National Tax Journal, Vol. 42, no. 4,
(December, 1989), pp. 405-11
AN ESTABLISHMNT
OR AN OLIGAI[TCHY?
LESTER C. THUROW*
N common parlance we often hear that
I Japan has an establishment while Latin
America has an oligarchy. In many ways
both terms refer to the sqm group. Both
are groups of well-connected
well-educated rich people who go to the same
schools, marry each other, and run their
countries. But there is a key difference.
The central goal of an establishment is
to insure that the system works so that
the country will in the long run be successful. An establishment
is self-confident that if the system works and if their
country does well, they will personally do
well. Being self-confident they don't have
to make their own immediate self-interest paramount when they influence public decisions.
In contrast an oligarchy is a group of
insecure individuals who amass fimds in
secret Swiss bank accounts. Because they
think that they must always look out for
their own immediate self-interest, they
arewt interested in taking time and effort
to improve their country's long-run prospects. They aren't confident that if the
country is successful, they will be successful.
America's history is not as consistent as
that of either Japan or Latin America. At
some points in time we have clearly had
an establishment. The founding fathers,
George Washington, Ben Franklin, were
clearly an establishment. We also had an
establishment after World War II. Rebuilding Japan and Germany, the Marshall Plan, and similar activities did not
happen because of spontaneous democratic combustion. These programs had to
be sold to a democratic electorate by the
establishment as in the long run good for
the world and as a result therefore good
for Americans.
Americans
were persuaded to support these programs even
though they in the short run cost Amer*Massachusetts Institute of Technology, Cambridge, MA 02139. This is the text of a Luncheon Address at the Eighty-second Annual Conference of NTATIA in Atlanta, GA, October 1989.
405
icans some resources that Americans
might otherwise have spent on themselves.
At other times in American history we
have dearly had an oligarchy. The 1920s
was clearly such a period. I suspect that
looking back from the future, historians
will also say that America had an oligarchy in the 1980s. Take-overs, junk bonds,
business magazines whose biggest selling
issues are lists of the wealthiest Americans, the lifedyles of the rich and famous,
trade and budget deficits that remain uncured-those
are all manifestations of an
oligarchy.
But what will America have in the
1990s-an
establishment or an oligarchy'? There are many areas that might be
examined to answer this question, but let
me look at the tax changes that are now
being proposed for the 1990s as a clue.
If an oligarchy is redesigning a tax system, it will rig the system so that it pays
the least possible taxes. These changes in
the tax laws will be defended as good for
the country, but the prime goal will be tax
cuts for themselves.
In contrast, an establishment will lower
its own taxes last even if there is a good
economic case that lower taxes for it would
help the country. An establishment does
so because that is how it persuades a
democratic electorate that it is an establishment and not an oligarchy. R lowers
its taxes last to be credible when it is
talking about the sacrifices that others
must make.
An oligarchy feeds first at the public
treasury whenever tax cuts or expenditure increases are to be had. An establishment feeds last. When a public diet is
required, an oligarchy is the last to pay
more taxes or get fewer public services.
An establishment puts itself on a diet before it puts others on a diet. Put simply,
it is the job of the establishment to insure
that the tax system is a system, rational,
efficient, and fair-not
simply a random
collection of different taxes -irrational,
National Tax Journal, Vol. 42, no. 4,
(December, 1989), pp. 405-11
406
NATIONAL
TAX JOURNAL
inefficient, and unfair.
Because we are talking about directly
taking money away from people or putting money in people's pockets, taxation
is a place where we can most clearly see
whether we have an establishment or an
oligarchy.
Democratic tax making faces a central
problem. It is rational for each individual
acting separately to be for fewer taxes
for himself. Yet if each individual gets
what is in his itnmeiiate self-interest the
social compact, democracy itself, breaks
apart. The establishment has to persuade
a democratic electorate to ignore its immediate individual self-interest to focus
on its collective healthy long-run survival.
Systems of Taxation
There are essentially two broad approaches to taxation. Let me label them
the American approach and the growth
approach.
The American approach as I remember
learning it from Otto Eckstein and teaching it with Richard Musgrave revolves
around Haig-Simons neutrality. From this
perspective a good tax system ought to be
designed so that the economic decisions
made with taxation are as close as possible to the decisions that would have been
made in a world without taxation. The
impact of taxation on market decisions
should be minimized. Market decisions are
presumed to be efficient and taxation
should not alter those efricient decisions.
A strong interest in equity is implicit
in this approach. Those with equal incomes before taxation should have equal
incomes after taxation. The rank order of
incomes after taxes are paid should be the
same as the rank order of incomes before
taxes are paid.
While it cannot be demonstrated empirically vertical equity becomes an important goal since it is widely believed that
the marginal utility of income falls as incomes rise. Equal sacrifice requires higher
taxes for those with more income. Since
there is no technical method for deciding
how fast marginal utility falls as incomes
rise burdens are to be distributed across
[Vol. XLII
income classes in accordance with decisions made in our democratic process.
In the American approach social and
economic objectives are best met on the
expenditure side of the budget. There is
a better democratic check on subsidies or
the direct provisions of services Um there
is on special tax provisions. Definite sums
have to be appropriated in the open each
and every year. Everyone knows where
the subsidies are going and who is getting
them. Expenditure programs can be investigated to see whether they are producing the results wanted by the public.
Tax expenditures are by their very nature much more secretive and much harder
to police.
In most of the rest of the world the approach to taxation is very different. In
countries such as Japan, Germany, Korea, or Taiwan, taxes are seen as a prime
vehicle for promoting economic growth.
The goal is not to preserve market decisions but to persuade the market to make
decisions very different from those they
would make in a world with no taxes.
Taxes are set to raise savings and investment, to improve the balance of trade, or
to promote specific industries.
Japan has its tax free savings accounts.
In their Provident Fund, Singapore forces
individuals to contribute to their tax free
savings accounts. Europe uses value added
taxes since they can be rebated on exports
and collected on imports. Taiwan taxes
micro-electronics at a rate much lower
than that on the rest of its industry.
This very different approach to taxation evolved for good historical reasons.
Japan saw that rapid economic development was vital if it were not to be made
into another Asian colony in the late 19th
century. Rapid domestic economic development was central to political independence. Germany had to play catch up first
with the United Kingdom and then with
the United States if it was not to be
squashed in central Europe.
These countries could not rely on the
market to bring about rapid economic development because the market had either
failed or from some historical reason it had
not come into eidstence. If the country was
to catch up and remain independent, gov-
National Tax Journal, Vol. 42, no. 4,
(December, 1989), pp. 405-11
No. 41
AN ESTABLISHMENT
eniment had to help local industries catch
up with foreign industries. Japan and
Germany had to grow at rates faster than
the free market rates of the United States
and Great Britain if they were ever to
catch up.
From the perspective of the traditional
Haig-Simons neutrality, higher growth is
not a legitimate goal of the tax system.
No one should be coerced by the tax system into saving more, investing more, or
exporting more than they would in a world
without taxes and government. The market and not the tax system should make
decisions as to which industries should
grow or shrink. There is no legitimate interest in forcing faster growth.
Implicit Counter
Assumptions
Factual
The American approach to taxation assumes that one can ignore the tax systems that exist in the rest of the world
when designing one's own tax system. Implicitly the model assumes that Americans do not live in a competitive worldthat Americans do not have to jockey for
economic position.
Consistent with this view the United
States has always, for example, ignored
the value added tax despite the fact that
it is the only tax that is rebatable under
the rules of international trade. By doing
so it substantially raises the price of its
exports relative to its imports. Since
American taxes are included in the costs
that must be covered by our exporters, exports are more expensive than they would
have been if the same revenue had been
raised with value added taxes. Conversely by levying value added taxes
rather than other alternative taxes, foreigners insure that their exports (our imports) are cheaper than they otherwise
would be.
In the 1960s and 1970s, tax economists
argued that the exchange rate would automatically adjust to offset the presence
or absence of value added taxes and that
therefore it was a waste of time to attempt to manipulate one's balance of payments with value added taxes. The 1980s,
however, empirically demonstrated that
OR AN OLIGARCHY?
407
exchange rates do not adjust in the necessary manner.
America now desperately needs to increase its exports and reduce its imports
to improve its current account deficit, yet
we are still prisoners of our approach to
taxation. We do not use the tax system to
help us cure our economic problems.
Similarly America does not know what
to do if a country, such as Taiwan, has a
tax system that taxes a particular industry (consumer electronics) at rates below
that available for other industries. This
same lack of response can be seen on the
expenditure side of the budget. Europe
gives multi-billion dollar subsidies to Airbus Industries without an American response.
In a world of roughly equal competitors
where anything can be made anywhere
and sold everywhere, our lack of response
is essentially a decision to not have the
industries targeted by the rest of the world
in either their tax or expenditure systems. Everything else being equal, those
industries will go to the locations where
their taxes are minimized. If all industries were created equal in their ability to
generate high wages, this would not matter, but they are not created equal. The
rest of the world targets our highest wage
industries -consumer electronics, autos,
machine tools, aircraft.
Essentially we refuse to recognize that
modern comparative advantage is manmade and not a product of natural resources or immutable factor endowments.
Man-made comparative advantage can be
created with other policies-R&D,
human resource-but the tax system!s impact on the aggregate level of savings and
investment and the tax syste&s direction
of resources toward favored industries
cannot be ignored.
In fact America often levies taxes that
favor specific industries. The current capital gains tax cut proposal will, for -example, give greater than average benefits
to timber, cattle, and real estate. But we
do so based upon special pleading and political influence, not upon some overall
growth strategy. In the tax system as in
the tariff system, we tend to protect the
lagging edges of our economy rather than
National Tax Journal, Vol. 42, no. 4,
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408
NATIONAL
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the leading edges of our economy.
America's lack of concern about tax
systems in the rest of the world was understandable in the post-World War Il period when we had effortless economic superiority. But it becomes less and less
sensible as major countries in the rest of
the world become technologically competitive with us and as our productivity
growth and balance of payments deteriorate. What we could in the past afford to
do (ignore tax systems in the rest of the
world), we can no longer afford to do.
But even if the rest of the world did not
exist, the slowdown in the American rate
of growth of productivity would call for
some response. In the American approach
a savings-investment deficiency cannot
exist. Whatever individuals, corporations,
and governments save or dissave in the
course of their normal decisionmaking is
the correct amount to save. Savings should
be determined by the market and not by
the tax system.
When the American approach was developed, no one believed that the federal
government could or would run persistent
large structural deficits. Neither did anyone believe that private Americans would
save as little as they now do. We now face
the reality that Americans in the aggregate are not saving the sums that will allow them to invest the amounts in housing and plant and equipment that are
necessary to ensure a world-class future
standard of living. A gross investment rate
of 15 percent in the U.S. is not satisfactory if the gross investment rate is 29
percent in Japan, as it is.
One can argue, as the rational expectationists do, that Americans are just
consciously deciding to have a lower standard of living relative to the rest of the
world in the future. Americans know that
by running a public deficit now, they are
enjoying more public services than taxes
in the short run but that in the long run,
they equally well know that they will have
to pay more taxes than they get government services because of the rising burden of interest payments on government
debt. Americans know that by running a
current account deficit now, they enjoy a
[Vol. XLII
higher private consumption standard of
living in the short run but that they will
enjoy a lower consumption standard of
living in the long run because they will
be forced to pay interest and dividends on
the assets foreigners are now acquiring
that allow us to finance our present current account deficit.
But we all know that these are the arguments of sophists. We all know that the
Americans of the future (ourselves or our
children) will not like living in a world
where we have a standard of living that
is less than that of the world's leading
countries. We all know that we will not
like living in a country where tax collections have to grossly exceed the public
services received. We all know that investment can be partially maintained by
borrowing from the rest of the world (23
percent of 1987 and 1988s investment was
so financed) but we equally well know that
Americans won't like living in a world
where foreigners have become the capitalists and they are the workers in the
American economy.
The United States now has a saving-investment problem.
The American approach to tax and expenditure decisions implicitly assumes that
goverrunent debt will be nationally held.
As a result interest payments on the national debt do not lower the average standard of living. Taxes have to be collected
from Americans to pay interest, but these
taxes are in turn paid to Americans, leaving average disposable income unaffected. There is an incentive burden
through having to use higher and higher
marginal tax rates to collect the funds
necessary to make interest payments, but
there is no income burden on average.
But now ever larger portions of government debt have to be held by foreigners
if we run a deficit. More government debt
means lower future American average
standards of living.
Despite a system designed to minimize
the impact of taxation upon private
choices, our current tax system is in fact
severely distorting market choices on two
dimensions. First, today's decisions are
making public goods more expensive in
National Tax Journal, Vol. 42, no. 4,
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No. 4]
AN ESTABLISHMENT
the future relative to private goods. A
higher and higher proportion of national
income will have to be taken in taxes to
finance a given level of public spending
as interest payments rise. Second, today's
choices to have more private consumption
than could be provided from private domestic production via a trade deficit means
that tomorrovis private consumption must
be less than private domestic production
due to the need to pay interest and dividends on the net assets that foreigners
have acquired in the United States. As a
consequence in the future, more work effort will be required to buy a given level
of consumption than would have been required if we had not run today's trade deficits.
Consistency, stability, and certainty are
central virtues in a good tax system. If
market decisions are not to be distorted,
everyone must know what the tax system
is and what it will be so that they can
make good long run decisions without
large information or uncertainty costs. But
such a condition can only hold if the current tax system is both known and changing along some known incremental path.
Yet what we now have is a tax system
that we know cannot last. At some point
massive amounts of revenue will have to
be raised or massive expenditures will
have to be cut and the longer we wait to
do anything, the greater the ultimate
changes will need to be.
Everyone knows that because of today's
actions, tomorrow's tax system will have
to be radically different. But no one knows
how it will be different. Given this reality
the tax system cannot be consistent, stable and certain. We are not in equilibrium and as a result, no one can make long
run decisions with the certainty that these
decisions will not be rendered foolish by
tomorrow's radically different tax system.
But who will assert these long run
truths? It is the establishment's job. Silence is one piece of evidence that we have
an oligarchy and not an establishment.
What we are now doing is economically
foolish, but an oligarch would say that to
say it was foolish would, to yourself, be
politically foolish.
OR AN OLIGARCHY?
409
Observations of an Oligarch
The oligarchy would run the current tax
and expenditure system until the rest of
the world yanks our chain and refuses
ftu-ther lending. Why should they pay
higher taxes? An oligarchy would support
putting more than half of the costs of the
savings and loan bailout bill off-budget,
not realistically estimating the costs of
cleaning up our nuclear weapons plants,
and not paying our bills for the last two
weeks of the year. The bookkeeping is
fraudulent, but since we all know what
we are doing, it is a public fraud that we
conmit upon ourselves.
An oligarchy would propose a capital
gains tax cut. Most of the benefits will be
concentrated at the top of the distribution
of income, but since the middle class will
get a few dollars in benefits, they can be
counted on to support such a reduction.
For a year or two, tax collections will go
up as people cash in their accumulated
capital gains, but in the long run tax collections will go down. Simple algebra reveals that growth cannot accelerate
enough to compensate for lower tax rates
in the future. But an oligarchy would focus attention on the short-run gains.
An oligarchy understands that the capital tax cut is the axe that knocks down
the tax reduction door for every other special interest group. We already know who
is next in line-those that favor the reestablishment of individual retirement
accounts.
The oligarch knows that there is an argument for lower taxes on risk-taking new
ventures that produce new products, but
he equally well knows that real estate,
timber and cattle cannot really qualify
under this rubric.
The oligarch surely understands that in
a low savings society, a tax stimulus to
investment must be accompanied by a tax
stimulus to save if the investment stimulus is not simply to result in higher interest rates. There is a reason why real
American interest rates were 5.8 percent
in 1988 while real Japanese interest rates
were 2.9 percent. Yet an oligarch's capital
gains tax cut will come without a pro-
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posal for raising savings.
Consider the repeal of social security tax
financing of long-term health care benefits. The oligarch knows that the elderly
on average have a higher per capita income than the non-elderly. The oligarch
knows that a small group of wealthy elderly citizens stampeded the system. The
oligarch knows that if the agreement between the American Association of Retired Persons and those that voted for the
tax increase is not allowed to stand, no
congressmen is going to vote for any tax
increase no matter who negotiates it. But
the oligarch supports that repeal anyway.
If We Had An Establishment, What
Would They Be Sayine.
Whatever the merits of a cut in capital
gains taxation, an establishment would
point out that the elimination of the capital gains tax was part of a deal to lower
the maximum tax rate. If one wants a
government that works in the future, one
lives up to the political promises made in
the past. Without long run trust, political
deals cannot be struck and without deals
the system does not work. An establishment would be saying that if a mistake
had been made and the capital gains tax
had to be reinstated, then maximum tax
rates should be increased to make up the
lost revenue.
An establishment would be against a
cut in the capital gains tax on principle
even if it could be shown to stimulate investment. They would know that it would
be seen to go to them (the top ten percent
of the income distribution) and that if they
were to get a big tax cut before everyone
else, they would lose their credibility with
the rest of the population on other issues.
By voting a tax cut for themselves and not
the rest of the population, they would become an oligarchy-be
seen as self-interested rather than disinterested.
An establishment would point out that
plant and equipment investment has fallen
from 11.6 percent of the GNP in the 1977
to 1980 period, to 11.3 percent in the 1981
to 1984 period and to 10.0 percent in the
1985 to 1988 period and that the fall would
[Vol. XLII
have been much worse if foreigners had
not been willing to finance 23 percent of
the total. A 15 percent fixed investment
rate (a rate that includes housing) in the
United States and a 29 percent fixed investment rate in Japan would not be acceptable to an establishment.
An establishment would be pointing out
that investment incentives without saving incentives simply lead to higher interest rates.
An establishment would be pointing out
that cattle, timber and real estate are not
part of real risk taking.
An establishment would be pointing out
that the indexing of capital gains is no
different than the indexing of any other
income stream. Indexing makes the system fairer in the short run at the longrun price of making inflation harder to
stop.
An establishment would point out that
America is not overtaxed-ranking
14
among major industrial nations if one
looks at OECD data on tax collections as
a fraction of GNP.
An establishment would be pointing out
that it is stupid for a country as rich as
the United States to be the world's largest
debtor nation-owing
more than $700
billion.
An establishment would be guaranteeing that if the citizens of the United States
were willing to raise taxes to cut the budget deficit, congress would be self-disciplined enough not to spend the extra tax
revenue on new expenditure programs that
were not intended by those voting taxes
upon themselves.
An establishment would be pointing out
that the real issue is not public versus
private spending but investment (public
and private) versus consumption (public
and private).
Most importantly an establishment
would be rethinking America's optimal tax
system given America's current needs.
What the rest of the world is doing needs
to be taken into account. A tax system
must be designed to stimulate growth if
America's children are to have a standard
of living as good relative to the rest of the
world as that enjoyed by their American
parents.
National Tax Journal, Vol. 42, no. 4,
(December, 1989), pp. 405-11
No. 41
AN ESTABLISHMENT
Such a tax system is easily designed
from either a conservative or liberal perspective. As I have outlined in detail elsewhere, my own personal optimal tax system would include value added taxes to
encourage exports and discourage consumption. An offsetting income tax credit
would make the value added tax progressive. Unlimited IRAs would turn the progressive income tax into a progressive
consumption tax. The optimal tax system
would eliminate the payroll tax to encourage investment in human resources
and eliminate the corporate income tax to
stimulate physical investment. Rates
would be set to raise enough extra revenue to run a surplus in the federal budget
so that government was contributing to
savings rather than subtracting from savings.
But in reality the system suggested
above would reflect only my own personal
preferences. The system we choose, however, would have to be a consensus system
that could be supported by both liberals
and conservatives in the establishment so
that as the political tides came and went,
the tax system could continue to provide
OR AN OLIGARCHY?
411
the long-run stable incentives for growth
that are needed.
A Return To Reality
But none of that is likely. America has
an oligarchy, not an establishment. All of
the evidence of the past few years points
in that direction.
In the future we will not raise taxes, we
will lower taxes. We will not cut government spending, we will raise government
spending. The real deficit will get bigger
even as accounting tricks are used to make
the 'technical Gramm-Rudman' deficit
smaller.
1989 was the window of opportunity. A
new president, a year without an election-if we can't make progress in such a
year, we won't make progress in an election year (1990) or in the run-up to the
next presidential election (1991 and 1992).
The window of opportunity has now
slammed shut.
In American taxation every group and
individual looks only at minimi7.lng their
own personal taxes. Let someone else
worry about our collective future.
National Tax Journal, Vol. 42, no. 4,
(December, 1989), pp. 405-11
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