The introduction to

the testimony of Martin A. Armstrong before the House Ways & Means Committee

July 1996

1

July 18,1996

Testimony ot Martin A. Armstrong

Chairman Princeton Economic Institute 214 Carnegie Center

Princeton, NJ 08540

Mr. Chai~an, m~mbers of the committee. I would like to thank you for inviting me here today to offer what Information PEl has gathered from our experience in dealing \"lith the multinational corporate and institutional sector of the global economy. Asabrief background,PEI maintains offices in the US, Tokyo, Hong Kong, Sydney and London. We currenttyprovide corporate and institutional advice under contract on global assets exceeding US$2:5tri~ipn.an amount equal to about half of the US national debt.

In ourqJpacityas an advisor serving the international. cornmunityin real life decisjon making rather than~ry, PEl may beuniquety qualified in providing insight as to how aod why both investment and business capital flows are affected by a nation's domestic policy objectives.

It has been our experience. that there ate five key factors that provide the COre stimulus behind

capital <flows internationally.

• 1) Fonaign Exchange

• 2)Taxation

• 3) Labor Coati

• 4) Jnfl.tiona. Interest Rates

• 5) 5&cumy(geopoJitical &. financial)

let ~ begin with foreign exchange as an iIIustnition of how capital is being affected before discussing taxation.

Foreign Exchange fluctuations have become the number one cause .of corporate losses. The percentage movement in the exchange value of currenc~ahllsbecome;as high as 40% ov.er a two year period. Exchange lOsses have impacted every sector of business· in every nation to the point iJlat ~ .• very way multinationals operate today is drQlTlatic;allyshifting. fJom1h9t of only "10 years ago. Multinationals have been forced to .changepJicingpolic)'a&~lIasthell:>cationof manu~ct\Jre.n.anE!ffort to redu~ extremefinanclal risks.fortllei("sh$r$noJde($. Transactions such ~sRocKefeller Center.MCA etc resulted in significant '0S8e8 to the Japanese investors, more so by the 40% depreci<ltion of the dollar thanthea<;tLJaJ decli~ in value of. the underJting assets. Japan.Airlines was forced to lay-off25% of.itswork force last year due to the fact that their cost base. was Japanese yen while their revenue was largetyforeignQ,llTency denominated. In Geamany, Mercedes has been forcedtorestructuretheirpridngpolicyas of July tst, 1996 due to fore;gnexchange_lnslaadof pricing the product in DMa~ around the worki,which ~ cost th~m market share, products will now be priced in local currency thereby transferring the currency nsk

bade to Germany. .

I

These are • but a few examples of how the more recent extreme fhJCtuations in the exchange value of currencies has impacted business and investment decisions on a global scale. V\lhile it may be politically preferable to manipulate currency values in an attempt to impact trade flows, in reality, traoeaccounts for less than 10% of the total world capital flow movement. Our warnings delivered in a letter to Congress and the White House back in 1985 cautioned against :such intentional currency manipulation as enacted in the G5 September Plaza Accord. The net result of

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attempts to influence trade through currency manipulation led to the 1987 Stock Market Panic. PEl's research was requested by the Brady Commission and we would like to think that we had some impact upon its findings since two of our clients were on the Commission itselt. Mr. Brady later stated that he believed that currency fluctuations had played a role in the Panic of 1987. Offered here is a graphic illustration (figure #1) of the net capital flow movement for that period. The upper portion of the graph plots trade and the lower portion capital movement which included. stod<S,bonds and real estate investment. What is important to note is that ever sinee1987. the fluctuations in net capital movement have become more than 10 times as vol~tile when compared to the pre-1987 era.

JAPAN Net. Ctlpiteil. !Wvement in Bib USf ~ Doot& 11*10 - JIIo"r l'iIMII

~ Yl T IT\ll T

Ij\; f\

In 1\

Ifi 11"1.

e:!::1 M!l _1 ae:1 eT-.1

~ 1'111 __ A:I. ... ~

Figu,.. ...

The second most important factor infJuencinQ net. capital flow movement is none other than taxation. ti.owever.tax~tion is. more than 8 pure .income tax. Taxation <;or)tnl>ytions impOsed on business ba$ed. upons()cial objectives. involving labor are of. greater· importance than the mere sUpE!rficiallevel of corporate income tax rates alone.

It i8 wrong to assume that manufacturing jobs flow to merely the .loweSt pos$ible (abor cost If this were true,then all manufacture should be conductedin Mexico. South .EastAsia t>r.better still -.Africa. In our capacity as a corporate advisor helping to make such strategicdecisio~as to where companies should or should not tocate. there are 5 primary considerations thatgoioto the final decision process on this level.

• 1) Rule of Law

• 2) Labor Skill .vallabllity

• 3) Taxation Contributions Required on labor

• 4) Corponlt. Tax Rate

• 5) Regulation

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We have clients who have turned down what appeared to be lucrative business ventures in 3rd world nations as well as Russia or China based upon the lack of a Rule of law that is required to secure the capital at risk. Without a solid Rule of Law. business cannot operate. Such ventures that do develop in those parts 01 the world depend upon govemrnentguarantees fron'! their native country of origin in an effort to underwrite the political risk at hand.

While it is obvious. that labor costs are closely associated. with labor skills. w~ is largely overlooked are the sqcial taxation and regulations associated with a work force. We:found Asian companies who wished to open manufacturing plants within tbe EC made their decision based upon the.level of skills ~vailableand then secondly chose the lower total cost otlabor, tor example. the UK attracted more than 40% of.all foreign investment into Europe due 10 the fact. that it had a skilled labor force but ~$ cost was much less compared to that of Germany or France. This cost factor was determined not by mere wages. but included the social taxation that companies were required by law to provid",.On that score, the.labor costs in the UKwere 40% less th~n Germany.

. When a company did NOT require 8 ma~or workforce butinstead merely needed aleg~1 ~ntity within the EC. then the primary deciding factor becameth~CQrporate tax rate .. While th~ UK cOlJXlrate.taxrate -was 19% less than Germany ,they were still mqre than twice thatof h~iQO$such as Spain and Ireland. Therefore, corporate headquarters or low skilled labor requirements tended to gravitate to the lowest possible corporate rate within the EC. This i$. ilItJStrated by the impressive Irish economic growthrCltes of 9% compared to European eoonomipgrowth rates of 2.5%. We have found that there is a correlation between high unemployment and high total taxation.and regulation costs across Europe today.

Of course, regulation was a major factor as well. This we can see within our own US borders as well. Southern States are aqively competin9forNorthem corporations and jobs. If we look at tho6e stat.es where regulation is. the least intrusive and taxation is the most favorable, you will find the highest number ofcorporale relocations and new foreign business ventures within the United

States. .

Domestic Taxation policy must take into consideration olJr new global economy. Y'/e must be sensitive to being competitive not merely on labor CO$1s, but also 00 the total tilxation ~i1dr~ulation CO!!lUl ifwellop~.toavoidthe dismal European example with its chronic unemployment ifl.~cesS of 10%. yEitilr after year. We. rnustaiso keep inmindth.at1axationitself. is largely ihfluencedby philosophical dedsions made by governments without considering the true total ecor¥>mic impact. For this reason. taxation has been a major factor in altering world c;apita1fk>'itls a~ wen ~s economic growth levels. V\ihen the. US . CQtporate tax rate .hit neal'ly·. 70% duri.ng1968-1969. virtually every A~n company begaoshiftingmanufacbJre offshore. Today. over 6S%.of the UStradl)df3fjcit is madeujJ otU$cqmpanies importing their"owogCJO(jSmlifll$CtiJred ~rrM':~re~.Jn fa(:t, if we allocate wortd trade according to • the flag. a company .ftie$instead.of the.1astport~f assemQIy. you Will find tnatthe.US has a net trade surplus in excess of $150 billiqn.

Much of the economic tunnoil in Japan today is being caused byexoes$i\lety high tax rates. In fact three of the first section listed companies on the Tokyo Stock Exchange have renounced their Jap~nese heritage and moved to Hong Kong d.ue to a 15% tax rate cpmpaf"edto rlearly 70% in Japan. Our economy contracted from the 19605 for 12 years, Japan appears lobe facing the very sa~long.lenntrend, After 6 years. the Japanese economy remai,", in.the thrQWS. of a near depression and taxes have still not been reduced. Despite the fact that interest rates ha~e fallen in Japan to 0.25%, there remains nl;> interest in borrowing for domestic economic expansion.

The method of taxation through domestic social objectives is also 8. key factor in shifting global capital flows. For example, the US is one of the \/ery few nations that seeks to 1ax thei~ ~ens a~ corporations on worldwide income. Most British Commonwealth nations tax wortdwide Income if

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earned in a tax free zone. Therefore, if the US were to totally eliminate the corporate income tax, we would fun the risk of corporate earnings in the US being considered as income from a tax free zone.

Furthermore. US tax code classifies income made overseas as if any overseas income is derived solely to avoid domestic taxation. The 50% and/or control rule for US companies as the sole criteria for taxation penalizes US enterprises forcing many into joint ventures simply to,*,oid double taxation in the US. We also discriminate against American companies trying to enter foreign markets by passing the tax burden directly to personal income even ifsucheamings are not distributed. Our tax code assumes that any offshore entity is merely trying to avoid taxes without testing whether or not an actual business is being developed as compared 10 an offsliore account

for investment purposes. .

In additiqn, our prejudice against capital gtlinsversus short-term income within our tax code provides a incentive to manufacture and develop domestic products offshore. The US is one of the few nations whose tax system punishes long-term investment while rewarding short-term speculation. Again. the capital gains taxation has exported more American jobs not becausaof the mere rate. but due to the fact that Josseshavebeen treated differenttyfromshort-term il'!come while disallowing the impact of inflation indexing. Cons.equentty, while virtually everyelectrtmic product from VCRs, CDs and assorted appliances were designed and patented in the US. their final development and manufacture have been morefairfy treated by nations such as Japan. This uncompetetivesocial philosophy inherent within. American tax code has been one pf the major causes offor(;ing US companies offshore into joint vemures than even the net level of income tax itself.

While many will argue that corporations pay little in income tax. what is grossty igf.ored is the taxation of labor that is a huge direct cost to business. H we look at our own revenue statistics. you will find that the taxation contributions to the payroll tax paid by corporations is substantial- generally twice the level of corporate income taxes.

We must also take into cOnsideration the net cost of taxation upon the nation as a ~hole. While it istroe that the national debt doubled under Ronald.Reagan moving from $1to$~ trillion. this alone does not mean that lower taxes or Reaganomics failed. Under Bush and Clinton. the national debt has now more than doubled from $2 to $5 triJlion despite raising 'taxes.

We must honestty review the. economic facts of the past 16 years in order to understand our Mure.Sin~· Ronald Re393n.we. have actually had abalanoed budget Jrorn.thep~pective ·of revenuevs spending. At 8% compounded. you doubleyour.mQney in a bank io·abovtB Years. The interest expenditures during the Reagan period were eqlJ(l1 to nearty$1 trilliQn.T()da~VJeactually coiled about $100 billion more in revenuethanCongrassactuallyspendsonprograms.11lis ;s being absorbed bV our interest expenditures. In fact. since 1950. the total interest~xpenditures paid now equal68%of the total outstanding national debt. We are indeed becoming a . Banana

Republic. J

At timeS. up to 40% of our national debt has been held by offshore investors who pay no income tax in the US. This means that domestic spending from Congress is no longer stinlUlating our domestic economy. H fact. an analysis of capital flows. reveals that the Japanese e~ more from

the US on their inves1ment income in the past 16 years than they did on trade. ,

By taxing interest income, we penalize Americans and overpay foreign investors exporting more capital1han would otherwise take place. If weeliminatetJ1e inco~tax ?" 9QV..-nmentbond~. we could reduce the interest rate to the actual net return after taxation. ThIS alone could result In an

.4

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instantaneous balanced budget since we currently collect more in revenue than we spend on

programs with the excess being consumed by interest. .

Capital is rushing around the globe today much in the same manner as it did going into the Great Depression. Herbert Hooverwrote in his Mernofrs that "capital acted like a loose cannon on Ute dec/{ in the middle of a torrent"'n 1985, the largest futures mutual fund was $100 million. Today. $1 billion funds are a dime a dozen. Everyone is investing somewhere else to avoidl6ca1 taxation. It IS now estimated that over $2 trillion sits offshore;' untaxed and unregulated eman~ng from all nations. If we eliminate the personal income tax. then America itself will become the iintemational magnet fOr this vast pool of capital. OUf interest rates would decline as it always does whenever excess capital emerges. This single step alone,COt1lbined with creating a tIDe free government bond structure. could spark untold economic growth and help loactually begin reducing our national debt rather than waiting for everything to go bustbeyo~the year 2000.

SUMMARY

There have been two schools of thought on debt and taxation since govemm~ntwas first ronceive<t. In modern times, these two schools oHhOU9ht have never stood in more contrast than

by the words of two very famous men. . I

• "The principle of.pending money to la paid by p6starlty, under the name of funding. i8 but ewfndlJng futurity on a large .cal •• "

THOMAS JEFFERSON. 1789

• "Th.8 only part ofth • .so-.call~ national Yiealththat aetu .. 11y enters into Unt collectives PO$!I$SS!ons of modem people.. Is their National DabL"

KARL MARX, 1873

If the purpose of this Committee is to fairly reflect upon how our tax code can be used to attract jobs and stimulate economic growth rather than employ gimmicks such as currency manipulation, special one-offtax deals or the continued denial of the damage caused by Marxism in the postwar era, then it is clear from our experience that there can be onty one conclusive path. .

• 1) End.th~ diacrimination ~~inot It>ng-~rm Inv .. ~ntby at leastallowjngCaplt$' gains

to be indexed to Inflatlel" r.troactJv.ey. .

• 2) Promo~honNt ,.form. of the.So<;ial ~l.Irity Sy •• mwtUt.raas contrib.,tjone made should be prlva~Jy managed as is the caseinmanyothe, nations .• TheP~1 Saving. System In Japana~1Iy rnas.on. deposit in,..' f\lndane.arty$.10 trillio.n which.~thon manag8dby tbe.,nvatesl!c::tor.underth. watchful.yeof .st0vernment. ~IaWlII help ,..duce the cost oUaborin theUS, CrN~ Jabe throughincrealSed ... vin9s.~nd result in lower payroll tax conbibutions for bt,Ulin~ OV.'t:he1oo9·IermWhi"$af61~uarding the long-tennvlabiliiy of th&secritical socia, programs..

• 3) EJiminau. the taxation on government bonds.

• 4) Eliminate the personal income tax and ~pJ.c.itwith a nation.' sales tax of 10% ae

originally in.nded by ttl. founding fatherawtth just cause. !

• 5) ROduce the corporate tax rate to 1 S·" mat.chingHong Kong thereby tnanafonnlng the US to the International magnet for capital. Allow interest paid to be deducted as a part of the coat of doing busine$!$,

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Mr. Chairman, members of the Committee:

This is a brief overview of our experience in dealing around the world on a first-hand observation basis. VIle strongly believe that the replacement of the current income tax system on individuals \yit~anational sales tax in combination with a corporate tax rate of 15% will prove not merely to ~revenua neutral, but also a major economic stimulus that will help our domestic econorrw grow whileJorcing majoreconomic change around the world restoring the beacon of hope and liberty by

our example. .

"It.is the highest impertinence of kings and ministe .. stopretend to. watch over tbeeconomyiof privatepeople and to re strain fhetr expense, either by $u.ItlPtu~ry laws, or by probibitingtheimpottation offoreign luxuries. They aretbemselvesailvvays, ano.witboutexception, the greatestspelldthtifts in the. society. Letthem lookwellaftertbeir own expe.nse, and they may safely.trusrprfvafepeople Withtbeirs. If their own extravagance d~es not fllinttiestate, that of their subjects never will."

Adam$mith

Wealth of Nations .1776

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Federal Corporate Income Tax Brackets and Rates 1909-1994

No1U

YMr Btiow btd t Rml $ R.ste3 S IUi.4 $ .Rat.t5 S JUtefi S R.a..,7 S : Rah8 $

:N:I-l.3 51 1%-

1913-15 0 1% (No 9XefTlCtion aner 03101/13)

1911 0 2%

1117 0 ~k

FnI B<ad<.., ~ Se<lOnd 8rado:.c ~", ~ Imd<el: 1M tVnI. If any. by ......... 80% of .... amount of ~ .... """"* in ..._ of"..

...... ~·-IIaCBdlt _ .... emOunt of lhe _ compulfld oodw· "" trst and _,.,oo ~ooIL ~

191W1a 2t 10%8

1922-24 2t 12.5%

1925 2t 13%

1926-27 2t 13..5%

1130-31 3t 12%

·O.ElcetnpOOns after 1931· I

1t32-35b 13.75% I

1')6-371; e% 2t 15% overM>1

Gradustl'd Su{taX 00 undistributed profits ranging from 7-27%b I

'1~12.~18% 251 i9%c over :z5l

194Gb '''.15-' •. 7%251 31.3% 31 964 3&.9" 3If.565~,,1IL. "656

1Nib 21-25% 251 44% 3It96431%~,!l$4

11M2-<J5b 25%51 27% 20t 29% 251 53% SOt tG% ove.-SOt

f1~ 21% 51 23% 2m 15% 25t 53%501: 38% over sot

f1950d . 23'J(, 251 IU% 0V8f 251

f951d 21.15% 25t 54>.75% over 251

1M2-53c1 30% 251 ~2'W. over25l:

~ . 22% 25t 50% ave." 25t

,96547 22% 251 .~ over25t

1~ 24.2% 25t 5:Z.8%0ver25t

1e7Oe 2i.S5% 25t U.2%over25

1811."" 22% 251 4I%o~ 2.5

1975-71 20%251 22%5Ot .48%~501

,,79411 17%251 20% ~30% 7St .. ..a% l00t~~100t

1M2 1$% 25t 111%501 .. 30% 7St.4O% 100t 4C%O\'ef lOOt

1H34& 15%251 18% ~. ---30% 75tAO% tOOt .~ o".n09t.

1M7...nt 1$~5Ot 25% 75t3-4% 'lOOt 39%Q.33St 3.<&'K.(Net33St' .

1m 15" 501 25%75t ,." iOOt 39"M 3351 34% 10m 35% 15m ··.3a'%h18113m~ov.18m

H4 15% 501:25% 75t,.% 100t ·38%h33Sf3-4%1Otn 35%15m38"!'h.161J3m,3.5%6v«18m

~,_,.... .

L 1n·,918....s la20. lw_praIIb ax _ ~8I1d'" pdIb _~.dlw prc*s 3.DOO pIua n d~

apIIIII (~to""_'2O%d""~_ 3.0(0). (SM ~Add181e *- .... an .. ~ .. -pdt' -a"Id a1IIdIL)

b_ From 1933111 11nS. S% d ... proIIII'_'21iY.d ~ deCiMId ....... of ~ lIIIXi: ..... ~f'ImI'93&1D11Q$."nonged._ e-.ID l:a on .,..._10'4 d.~ ~ ....... FtMI1N1ID 1~.·'_w(,...._ 5.lnr.1II ~ In e<IdiIIon. pooMI~~C)lfh"""''''''1ntJooM IOtlllJ6..'SI3!J,1*a ~_,._, .. ~ ..... C)If~;., llM1.3&fiIO% In ,~.~ ft ..... _, 915% In 19o'S.

c.t... ~ "M.02!;'Ji. of~.........,....s U% or~ peId. I

d.~ IDof:ml or proIIIJ -*'0"'" or ..... hcome { ...... ()(3 hIghOIIt~ 194&4) ~ by cNftgM In b.piIooI.-.: (1"'6-

~ _ ~ in '11150~" ofl"MOli! _ n 1951-53). T,*,_~IIIfhM' d _ PII* in«Inw ...._·~d ___

ptaIitI ....... (S:2S.OOO) In 19111. ItIe fMlCirIuoI _,.,., PfOI* _1mIIId II) 17..25% of .... proh ~ "*""' ~ d --

ptOIIIIa cndIl of $25.000. For 1952-$3 'lId",. _ 18% '

........ ~ ""OY.'" 196hrod 19410. end 2.!S% In 1m. ;

f. .-- ahown eh<:i¥c lOt ~ ~ Oft. 0< ..... m1ll7. ~ In ... yMrlIlIlet induck 7f11l17l"'__'" ..... CIM of....", ~

1It....t+od •• bMncIH .

8- Thill ~ P'-es COOl'" ~ or ~ for mrpoi .... wIIh ~ Incxltrw ~ $100.000 lind $336,QOO. Cor1>Ot.1ioo ..

""" ..... hoome .00.... $33$.000. _, ehc:t. r-t of l'~

h.. n.. 3K'w-t 3e'l' __ ~ ~ P'- o..t lhe ._.. dh Ioww~ for ~ '""poo..,. .....

~~~on\~ .... ~.IJ$~

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