Prepared Testimony By
Wayne D. Angell

JEC Hearing on Tax Cuts and the Budget Surplus
September 13, 1999

Mr. Chairman, members of the committee, thank you for the opportunity to testify today on the subject of tax cuts.  It is a very welcome opportunity to discuss some of the important economic analytical principles that, I believe, should be used to cast light on the current debate about tax reduction in the context of the Republican plan to cut taxes by $792 billion over the next 10 years.  Let me say at the outset that while the plan is far from perfect, it represents a first step toward addressing our most critical problem�the inadequacy of national saving in financing the burgeoning growth of capital spending on which our new era economy depends.  Before turning to the critical risk posed by our undersaving problem, I believe it is important to review the performance of the U.S. economy and the favorable economic outlook.

U.S. economic performance and outlook
U.S. economic growth is very strong, core inflation rates are at their lowest levels in over three decades, job creation is robust, unemployment is at a three-decade low, real wages are rising, and the stock market hits new records with remarkable frequency.  The current economic expansion is in its 103rd month and is the longest peacetime expansion in the history of the United States.  However, the expansion shows no signs of old age.  Over the last three-and-a-half years, annualized real GDP growth has averaged 3.9% as measured by the Commerce Department, and there are good reasons to believe that this growth rate is understated.  Inflation, however, has fallen on balance over this period to levels that policymakers thought unlikely to occur.  Indeed, during the first seven months of 1999�a period during which inflation anxieties have risen in some quarters�the core rate of CPI inflation has been only 1.7%, which is the lowest rate of core inflation over such a period since 1965. The unemployment rate has fallen to a 29-year low of 4.2%.  All socioeconomic groups have increasingly felt the fruits of the expansion, although much progress yet needs to be made.  This is why I favor policies that will produce the fastest sustainable rate of economic growth.

I believe that this remarkable economic performance is consistent with the view the U.S. economy has entered a New Era.  The font of New-Era economic performance is the focus on shareholder value by U.S. companies that has in turn produced a sharp increase in the growth rate of labor productivity.  The Federal Reserve and Congress have made important policy choices that have helped bring about this economic transformation of U.S. companies.  First and foremost has been the Fed�s pursuit of gradual disinflation that appears to have removed from CEOs the notion that they have any pricing power.  Second, the administration and congress have, for the most part, been supporters of free trade policies, including the passage of NAFTA.  Third, budgetary discipline has freed real resources for private employment and has permitted the emergence of federal government fiscal surpluses, which, up to now, may have contributed to lower borrowing costs.  Fourth, the reduction in capital gains tax rates combined with the lower effective tax rate on capital that is a product of the decline in inflation has offset the partial reversal of the 1980s� tax rate reductions by the Bush and Clinton administrations and thereby our economic performance has remained on track.

Perhaps the most important contribution that has been made is the restoration of confidence in the dollar that enabled an emergence of a highly competitive entrepreneurial high-tech economy.  The emerging digital economy, so well described in a recent Commerce Department study, has provided CEOs, CFOs, COOs, line managers, and workers with the tools to enhance productivity growth, cut costs, and better address the needs of customers.  Over the last three-and-a-half years, nonfinancial corporate productivity growth has averaged 2.9% per year, and, over the last year has run at an even higher rate of 3.8%.  This compares very favorably to the 1.5% average growth rate of productivity recorded between the mid-1980s and the mid-1990s.  This rapid growth of labor productivity has been made possible by a sharp rise in investment as a share of the overall economy.  In real dollar terms, the share of nonresidential fixed investment in GDP has risen to a record-high 13.3% in the second quarter of 1999 from a low of 8.8% at the beginning of the current expansion.  Spending on computers has grown rapidly, averaging an annualized growth rate of 50% since the end of 1995.

Our undersaving problem
This remarkable economic performance, however, cannot be taken for granted.  We face a persistent and growing mismatch between national saving and gross private domestic investment.  Quite simply, our after tax rate of return on savings does not provide sufficient motivation to save annually the $1.5 trillion dollars needed for investment in labor productivity enhancing capital goods.  Currently, domestic savings of government, business and households of nearly $1.2 trillion falls about $0.25 trillion short of our demand for capital goods necessitating a foreign inflow of money capital.  That means that over the next 10 years we are at risk that our net external obligations of net debt and net external equity obligations nearly double as a percent of $GDP from the current 17% to 30% in 2009 as our net external obligations rise from $1.5 to perhaps $4.3 trillion.  In contrast, it is likely that the U. S. debt held by the public to $GDP ratio will decline from the 41% current level to 17% in 2009.  And that includes an assumption that the Congress will decrease tax rates sufficiently to hold general government revenues in balance with general government expenditures over the next 10 years.

Social Security trust fund receipts are likely to exceed outlays by about $1.9 trillion over the next ten years.  If we were to balance the general government budget on average over the next ten years then U. S. government debt available to be held by the public would be cut in half from $3.8 trillion to $1.9 trillion.  That would mean that the debt held by the public to $GDP ratio would have declined from 50% in 1995 to the current 41% and continue to decline to 17% in 2009.

Foreign central bank current holdings of $0.6 trillion and other foreign holdings of U. S. Treasury securities of $0.7 trillion surely would need to rise by at least 50% over the ten year period if we are going to attract capital inflows.  And assuming that the Federal Reserve grows its balance sheet of Treasuries at the same 5% growth rate assumed for $GDP there would be no Treasury securities for the private sector.  No Treasuries bills, notes and bonds for holding by state and local governments, including pension plans.  Likewise there would not be any U. S. savings bonds or Treasuries available for holding by U. S. citizen including all of our private pension plans.

From this perspective it would seem irresponsible to continue to overtax our citizens to pay down the national debt. As the public debt to GDP ratio falls the corporate plus household debt to $GDP ratio will increase, unless we enter a period of credit contraction, and we can expect to continue to see the spread between Treasury securities and corporate securities widen.  In principle, there is some level of debt to GDP that is optimal given the preferences of society.  Given the high priority use of Treasury securities for the Federal Reserve and for other central banks there is ample reasons to suggest that that optimum ratio should not fall below 25 percent.  In addition to central bank functions government debt is demanded by investors and public pension plans managers who require a very safe and highly liquid asset�indeed the concept of a risk-free asset is central to numerous theories of the efficient functioning of financial markets.

Consider, for example, the dollar�s central role as the reserve asset of the world.  Clearly, such a role has imparted tremendous benefits on the U.S., not the least of which is the seniorage gain from the $487 billion of U.S. currency that circulates, with perhaps at least two-thirds of these greenbacks circulating overseas.  In addition, overseas monetary authorities as the major asset in their foreign currency reserves hold $603 billion of U.S. government securities.  It is unlikely, in my judgment that foreign monetary authorities would hold anywhere near the amount of dollars that they currently do if there were no safe, liquid asset for them to hold.  And as the Federal Reserve succeeds in making the dollar synonymous with price stability and the economy of the United States creates high rates of returns on capital, more countries are likely to consider dollarization, currency boards, or to maintain even higher dollar reserves in floating currency systems.

The Federal Reserve also needs a safe, liquid asset in order to conduct their open market operations.  The Fed alters the level of overnight interest rates by buying or selling U.S. Treasury securities.  The Fed would face considerable operating difficulties if there were not a liquid Treasury market.  Think of the credit assessment signal that could occur if the FOMC were forced to substitute corporate debt for Treasury bills and notes in doing open market operations.  Corporate securities in Federal Reserve banks portfolios would necessitate an FOMC credit rating and credit approval.  Imagine the banking community and Wall Street ramification of word that X Corporation securities have been removed from the FOMC approval list.  Clearly risk free Treasury securities have a decided advantage.  Furthermore, the Treasury securities in the Fed�s portfolio provide the asset that is used to back the U.S. currency.  The Federal Reserve currently owns $486 billion of U.S. Treasury debt.  Immediately we see, therefore, that the Federal Reserve and other central banks hold $1.1 trillion of federal debt.

The private sector also has a need for the safety and liquidity of U.S. Treasuries.  Private pension companies, state and local pension plans, and insurance companies hold $683 billion of U.S. Treasuries, despite the fact that higher yielding assets, such as corporate bonds and mortgages, are available.  It is because of the demand for the perceived safety of Treasuries that the government is able to borrow at lower rates than the private sector.  If the private sector views holding some Treasury debt in its portfolio as desirable, it is likely that optimal debt-to-GDP ratio is somewhere between 25% and 40%.
On the other hand, the appetite for government debt is not unlimited.  One of the major causes of financial instability and consequent inflation in other parts of the world and at other times has been an unsustainable large government debt, which has ultimately ended in some form of monetization of the debt.  In recent experience, the examples of Russia at the present time and Brazil earlier in the decade should serve to illustrate the point.  It is possible that Japan is heading in that direction since the debt-to-GDP ratio in Japan moved above 100% at the end of last year.

By international standards, the U.S. debt to GDP ratio is relatively low.  The ratio of federal debt held by the public has fallen to 41.1% in the second quarter, which is down sharply from a ratio of 50.1% in 1995.  With the federal government projected to run significant surpluses, this ratio is likely to fall sharply over the next decade.  Note that at present levels of growth (I assume 5% nominal GDP growth) and federal debt, the debt will decline as a share of GDP as long as the deficit is below 2% of GDP.  Note also that if the federal budget is just kept in balance, the debt to GDP ratio will fall to 17% by the end of the next decade, which is lower than the debt to GDP ratio has reached in the post was period.  If, in addition to a $1.9 trillion buy down by the social security trust funds, a general government surplus were to run at 1% of GDP, federal debt would fall to less than 10% of GDP by the end of the next decade.
Compare this level of debt to European debt levels.  In Germany, the debt to GDP ratio was about 63% last year.  In France, the ratio was about 59%.  In Italy, about 119%.  And in the UK, the ratio was about 53%.  By G-7 standards, therefore, US debt is low in relation to GDP.  Why should we postpone reducing taxes to push the federal debt to levels that we have seen in the post war period or across other G-7 countries?

Tax policy and the saving rate
Some prefer to keep marginal tax rates high in order to pay down the national debt in order to foster a low interest rate environment.  Surely, it is not hard to understand that with a continued shortfall in national saving as compared to our investment demand it is likely that interest rates will remain high enough to continue to attract money capital inflows from abroad.  Consequently, there is little likelihood that interest rates can come down and some risk that rates will increase.  Until we alter our tax disincentives to saving, interest rates will necessarily be high enough to offset the tax rate or to attract additional money capital from abroad.

The only way to get our economy back onto a path to lower interest rates is to alter the after tax rate of returns on savings.  That is why I have supported a radical switch from an income tax to a consumer spending tax.  But, that is not the choice that we have today.  Our choice today is to take the first step toward a reduction in marginal tax rates that will improve expectations for lower taxes on saving in the future.

The proposed $792 billion tax cut over 10 years amounts to less than $80 billion per year.  Assuming 5% nominal GDP growth, the average annual level of GDP over the next decade would be almost $12 trillion per year.  The GOP tax cut proposal represents, therefore, a very modest two-thirds of a percent of GDP.

From one perspective it may seem too low to make much difference.  Yet, we should know that failure to take this small step would likely lead us to a legislative atmosphere of spending the money and thereby losing momentum for economic growth.  In order to continue the surge in non-residential capital spending which is essential in order to continue to increase labor productivity, we have to be very Spartan in our use of our labor and capital to produce public services.  And this tax cut proposal that includes marginal tax rate reductions, a reduction in the capital gains tax rate, and reductions in death taxes does go several small steps in the direction of increasing our saving rate.

Once again, I want to reiterate that our fabulous new era economy is essentially driven by the surge in non-residential capital spending from 9% of real GDP in 1990 to 13.3% in the second quarter of 1999.  High technology capital spending is the source of the growth of non-financial corporate productivity to 2.9%.  Yet national saving lags far behind and is growing at the same rate as $GDP�just over 5%.  Meanwhile capital investment is growing at a 9% annual rate.  The shortfall in saving is large as a percent of $GDP and getting larger.  That means that the annual deficit in our external sector is getting larger and that our net external obligations as a percent of $GDP are likely to rise from the current ratio of 17% to 30% in 2009 or in dollars from $1.5 to $4.3 trillion.  At some point we run the risk that foreign investors and central banks will want higher interest rates to compensate them for the risk of dollar devaluation.
Up to now in its conduct of monetary policy  the Federal Reserve has been free to focus almost exclusively on price stability conditions in our domestic economy.  If we fail to make savings more attractive by reducing the tax disincentive to saving then Federal Reserve monetary policy considerations may increasingly be at risk as to the willingness of foreign investors and central banks to hold dollars in either Treasury or corporate securities.  Think of the ramifications of a downturn in bond prices and a downturn in equity prices generated by a declining dollar or vice versa.  Our economy is not immune from changes in foreign assessment if we continue a tax system that damages our incentive to save.  It is time to begin.  Let�s not risk waiting until we have a crisis.