Shared Economic Growth Website

Shared Economic Growth
A Proposal to Restore Our Middle Class While Boosting Economic Efficiency
SharedEconomicGrowth.org
The U.S. Economy is Broken
Productivity Gains Are Not Flowing to the Bottom 60% of Americans
And Productivity Gains Are Heavily Skewed Even Near the Top
Land of Opportunity?
Bhashkar Mazumder, a Federal Reserve Bank of Chicago economist, recently combined a Labor Department survey with Social Security records for thousands of men born between 1963 and 1968 to see what they were earning when they reached their late 20s or 30s. Only 14% of the men born to fathers on the bottom 10% of the wage ladder made it to the top 30%. Only 17% of the men born to fathers on the top 10% fell to the bottom 30%. A substantial body of research finds that at least 45% of parents' advantage in income is passed along to their children, and perhaps as much as 60%. Since mobility is limited and the distribution of income and wealth are becoming increasingly skewed, the foundations of our democracy are being undermined. We need to restore and defend a strong middle class
But America Has Always Bounced Back Before

The current situation is demonstrably different America rose based on natural resource wealth and then a well educated, technically proficient, creative population Our resource wealth, other than agriculture, is diminished, and we have squandered our inherited advantage. Our human and technological advantage is fading Our economy is now weak and vulnerable
SharedEconomicGrowth.org 6
We Are a Debtor Nation
And We Buy Our Goods on Credit
We Have Become a Net Importer of High Tech Goods
And These Are Large Numbers

The estimated federal deficit as of June is $9.4 trillion The U.S. current account deficit was $738B for 2007, of which $709B was for goods & services The April 2008 goods and services deficit was $61B, or a $732B annual rate, despite the weak dollar. To cure this deficit through dollar weakness, Americans would have to suffer severely
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We Have Lost Our Advantage on Advanced Degrees
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More on Advanced Degrees
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And We Are Losing Our Advantage In Scientific Output
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Our Population of Engineers is Fading
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Partly Because Our Public Education Lags
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Then Surely We Must Invest

Both Presidential candidates have noted that we must invest in education, but that is expensive and has a long time lag, and other countries are investing, too. 34% of our working PhDs are foreign born what if they stopped staying? Meanwhile, we have a looming retirement crisis
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The Social Security Problem is Well Known

The Social Security Trust Fund has all been spent to finance the deficit. Future liabilities must be 100% paid by future workers as the baby boomers retire. That is fiscally impossible with current trends. But there is a savings gap even with Social Security, and if Social Security funding is not adequate, what will the middle class do?
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Savings Are Inadequate to Cover the Gap
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America Has Never Been in Such a State

The difficulty of our position is truly novel Our novel position requires a novel response one that will rebalance trade and investment, boost the market power of American employees, and improve retirement savings while not increasing the government deficit and while improving the progressivity of our tax system. Shared Economic Growth fits the bill
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What is Wrong With Our Economy?

Globalization was supposed to raise all economies based on their supposed natural advantages. Low tech, low wage, low margin jobs were to flow to the developing world, while high tech, high margin, high productivity jobs would grow in the developed world But U.S. policies did not adapt. We kept the suicidal tax structures that were tolerable in the 50s and 60s, without noticing that they would take away the advantages of globalization by selectively discouraging the activities we should keep
After Tax Benefit of U.S. vs. Dominican Republic Investment

U.S. Pretax income = $100 Corporate tax = $35 After tax income = $65 D.R. Pretax income = $ 100 Corporate tax = $ 0 After tax income = $100
Which would you choose? The foreign investment is worth 54% more due to U.S. tax
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High Value Product Example

Assume a high value, fairly automated product with 60% manufacturing margin and 15% labor cost (i.e. labor=37.5% of COGS) The 35% U.S. tax would be 60% x 35% = 21% of sales, or 140% of the labor cost Therefore, it would pay a U.S. company to locate these operations in a no or low tax environment even if the foreign wages were more than twice as high as U.S. wages This effect is much more significant than low foreign wages in determining the location of high margin operations
The Effects of This Policy Are Clear in the Numbers

In our economy, money starts at the top with corporate boards and officers and service firm partners and only flows down if employees have the leverage to demand it Productivity increases effectively grow the labor supply, and thus reduce employee power unless employment demand grows for other reasons Global competition for low wage jobs undercuts the bottom end, hence the strong stagnation there
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And the Trend is Moving Up the Scale

The most educated Americans held their own at first due to lack of qualified foreign labor, and so harvested a piece of the productivity gains But as we have seen the supply of high end foreign labor is growing, and high end competition is thus growing. This causes income to concentrate closer and closer to the top, with the power of a college degree no longer being enough to demand a healthy piece of the action. Scientific and technical median salaries peaked out at around $57,000 in 2001 and went flat to down. Engineering and computer science peaked first, as you would expect for a globalization driven effect
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The Addiction to Foreign Investment

Say you have $100 of deferred D.R. earnings Bringing the cash to U.S. to invest triggers $35 tax, so only have $65 left to invest Investing the cash abroad maintains deferral, so full $100 is invested Would you prefer to spend $100 on R&D abroad, or only $65 in the U.S.? Add in the lower foreign rates on the investment income, and the U.S. is highly unattractive. This increases geometrically the more you reinvest abroad, the more you need to reinvest abroad
Treasury is Not Helping

Recent regulation projects have attempted to boost U.S. tax revenue by imposing high mark-ups on U.S. based services and U.S. origin technology Companies have already been moving services and R&D abroad. Such regulations will just accelerate those trends The U.S. cannot continue to act like it is unique. Operations rarely pick and move overnight in a wholesale manner, but new operations locate abroad, and old ones bleed away over time
The Rangel Bill Would Not Help

Chairman Rangels proposed reforms would largely eliminate deductions for U.S. based headquarters services. Those jobs would quickly migrate abroad (see next slide) His bill would combine all foreign earnings into one low tax pool, imposing a high penalty for bringing home any dollar of cash, increasing the incentive to invest abroad or buy out U.S. assets, making our companies attractive targets
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Rangel Bill Example

Foreign E&P Tax credits US services cost Bring home cash to cover services Tax on cash after credits/GU Value of deduction allowed Net cash after tax $1,000.00 $111.11 $50.00 $62.77 -$13.95 $1.18 $50.00
Given a choice between burning $62.77 of foreign earnings to pay the services cost or moving the services to an equivalent cost foreign location, you fire the Americans and move the stewardship abroad. These numbers hold for any substantial accumulated deferral, and are significant even at a relatively high foreign tax rate
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Eliminating Deferral Would Not Help

The U.S. is not the only country with money in fact given what we owe we have a solvency problem. Lots of foreign corporations and governments are sitting on large piles of strong currency, looking for something to spend it on (e.g. Anheuser Busch) Eliminating deferral would crash stock values of multinationals Foreign operations tend to be high basis and easy to strip. U.S. headquarters jobs and other operations would be shut down, and all the U.S. services jobs that feed off of our multinationals would suffer proportionately Our remaining portfolio would be mainly non-exporters using imported inputs, making the balance of trade worse Experience with eliminating deferral on insurance and shipping shows that this threat is not speculative
What Would Fix the Problem?

Eliminate the U.S. corporate tax burden But, just bringing corporate rates down to zero is not feasible the revenue loss would be huge, cash lock-in would skyrocket, and individuals would shelter cash in corporate shells despite existing anti-shell corporation provisions Bringing rates down to 25-30% would not be enough to greatly affect behavior when 0-10% is available. We need to eliminate the corporate tax burden in a particular way
The Dividends Paid Deduction

The dividends paid deduction avoids cash lock-in, because the benefit is only available to the extent earnings are paid out It avoids individuals sheltering income in corporations, because the full 35% corporate tax persists until earnings are paid out It is largely self funding, once the low individual rates on dividends are eliminated, due to individual tax on incremental dividend pay outs The automatic offset, individual tax on dividends, is more progressive than the corporate tax eliminated, improving the overall progressivity of the system.
What Would This Do for Middle Class Market Power?

Again assume a high value, fairly automated product with 60% manufacturing margin and 15% labor cost (i.e. labor=37.5% of COGS) A 25% foreign tax would be 60% x 25% = 15% of sales, or 100% of the labor cost Wage costs could thus rise 100% under the new equilibrium if the income was brought to the U.S., assuming no other cost savings. n.b. Qualitative effects of repatriating cash and circulating cash more efficiently would multiply this effect significantly
Effect on Wages
The tax incentive would permit a significant increase in U.S. wages for high tech, high productivity, high margin operations the kind we like to have in this country Need proof? Look at wage growth in Ireland, Singapore and Switzerland in past 25 years while our incomes have been stagnant. Ireland was equivalent to Spain until it cut corporate rates, but it is now a high wage powerhouse hence the rejection of the EU treaty amendment by a 53% majority. Swiss senior secretaries can earn over $100,000. Singapore has leapt from a third world nation to glittering well distributed affluence. The effect might be less spectacular in our large economy, but the trend would be the same
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Corporate Tax Rates, Innovation and GDP per Capita by Country

60.00% 40.00% 20.00% 0.00%
i tz er la nd De nm ar k Sw ed en Ne th er lan ds Gr ee ce
Ire lan d
Be lgi um
Ca na da
Sp ain
-20.00% -40.00% -60.00% -80.00%
Sw
Variance from Average Corporate Tax Rate Variance from Average WEF Innovation Score Variance from Average GDP per Capita
Tax is not the whole story, but high tax plus limited innovation equals failure, and we are slipping on innovation partly due to tax SharedEconomicGrowth.org 36
Ge rm
Fr a
Ja pa n
nc e
US A
Ita ly
an y
Other Benefits
Besides increasing the demand for, and thus the income of, U.S. employees, a dividends paid deduction would enhance the overall efficiency of our economy, reduce debt levels (debt and equity would become tax equivalent), and increase retirement savings It would do so in a way that decreases corporate and executive power, by pressuring corporations to pay out earnings as dividends And it would boost overall tax compliance, eliminating concerns about tax shelters and transfer pricing
The Excuse to Hold Cash

Because bringing cash home to pay dividends triggers U.S. tax, there is a strong reason to reinvest cash abroad, even inefficiently. A 4% after tax foreign return on $100 is equal to a 6% return on $65, i.e. on the earnings that would remain after repatriation. Add in tax on the earnings at a 35% U.S. rate versus 0% foreign, and a 4% foreign return = 9.5% U.S. return This encourages inefficient investment and starves U.S. innovative investment opportunities Similarly, even the low current individual rates on individual income gives management an excuse to resist paying dividends and make inefficient investments Further, currently when management does pay out cash, it is largely in a non-transparently selfish manner see Exxon example
The Effect of Stock Buy-Backs Exxon 2007

After tax income $40,610,000,000 Dividends paid $ 7,261,000,000 Remaining earnings $33,349,000,000 Shares at beginning of year 5,729,000,000 Income per share after dividend = appreciation $5.82 Exercisable options/officer RSUs total 113,762,000 Options/RSUs held by named officers 5,699,835 Income per diluted share after dividend $5.71 Appreciation diverted to options/RSUs $ 649,327,304 Appreciation diverted to named officers $ 32,533,206
SEG would give this back to the shareholders, and only give executives credit for real growth
Profitability vs. Growth

Our current tax structure has created a dysfunctional fixation on growth. Having a stable, profitable, well run business is frowned upon. Companies are pressured to invest for growth, even where that means acquiring other companies. Studies show that most acquisitions destroy combined value A dividend oriented tax structure would shift focus to real return on shareholder dollars. This is likely to be more rational, and lead to more economic diversity
The Hidden Tax on Retirement Savings

IRAs, 401(k)s, and similar plans are supposed to allow tax free saving for retirement. Persons with income under $100,000 own 57% of IRA assets, while those with income over $500,000 own only 6%. 71% of pension and annuity distributions go to persons with incomes under $100,000, and only 1.68% to those with incomes over $500,000 By imposing corporate tax rather than the SEG option of individual level tax, the earnings on equity investments are reduced by 35%, i.e. they would be up to 54% higher (1 versus 0.65) under SEG. This is a hidden tax on retirement savings and other low bracket savings Removing this tax would reduce need for Social Security using just existing savings vehicles If Congress chooses, then it can tax these earnings openly at some chosen rate and reduce or eliminate the offsetting 7.5% tax on income > $500K. This might be a reasonable choice for defined benefit pension funds
The Retirement Savings Effect is Significant

Unfortunately, commentators on the corporate tax tend to miss this point. They focus on the Federal Reserve data statistic that some 50% of corporate stock that is directly held is held by very high income individuals, neglecting to trace through ownership through mutual funds and retirement savings vehicles Middle class individuals have substantial IRA and 401(k) funds invested in equities. The stock held through such vehicles and pension funds is roughly equal to that held directly by very high income individuals. Boosting these earnings would not replace Social Security, but it would reduce the pain if Social Security needs to be cut for the top 40%. 43% of households surveyed in 2004 would not be able to maintain their standard of living if they retired at 65
Solving Corporate Compliance

The government expends substantial resources on enforcing the corporate tax rules, dueling against the creativity of many expensive lawyers. Further, these efforts often overreach, imposing heavy compliance burdens on even non-aggressive taxpayers, punishing all for the sins of a few SEG solves that problem, shifting the taxable income to easily taxed Form 1099 individual dividend income. Corporations are excellent withholding and reporting agents
The Offsets
SEG requires certain affordable offsets, which can be chosen from a menu of possibilities Our math overlooks a likely double count, since capital gains would be decreased by increased dividend pay outs, but it also overlooks the certain impact of increased foreign repatriation which should be larger As proposed in the article, we would produce large excess offsets from a combination of foreign withholding tax, changing the foreign tax credit to a deduction, eliminating capital gain and dividend preferences, and eliminating basis step-up at death beyond a floor designed to exempt the normal family situation
The Math Based on SOI and Fed. Reserve

For 2005, CT after credits was $278B Distributions large enough to offset that tax would be $248.7B greater than actual 2005 dividends paid if FTCs made deduction Individual tax on incremental dividends = $84.4B Incremental 7.5% AGI tax on individual income >$500K = $71.7B Foreign withholding = $56B Cap.gain benefit offset = $57.8B (but assumes gains unaffected) Step-up offset = $38B, less the exemption Excess offset ~ 38B, assuming no incremental repatriation
Why These Offsets?

These are largely things that are ONLY feasible under SEG. Absent SEG, it would not be permissible under international law to change the foreign tax credit to a deduction, as that would create double tax. It would not be permissible to boost foreign dividend withholding taxes. Eliminating capital gains preferences would trigger significant equity lock-in These offsets provide a no escape framework, shutting down avenues to try to game the benefit as well as existing tax games The 7.5% tax on AGI >$500,000 makes the proposal highly resilient to changes in assumed baseline corporate tax revenues. At that tax rate, tax on incremental dividends to top income individuals offsets tax revenue leakage on lower brackets and retirement savings.
Is Eliminating Cap Gains Preferences Bad?

Since corporate cash would be recirculated in the economy, equity lock-in would become irrelevant No strong evidence that lock-in on real estate or other capital assets is particularly harmful (homes are covered by other provisions). Thats why no preferences are granted to corporations now, despite their status as major investors Eliminating preferences shuts down distortions and games
Do We Need Step-Up?
Estate administration issue goes away with a reasonable threshold for normal stuff perhaps up to $2,000,000 allocated first to tangible physical property, if that ends up being the Estate Tax threshold Eliminating step-up has the opposite effect of an estate tax regarding family farms
Estate tax liability can force a sale Step-up encourages a sale because sale would be tax free for full NPV, while holding property to earn income would be taxable
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Is Incremental Tax Unreasonable?

Taxing high income individuals is largely offset by increasing the value of their equity interests - ~50% of taxable stock holdings. The remainder makes the code more progressive for the middle class Top federal bracket would only rise to 47.1%, and average total effective rate on that class only increases up to 37.6% including state and foreign income taxes. Therefore, if this top rate is viewed as being too high, Congress could bring it down by broadening the base and bringing down the rate on the individual side Economist models are all very nice, but the full history of U.S. taxation indicates that this level of tax on that income segment would not hurt the economy. Also note that this particular tax would be quite difficult to evade
Average Real Income and Top Marginal Income Tax Rates in the U.S. (1913-2005) 60,000 50,000 40,000 Income 30,000 20,000 10,000 0 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%
Comparison with slide 2 shows that the recent year growth is skewed by the top 1%
19 1 19 3 1 19 7 2 19 1 2 19 5 2 19 9 3 19 3 3 19 7 4 19 1 4 19 5 4 19 9 5 19 3 5 19 7 6 19 1 6 19 5 6 19 9 7 19 3 7 19 7 8 19 1 8 19 5 8 19 9 9 19 3 9 20 7 0 20 1 05
Average Income (2005 Dollars)
Top Marginal Individual Income Tax Rates
Tax Rate
High Incomes for the Top 1% Do Not Translate Into Income Growth for Everyone Else
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The Excess Offset

The excess revenue offset is designed to allow for tweaks to reduce the offsets We would recommend reducing the withholding tax to 10% for payments by U.S. subsidiaries to foreign parent corporations entitled to treaty benefits. This would encourage U.S. investment. Foreign territorial regimes often require a minimum tax as a condition of exempting the income in other words, the foreign companies may be happy to have a 10% tax
Other Possibilities
Of course the revenue could come from many places. For example, the deduction for state income taxes is extremely regressive. High income people pay state tax at higher rates on higher income levels. The federal government then gives them a disproportionately high benefit on each dollar of deduction. 37% of the benefit of the deduction goes to persons with incomes over $500,000, while 21% goes to persons with incomes under $100,000. Eliminating this deduction could reduce the 7.5% AGI tax offset down to 1.1% based on 2005 numbers
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Could This Be Phased In?

Yes, but not entirely cleanly Step-up would be repealed immediately Dividends paid deduction would phase in the cap at 25% of base year dividends plus 25% of incremental dividends, to avoid lock-in that would result from phasing rate rather than phasing cap Foreign withholding and AGI tax would phase in and capital gain benefit would phase out Conversion from foreign tax credit to foreign tax deduction would occur in final year
Revenue Pulse
The repeal or phase out of capital gain benefits would trigger a great deal of equity churning to beat the tax increases, resulting in a pulse of tax revenue that would help with the deficit While this profit taking would provide downward price pressure, the prospect of eliminating corporate tax would result in offsetting upward price pressure. The middle class would have a chance to buy in
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Conclusion
This is a feasible, simple, fiscally responsible, progressive market based solution for a market distortion problem It addresses Democratic concerns in a powerful way that would boost rather than damage the economy
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For More Information

Matt Lykken, Director, SharedEconomicGrowth.org Matt@sharedeconomicgrowth.org 630-588-9329 http://www.sharedeconomicgrowth.org
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Shared Economic Growth

A Proposal to Restore Our Middle Class While Boosting Economic Efficiency

The U.S. Economy is Broken

Productivity Gains Are Not Flowing to the Bottom 60% of Americans

But America Has Always Bounced Back Before

We Are a Debtor Nation

And We Buy Our Goods on Credit

We Have Become a Net Importer of High Tech Goods

And These Are Large Numbers

We Have Lost Our Advantage on Advanced Degrees

More on Advanced Degrees

And We Are Losing Our Advantage In Scientific Output

Our Population of Engineers is Fading

Partly Because Our Public Education Lags

Then Surely We Must Invest

The Social Security Problem is Well Known

Savings Are Inadequate to Cover the Gap

America Has Never Been in Such a State

What is Wrong With Our Economy?

After Tax Benefit of U.S. vs. Dominican Republic Investment

High Value Product Example

The Effects of This Policy Are Clear in the Numbers

And the Trend is Moving Up the Scale

The Addiction to Foreign Investment

Treasury is Not Helping

The Rangel Bill Would Not Help

Rangel Bill Example

Eliminating Deferral Would Not Help

What Would Fix the Problem?

The Dividends Paid Deduction

What Would This Do for Middle Class Market Power?

Corporate Tax Rates, Innovation and GDP per Capita by Country

-20.00% -40.00% -60.00% -80.00%

The Excuse to Hold Cash

The Effect of Stock Buy-Backs Exxon 2007

Profitability vs. Growth

The Hidden Tax on Retirement Savings

The Retirement Savings Effect is Significant

Solving Corporate Compliance

The Math Based on SOI and Fed. Reserve

Why These Offsets?

Is Eliminating Cap Gains Preferences Bad?

Is Incremental Tax Unreasonable?

Average Income (2005 Dollars)

Top Marginal Individual Income Tax Rates

The Excess Offset

Could This Be Phased In?

For More Information

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