Raise Savings, Not Taxes : We Should Learn From Japanese Methods of Discouraging Spending

I thought that I had already heard all the reasons for raising taxes. But since arriving here several weeks ago I’ve been hearing that higher taxes are needed to strengthen the dollar. And the argument, like Dunkin Donuts and McDonald’s, is imported from America. It is being manufactured inside Washington by Congress and outside Washington by a chorus of economists in financial centers worldwide.

There is no reason to suppose that higher taxes will strengthen the dollar. Even if there were, it is by no means clear that the exchange rate is an appropriate target for fiscal policy, especially in view of the fact that federal taxes are currently absorbing an abnormally high share of the gross national product.

At the risk of seeming to be impolite to my hosts at the Bank of Japan who like the idea of higher taxes in America, I offer some contrary arguments. First, even with no spending cuts or tax increases, at $136 billion next year’s budget deficit will be down to 2.5% of the gross national product. That is well below the 1988 Group of Seven (United States, Japan, West Germany, Britain, France, Italy and Canada) average of 3.3% and even below the Organization for Economic Cooperation and Development’s estimate of Japan’s figure of 2.8% for 1988.

Next I point out what any close observer of Congress could predict. An increase in taxes would not cut the budget deficit because of Congress’ “pent-up demand” for new programs for everything from the environment to affordable housing for yuppies. Congress is tired of making cuts. It wantsto spend more, and will do so if more tax revenue is available When I point out that the dollar will weaken further if the American budget deficit is cut, no one believes me. But, as any good international economist can tell you, standard theory--not to mention recent experience--demonstrates that deficit reduction will, all else being equal, cause the dollar to weaken.

Is there any doubt that the link between a lower American budget deficit and a weaker dollar has already been established over the past few years? The American deficit-reduction process began in earnest in October, 1985. The Gramm-Rudman deficit-reduction measure was passed then, just weeks afer the September, 1985, Plaza Agreement that has, after the fact, erroneously been identified as the major force behind a weaker dollar. As the budget deficit was declining from 4.9% of the gross national product in 1985 to 3.4% in 1987, the dollar was steadily weakening. The dollar’s fall accelerated during 1987 as the budget deficit fell by one-third. It would have fallen further had not foreign central banks propped it up--thereby keeping up American demand and prolonging the large trade deficit.

After last year’s stock-market crash wiped out a trillion dollars in paper wealth, the “sky’s the limit” types were scared into actually saving more. A $60-billion surge in savings during 1988 combined with a steady budget deficit will cut this year’s trade deficit by about $40 billion. That’s a drop of nearly 25%.

The crash of the stock market did have one positive result. It showed us that the right way to reduce spending and bring the trade deficit down is to stimulate saving. A higher rate of savings encourages more investment, capital formation and growth and helps to relieve “overheating” pressure on the economy by increasing the supply of goods and services.

Higher savings, like higher taxes, mean less demand. But, unlike higher taxes, they are likely to stabilize the dollar, since they also lead to an increased supply of goods. The prospect of more output and less demand relieves inflationary pressure, cuts expected dollar depreciation and thereby attracts capital inflows from abroad, even at lower interest rates.

How can the savings of Americans be increased without another collapse of the stock market? Very simply. Take a lesson from the high-saving Japanese and use the tax system to encourage saving instead of spending. Savers should be taxed on only half their interest earnings, while borrowers should be able to deduct only half their interest expenses. This change would tax only the “real” (non-inflation) portion of interest earnings while allowing borrowers to deduct only real interest expense. Savings would rise because rewards to saving would be increased while the cost of borrowing (not saving) would also be increased. Since high borrowing is the cause of heavy accumulation of debt, the much-decried debtor status of the United States would decline.

A tax policy to encourage saving could be enacted by changing only one or two lines of standard tax forms. The members of Congress who say that they want to see more saving, lower interest rates, a stronger dollar and less debt should all favor the change, even if they have to give up on raising taxes.