting such legislation, I do not believe that we could reasonably expect fundamental tax reform legislation to be enacted quickly enough to meet the needs of the present business cycle. Fundamental tax reform would be a boon to the long-term growth of our nation’s economy. Our most important problem is not our economy’s long-term health, which I believe to be quite promising; it is the massive imbalance that has emerged in our economy, which could derail our present business cycle expansion.

To understand the present situation, it is important to examine recent budget and revenue history. The most stunning fact about this history is that it is serendipitous. It resulted from factors outside of the control of the President and the Congress. Stating this fact does not in any way diminish the efforts of the Congress or of the Administration in attempting to control spending or close the budget gap, but it remains a fact of life.

Figure 1 illustrates this quite clearly. Dr. Robert Reischauer, who headed the Congressional Budget Office until January 1995, prepared the figure. It shows the projected budget deficit as calculated by CBO at various points in time, but excludes the 1997 Reconciliation Act. In other words, the 1993 budget reduction and the 1995 budget reduction, which raised taxes and cut spending, are already factored into these figures. Back in 1996 it was projected that the upcoming year’s budget deficit would have been roughly $250 billion. Today we project a surplus of some $50 billion.

 Figure 1

Part of the reason for the improved revenue collection has been economic growth, which has been more rapid than expected. The economy has grown at a real rate of about 3.6 percent over the last three years instead of an expected 2.5 percent. Thus, GDP is about 3.5 percent larger than one might have expected just three years ago. In addition, and more importantly, the federal tax share of GDP has risen sharply, from 20.0 percent in 1995 to 21.8 percent in 1998. This rise in the tax share of GDP is roughly three times as important as the extra economic growth in producing the unanticipated growth in revenue since 1995.

Thus, between 1995 and 1998, GDP rose by $1213 billion or 16.7 percent. Federal revenue rose by $390 billion, or 26.9 percent. Stated differently, extra federal taxes took 32 percent of the total growth in GDP between 1995 and 1998. This is an extraordinary revenue surge, which has led federal tax collections to their highest share of GDP in history.

A closer look at the data indicates that this surge in tax collections has been concentrated on the individual income tax. The data presented in figure 2 show that corporate income taxes and social insurance taxes have risen at about the same rate as GDP; while other taxes, such as excises, have been relatively static. In the last three years personal income taxes have surged 43 percent, two and one half times as fast as personal income.

 Figure 2

While we will not know precisely who paid this extra revenue, some estimates I have made based on the details known about 1995 tax collections and aggregate 1998 collections indicate that most of this revenue surge comes from the upper brackets of the income tax and the special capital gains tax rate. Of the $256 billion gain in revenue, about half came from the 15 percent and 28 percent brackets. Thus, the special capital gains and upper income brackets saw their share of revenue increase from about 31 percent in 1995 to 36 percent in 1998.

Why would this be the case? What surprising event has occurred in the last three years that might explain this kind of revenue behavior? In my opinion, the primary cause is the enormous run-up in the stock market. The Dow Jones Industrial Average has roughly doubled from its average level of 4493 in 1995. The Standard and Poor’s index has exhibited even faster growth.

The contributions of the stock market growth to revenues are probably complicated. One of the most striking facts is that while the stock market has doubled, corporate profits taxes, which closely track corporate profits, have risen only 15 percent, or roughly in line with GDP. Therefore, the surge in the stock market has not produced revenue through increased corporate profitability. Nor can the stock market surge explain the revenue increase through faster economic growth. As noted above, the extra economic growth is only about one third as important as the rise in revenue relative to GDP in explaining the additional revenue in federal coffers.

Of course, one explanation is the rise in capital gains tax revenues, which have surged even though the capital gains tax rate has been cut. But more important, in my estimation, is a dramatic change in corporate compensation schemes. Today it is quite common for a large portion of the management structure to be compensated, in part, with bonuses. In addition, it is fairly common practice to tie these bonuses to the performance of the company’s stock. A surging stock market produces record setting bonuses. Most of these bonus recipients are in upper income brackets, which helps explain the surge in collections from top bracket individuals.

This logic is also supported by other data. The Labor Department reports that average weekly earnings of production and non-supervisory workers rose 12.2 percent between 1995 and 1998. In addition, civilian employment has risen 4.9 percent. The combined effect should have produced an increase in wages and salaries of 17.7 percent. But, wages and salaries have risen 21.1 percent over that time. That extra pay, which amounts to about $180 billion, represents increased pay to managerial workers above and beyond the 12.2 percent pay increase that was more typical for non-managerial workers. Let’s call it a managerial bonus. If you figure that many of these managers were in top tax brackets, you can explain a revenue surprise of between $50 billion and $70 billion.

In sum, the government has been collecting a record amount of revenue relative to the size of the economy. Tax burdens and the share of economic growth going to federal revenue are currently at record levels. A disproportionate share of this extra revenue is coming from upper income taxpayers through higher income tax payments. The likely reason for these payments is the booming stock market. The extra revenue is in part due to higher capital gains realizations due to higher stock prices, but is probably even more dependent upon higher bonuses being paid to upper bracket individuals. That said, it is important to consider the implications of these trends for the stock market, continued revenue collection, and the economy more generally.

As noted above, the stock market has more than doubled in the last three years while the economy has grown by about one sixth. What can explain this? Let me admit that if I could successfully explain the stock market I would be a rich man and would seek some warmer climate than Washington in which to enjoy January. One should begin by noting that today's stock market levels are unprecedented relative to historic experience. Figure 3 traces three disparate measures of valuation: stock prices relative to: GDP, earnings, and dividends. In all cases they are at record valuations.

 Figure 3

A standard way of valuing the stock market is to take the expected stream of future earnings and discount that stream back over time to the present. Over the past three years, profits have been growing at a rate of between 4.5 and 6.5 percent, depending on the measure one uses. Over the long term it is unlikely that corporate profits would grow at a significantly different rate than the overall economy, which has been averaging 5.3 percent nominal growth. There is no sign that the rate of corporate profit growth has accelerated recently. Indeed, all signs suggest that it decreased sharply in 1998 and is likely to do so again in 1999. Of course, the level of profits has risen since 1995 and this would affect the level of stock prices. Had stock prices risen in proportion to profits, one might have seen stock prices move from an average 4500 in 1995 (on the Dow) to an average 5400 in 1998.

Thus, the only way one might explain the higher level of valuation is to assume that the rate of discount applied to the stream of future earnings has fallen. There is every indication that this is the case as long and intermediate range bond yields have fallen significantly. Corporate bond yields have fallen by a bit over 100 basis points since 1995 while Treasury bond yields have fallen 170 basis points. Although any such estimates must be viewed as approximate, applying the Aaa bond yield decline to stock valuations would suggest an increase in that 5400 value of the Dow to about 6250. Applying the 10-year Treasury decline would produce a Dow value of roughly 7250. Standard valuation models therefore suggest that a significant decline in the Dow would be understandable. As noted in the previous section, this would have very adverse consequences for revenue.

This analysis brings to our attention a second fact. The growth in the stock market is not due to a fundamental increase in the profit rate. Rather, it is due to an easing of monetary conditions. Fed funds are now 108 basis points below their level in 1995 even though the rate of nominal economic growth is virtually unchanged and labor market conditions are significantly tighter. More fundamentally, the rate of money growth is significantly higher. M2 grew at a 4.2 percent annual rate in 1997. This year it has been growing at twice that rate—8.5 percent.

Let me state explicitly that I do not mean to imply that I disagree with the decisions that my former colleagues on the Board have made. But it is important to reiterate the point made in my introduction. While fiscal policy has become more restrictive in the past three years, monetary policy has more than compensated. Thus the macroeconomic policy mix has become increasingly reliant upon easy monetary conditions.

The reason that this is a matter of fundamental concern is that the mix of policy matters a great deal for the type of economic activity that is undertaken. Fiscal policy tends to work through the income statement whereas monetary policy tends to work through the balance sheet. By this I mean that fiscal policy affects economic activity by affecting people’s paychecks and the after-tax profitability of business investment. Monetary policy affects economic activity by affecting the value of existing financial assets. Easy money lowers the rate at which future profits are discounted, thus driving up stock prices, for example. People feel richer and therefore spend a bigger fraction of their incomes.

The current economic expansion is almost a textbook case of a balance sheet driven expansion. The first point to note is that economic growth is becoming increasingly consumption oriented. In the year ended in the third quarter of 1998, increased consumption accounted for 83 percent of the increase in GDP. Americans feel much richer and confident about the future and therefore are increasing their consumption.

Figure 4 illustrates the magnitude of this. In particular, it shows that people have been financing their increased consumption out of reduced saving. Household saving has fallen in real terms in each year since 1993. In 1998 this decrease became a wholesale collapse, with saving declining at an annual rate of nearly $100 billion. In the present quarter we have reached a saving rate of zero, a rate unheard of since data began being collected on the subject almost three decades ago.

 Figure 4

There is reason to believe that the fiscal policy story I described earlier is also contributing to this saving collapse. Figure 5 shows the relationship between the saving rate and the marginal tax take. Households appear to be unaccustomed to the dramatic increase in the share of their incomes taken in taxes. They are consuming, at least in part, based on earlier expectations of tax liabilities. But, personal taxes are now growing two and a half times as fast as incomes. Thus, a theoretical individual who hears he is getting a $20,000 bonus may feel that he will take home $15,000 of that bonus. When the bonus comes through, he finds he may only keep $12,000 after taxes. The extra $3,000 may already have been factored into the household spending plans, however.

 Figure 5

This is probably even more the case with households who trade stocks. A household may want to diversify a $5,000 gain it reaped in one stock by selling it and buying another stock that hasn't risen as much in price. But, the act of transferring the portfolio from one stock to another causes an increase in capital gains tax. If the household keeps its consumption unchanged, its savings would have to fall by $1,000 in order to cover its increased tax liability.

Thus, the relative tightness of fiscal policy is compounding the effects of the relative easiness of monetary policy on the personal saving rate. The key factor to keep in mind is that plummeting saving is not sustainable indefinitely. When households stop cutting back on their saving they will have to stop increasing their consumption at the same rate. This will in turn slow both economic growth and the rate of growth of profits. In turn, this will spell trouble for the stock market, which is underpinning both the boom in tax receipts and the rapid pace of consumption gains.

Let me turn to one other factor: increasing international indebtedness. Figure 6 shows the annual rates of increase in U.S. investment abroad and foreign investment here. In each year of this decade, foreigners have invested more here than we have abroad. That means, if we were to somehow "settle up" we would have relatively less to sell them than they have to sell us. In short, we are becoming increasingly indebted, on net, to foreigners.

 Figure 6

In the past three years this annual increase in America’s international indebtedness has skyrocketed to well over $200 billion per year. Just like the ever falling level of personal saving, an ever rising indebtedness to foreigners is not a sustainable proposition. At some point foreigners will begin to question our creditworthiness and stop lending us ever-increasing amounts of money. If that were to happen suddenly, interest rates in the United States would have to rise sharply in order to ration the demand for credit given the reduced supply of financing. With higher interest rates, the rate of discount of future corporate profits would rise, the value of future income streams would fall, and the stock market would fall.

So, our economy and financial markets are closely intertwined with the mix of fiscal and monetary policy we undertake. The present mix, unfortunately, is unsustai nable. We are fast headed for two problems; either one of which could derail our economic expansion, adversely affect our capital markets, and cause a decline in expected federal revenues: a reduction in household saving and foreign indebtedness. I would like to turn to the policy prescription this implies:

If, as I have implied, the current stock market induced surge in revenue is unsustainable under current policies, then two alternative courses of action present themselves. I will admit at the outset that they are, at least superficially, a bit contradictory. But the key disparity is one of timing, not of fundamentals.

First, if the revenue surge we are now experiencing is truly temporary, then it would certainly not be prudent to make any long term commitments with these resources. In particular, one should not use temporary revenue to expand consumption-based programs, which are permanent in nature. Entitlement programs represent the most common form of this type of program. If these programs are to be expanded, or in the case of social security, maintained at benefit levels that exceed permanent funding sources, they should be funded by a permanent increase in revenue such as a rate increase. The reason why consumption based programs are different is that if the revenue surge were to stop, the country would be faced with maintaining a permanently higher level of consumption on a lower level of income.

Ultimately it is a rare government program that can be terminated when economic conditions change. Indeed, when things turn down it is often argued that the program is needed even more. From this approach, the right policy prescription is to view the current situation as a windfall and refrain from spending it. Unfortunately, this decision guarantees that the windfall will indeed be temporary in nature as the unsustainable fundamentals of existing policy are left in place.

The second approach one might take to this set of circumstances is to make prudent policy investments in trying to maintain the permanence of the present economic expansion. That is, we could use the existing windfall to try and redress the imbalances of which I spoke earlier. Without question, the most simple and direct means of doing so would be to pass a two or three year temporary income tax rate cut.

As I mentioned in my introduction, I would view such a tax cut as an insurance policy. It would maintain household cash flow even if the stock market were to decline. This would mean that overall spending in the economy would not be adversely affected by trouble in the financial markets. A failure to buy such an insurance policy would mean that a stock market decline would precipitate a contraction in real activity. This would lower profits and incomes still further; thus causing further financial distress, lower stock prices and an even greater cutback on the part of consumers. In short, a tax cut is insurance against a recession caused by trouble in the financial markets. And, as I view trouble in financial markets as a likely event, buying such insurance represents prudent fiscal policy.

One might argue that given the extended nature of the current economic expansion and given the high degree of excessive optimism in financial markets, that an economic downturn is not only due, but would be cathartic in its effects. If one adopts this point of view, then one should certainly hold to the initial course of action recommended above: do nothing and let economic forces take their course.

While this view is not entirely without merit, I believe that there are special circumstances prevailing today, which make preserving the existing economic expansion in the United States an absolute imperative. The simple fact is that the rest of the world is in perilous economic shape. Asia remains deeply mired in recession with little hope of recovery either this year or next. Europe, while still growing, is faced with economic forecasts that are constantly being reduced. The reasons are many, but they generally center on the need in Europe for the kind of deregulation and restructuring that took place in this country during the last two decades. Meanwhile, much of the rest of the world, particularly Latin America and the Middle East face deteriorating economic fundamentals.

In this environment, a recession in the United States would surely tip the planet into the first global downturn since the 1930s. The consequences of such a development would not be attractive. First, it would be more difficult for the United States to recover from its own recession if it were a part of a global downturn. Complicating this would be a likely rise in protectionist sentiment around the world. As the United States has become the premier organizer of global economic activity, we would be the primary losers from such a development.

More importantly, the political risks that a global downturn might pose to the advance of democratic capitalism cannot be underrated. The last time we had a global recession—the 1930s—both democracy and capitalism were set back many years. Political instability throughout the world is already growing, and potential dictators are everywhere raising their voices promising troubled electorates an "easy way out" that avoids economic competition abroad and political competition at home.

At the same time, there is reason to believe that both Japan and Europe are laying the groundwork for a more sustained course of economic growth in a few years. Both are undergoing significant structural changes, which could lead to a more permanent base of economic growth in two or three years. At that time, the need to maintain American economic growth for global reasons would be significantly reduced. Any American recession would then be shallower and shorter lived because robust demand from Europe and Asia would buy some of the goods that our overextended consumer sector could not.

In sum, I believe that the Congress and the Administration now have a choice to make: either to let economic forces take their course, or to buy some insurance against what might come. Quite a bit is at stake: not only the economic expansion, but the balance sheet of the household sector, the financial markets, and the revenue surge which is providing us with the first fiscal surplus in many years.

Of course, all of this has little to do with the immediate topic of the hearing, which is Federal Tax Policy in the New Millennium. The focus of my remarks to this point have been on just getting us through to the new millennium. But, the objectives of tax policy in the 21st century should be the same as the objectives of tax policy now. They are summarized in the phrase: Broader Base—Lower Rates.

The twin concept of a broad tax base with low rates is clearly the dominant view among tax professionals and public policy economists. It seemed 10-15 years ago that a bipartisan consensus had emerged in favor of this objective. At that time Senator Bradley and Congressman Gephardt sponsored legislation to accomplish just that with a top tax rate of 26 percent. President Reagan proposed a comprehensive tax reform proposal to broaden the base in 1985. In 1986 the concepts behind these objectives were enshrined into law. The income tax base was broadened significantly and the top tax rate was reduced to 28 percent, although the benefits of lower rates were phased out leading to a temporarily higher tax rate of 33 percent. The 1990 budget legislation removed this bubble by creating a uniform 31 percent bracket, but then began a phase-out of itemized deductions which raised the effective top tax rate to just under 32 percent.

Unfortunately, tax policy during the 1990s has moved in a way that is diametrically opposed to the concept of broader base—lower rates. First, rates were increased significantly in the 1993 tax legislation. The nominal top rate was increased to 39.6 percent. But, with the phaseout of itemized deductions, the maximum rate was effectively 40.8 percent. On top of this, the cap on Medicare tax was removed adding a further 2.9 percentage points to the top tax rate. This latter change is moving Medicare away from a system based on contributions by workers for health care in their retirement and toward a pure welfare system in which benefits are not tied to contributions.

But the most troubling development has been the adoption of various phaseouts, including a phaseout for personal exemptions. This latter phaseout raises effective tax rates by roughly one percentage point for every individual in the taxpaying household. Not only do these changes raise marginal rates; they do so in a way that decidedly complicates the tax return.

I recently thumbed through my instructions for form 1040. There was the state and local tax refund worksheet, the simplified method worksheet for annuities, the social security benefits worksheet, the IRA deduction worksheet, the student loan interest deduction worksheet, a special standard deduction worksheet for non-itemizers which was separate from the calculation limiting itemized deductions for high income itemizers, the personal exemptions worksheet, the child tax credit worksheet, and a worksheet to see if I needed to do the alternative minimum tax calculation, which if I passed, would require yet another calculation.

This is not what was meant by broader base—lower rates. Indeed, even the very concept has been turned on its head politically. The President speaks of targeted tax relief. Targeted relief means, by definition, a narrower tax base. Some economic activity becomes tax favored while, to compensate, other forms of economic activity must carry higher marginal rates to make up the difference.

I can well understand the political drive for such targeting. If politicians need to show that they care about a special need, they can either do so through a direct appropriation or through targeted tax relief. But this detailed, case by case approach to both tax and budget policy places individual special interests ahead of the national interest in an efficient and simplified tax code. It was because special interest lobbying had made our tax code so complex that the bipartisan consensus for a broader base and lower rates emerged in the 1980s. It is a shame to see the political process running that in reverse during the 1990s. Hopefully the 1990s will prove to have been politically aberrant.

The move toward higher rates has, to some degree, further exacerbated the balance sheet problems described above. The most obvious damage has been in creating an over-emphasis on capital gains, or for untaxed or lightly taxed transactions that result from merger activity. Many corporations have opted for stock buy back strategies as a way of distributing earnings to share holders in a tax-favored way. Dividend payments have collapsed.

In 1993, $100 invested in the S&P bought $4.46 in earnings and $2.78 in dividends. In mid-1998, that same $100 bought $3.44 in earnings and only $1.47 in dividends. In other words, in this rising market, dividends on the S&P fell from 62 percent of earnings to 43 percent of earnings. In addition, the really hot markets, particularly the NASDAQ, are dominated by companies that pay no dividends at all.

What is wrong with this? In one sense, nothing, if the result were not driven by tax considerations. Markets should provide a return to investors in the manner most preferred by those investors. But, taxes are distorting the preferences of investors in a way that is contributing to three of the excesses we now see in the market. First, tax considerations favor hot new stocks with little or no earnings history over established companies. Second, tax considerations favor stock buybacks that shrink the total supply of stock in the market. Third, tax considerations are distorting the market against dividend payouts, letting corporate management make the portfolio allocation decisions rather than individual investors. All three of these phenomena are directly tied to a tax policy geared to politically targeting the tax code—a policy of higher rates and a narrower and more politically determined tax base.

In sum, Mr. Chairman, I believe that the type of tax policy we have opted for in the 1990s has somewhat exacerbated the excesses caused by the fiscal and monetary policy mismatch which has also characterized much of this decade. The temptation for a politically motivated tax policy, in which tax breaks are given to favored groups, is a natural temptation. But, just like the over-reliance on excessive stock market valuations to provide tax revenue, it will produce a result in the end that we will all regret.

Lawrence B. Lindsey is a resident scholar at AEI.