"The Postal Savings System
in Japan actually has on deposit in real funds
nearly $10 trillion which
is then managed by the private sector
under the watchful eye of government."
July 18, 1996
Martin A. Armstrong
before US Congressional
House Way & Means Committee
Chairman Princeton Economic Institute
214 Carnegie Center Princeton, NJ 08540
Mr. Chairman, members of the committee. I would like to thank you
for inviting me here today to offer what
information PEI has gathered from our experience in dealing with
the multinational corporate and institutional
sector in the global economy. As a brief background, PEI
maintains offices in the US, Tokyo, Hong Kong,
Sydney and London. We currently provide corporate and
institutional advice under contract on global assets
exceeding US$2.5 trillion, an amount equal to about half of the
US national debt.
In our capacity as an advisor serving the international community
in real life decision making rather than theory,
PEI may be uniquely qualified in providing insight as to how and
why both investment and business capital flows
are affected by a nation's domestic policy objectives.
It has been our experience, that there are five key factors that
provide the core stimulus behind capital flows
1) Foreign Exchange
3) Labor Costs
4) Inflation & Interest Rates
5) Security (geopolitical & financial)
Let me begin with foreign exchange as an illustration 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 currencies has become as high as 40%
over a two year period. Exchange losses have
impacted every sector of business in every nation to the point
that the very way multinationals operate today is
dramatically shifting from that of only 10 years ago.
Multinationals have been forced to change pricing policy as
well as the location of manufacture in an effort to reduce
extreme financial risks for their shareholders.
Transactions such as Rockefeller Center, MCA etc resulted in
significant losses to the Japanese investors, more
so by the 40% depreciation of the dollar than the actual decline
in value of the underlying assets. Japan Airlines
was forced to lay-off 25% of its work force last year due to the
fact that their cost base was Japanese yen while
their revenue was largely foreign currency denominated. In
Germany, Mercedes has been forced to restructure
their pricing policy as of July 1st, 1996 due to foreign
exchange. Instead of pricing the product in DMarks around
the world, which has cost them market share, products will now be
priced in local currency thereby transferring
the currency risk back to Germany.
These are but a few examples of how the more recent extreme
fluctuations in the exchange value of currencies has
impacted business and investment decisions on a global scale.
While it may be politically preferable to manipulate
currency values in an attempt to impact trade flows, in reality,
trade accounts for less than 10% of the total world
capital flow movement. Our warni ngs 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 attempts to influence trade through currency
manipulation led to the 1987 Stock Market Panic. PEI'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 itself.
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, stocks, bonds and real estate
investment. What is important to note is that ever since
1987, the fluctuations in net capital movement have become more
than 10 times as volatile when compared to the
The second most important factor influencing net capital flow
movement is none other than taxation. However,
taxation is more than a pure income tax. Taxation contributions
imposed on business based upon social objectives
involving labor are of greater importance than the mere
superficial level of corporate income tax rates alone.
It is wrong to assume that manufacturing jobs flow to merely the
lowest possible labor cost. If this were true, then
all manufacture should be conducted in Mexico, South East Asia or
better still -Africa. In our capacity as a
corporate advisor helping to make such strategic decisions as to
where companies should or should not locate,
there are 5 primary considerations that go into the final
decision process on this level.
1) Rule of Law
2) Labor Skill availability
3) Taxation Contributions Required on Labor
4) Corporate Tax Rate
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 of the world depend
upon government guarantees from 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, what is largely overlooked are the
social taxation and regulations associated with a work force. We
found Asian companies who wished to open
manufacturing plants within the EC made their decision based upon
the level of skills available and then secondly
chose the lower total cost of labor. For example, the UK
attracted more than 40% of all foreign investment into
Europe due to the fact that it had a skilled labor force but its
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 provide. On that score, the labor costs in the
UK were 40% less than Germany.
When a company did NOT require a major work force but instead
merely needed a legal entity within the EC,
then the primary deciding factor became the corporate tax rate.
While the UK corporate tax rate was 19% less
than Germany, they were still more than twice that of nations
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 is illustrated by the impressive Irish economic growth
rates of 9% compared to European economic
growth 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 actively competing for Northern corporations and jobs.
If we look at those states where regulation is
the least intrusive and taxation is the most favorable, you will
find the highest number of corporate relocations and
new foreign business ventures within the United States.
Domestic Taxation policy must take into consideration our new
global economy. We must be sensitive to being
competitive not merely on labor costs, but also on the total
taxation and regulation costs if we hope to avoid the
dismal European example with its chronic unemployment in excess
of 10% year after year. We must also keep in
mind that taxation itself is largely influenced by philosophical
decisions made by governments without considering
the true total economic impact. For this reason, taxation has
been a major factor in altering world capital flows as
well as economic growth levels. When the US corporate tax rate
hit nearly 70% during 1968-1969, virtually
every American company began shifting manufacture offshore.
Today, over 65% of the US trade deficit is made
up of US companies importing their own goods manufactured
somewhere else. In fact, if we allocate world trade
according to the flag a company flies instead of the last port of
assembly, you will find that the US has a net trade
surplus in excess of $150 billion.
Much of the economic turmoil in Japan today is being caused by
excessively high tax rates. In fact, three of the
first section listed companies on the Tokyo Stock Exchange have
renounced their Japanese heritage and moved to
Hong Kong due to a 15% tax rate compared to nearly 70% in Japan.
Our economy contracted from the 1960s
for 12 years. Japan appears to be facing the very same long-term
trend. After 6 years, the Japanese economy
remains in the throws of a near depression and taxes have still
not been reduced. Despite the fact that interest
rates have fallen in Japan to 0.25%, there remains no interest in
borrowing for domestic economic expansion.
The method of taxation through domestic social objectives is also
a key factor in shifting global capital flows. For
example, the US is one of the very few nations that seeks to tax
their citizens and corporations on worldwide
income. Most British Commonwealth nations tax worldwide income if
earned in a tax free zone. Therefore, if the
US were to totally eliminate the corporate income tax, we would
run 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 avoid
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 if such earnings 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 to an offshore account for
In addition, our prejudice against capital gains versus
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 because of the mere rate, but due
to the fact that losses have been treated
differently from short-term income while disallowing the impact
of inflation indexing. Consequently, while virtually
every electronic product from VCRs, CDs and assorted appliances
were designed and patented in the US, their
final development and manufacture have been more fairly treated
by nations such as Japan. This uncompetetive
social philosophy inherent within American tax code has been one
of the major causes of forcing US companies
offshore into joint ventures than even the net level of income
While many will argue that corporations pay little in income tax,
what is grossly ignored is the taxation of labor that
is a huge direct cost to business. If 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
We must also take into consideration the net cost of taxation
upon the nation as a whole. While it is true that the
national debt doubled under Ronald Reagan moving from $1 to $2
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 trillion despite raising taxes.
We must honestly review the economic facts of the past 16 years
in order to understand our future. Since Ronald
Reagan, we have actual ly had a balanced budget from the
perspective of revenue vs spending. At 8%
compounded, you double your money in a bank in about 8 years. The
interest expenditures during the Reagan
period were equal to nearly $1 trillion. Today, we actually
collect about $100 billion more in revenue than
Congress actually spends on programs. This is being absorbed by
our interest expenditures. In fact, since 1950,
the total interest expenditures paid now equal 68% of the total
outstanding national debt. We are indeed becoming
a Banana Republic.
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
stimulating our domestic economy. If fact, an
analysis of capital flows reveals that the Japanese earned more
from the US on their investment income in the past
16 years than they did on trade.
By taxing interest income, we penalize Americans and overpay
foreign investors exporting more capital than
would otherwise take place. If we eliminate the income tax on
government bonds, we could reduce the interest
rate to the actual net return after taxation. This alone could
result in an 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 Hoover wrote in his Memoirs that "capital acted like a
loose cannon on the deck in the middle of a
torrent." In 1985, the largest futures mutual fund was $100
million. Today, $1 billion funds are a dime a dozen.
Everyone is investing somewhere else to avoid local taxation. It
is now estimated that over $2 trillion sits offshore,
untaxed and unregulated emanating from all nations. If we
eliminate the personal income tax, then America itself
will become the international magnet for this vast pool of
capital. Our interest rates would decline as it always
does whenever excess capital emerges. This single step alone,
combined with creating a tax free government bond
structure, could spark untold economic growth and help to
actually begin reducing our national debt rather than
waiting for everything to go bust beyond the year 2000.
1) End the discrimination against long-term investment by at
least allowing capital gains to be indexed to inflation
2) Promote honest reform of the Social Security System whereas
contributions made should be privately managed
as is the case in many other nations. The Postal Savings System
in Japan actually has on deposit in real funds
nearly $10 trillion which is then managed by the private
under the watchful eye of government. This will
help reduce the cost of labor in the US, create jobs through
increased savings, and result in lower payroll tax
contributions for business over the long-term while safeguarding
the long-term viability of these critical social
3) Eliminate the taxation on government bonds.
4) Eliminate the personal income tax and replace it with a
national sales tax of 10% as originally intended by the
founding fathers with just cause.
5) Reduce the corporate tax rate to 15% matching Hong Kong
thereby transforming the US to the international
magnet for capital. Allow interest paid to be deducted as a part
of the cost of doing business.
Mr. McCrery. I just want to ask a few questions before going to
my colleagues. There seems to be, and maybe
I misunderstood, but there seems to be some disagreement among
the panelists on the efficacy of going from an
income tax system to a consumption tax in terms of encouraging
foreign business to relocate in the United States.
Mr. Armstrong, I thought you said that if we did away with the
income tax, went to a consumption tax, you would
find that those businesses would simply have to pay their
domestic income tax and, in many cases, that would
discourage them from coming to the United States, while the other
two panelists seem to imply that going from an
income tax system to a consumption-based system would encourage
Did I miss something there or is that a correct interpretation?
Mr. Armstrong. From my perspective, we see two types; one, if you
are talking about a company that is setting
up a plant. Because of the international tax code, for example,
many British Commonwealth nations do not tax
foreign income, however, there is a kicker to it. If it is income
earned in a tax-free zone, then it is subject back.
They do that for offshore investors, etc.
Our concern is that if you had a complete zero income tax rate
here and even though the company would be
subject to a consumption tax in some way or another along the
line, that could be interpreted from a foreign
perspective as being a tax-free zone, and I would like to point
out that last April, Germany was very interested in
how it is dealing with its budget crisis.
Germany surrounded all of the offices of Merrill Lynch and
several other banks. They attacked the company as if
it was a drug raid. They cut off all the phones of Merrill Lynch,
all the hand-held cellular phones that the brokers
had. They went in, raided all the files, looking for German
citizens putting capital offshore.
The net result of those raids effectively sent the Deutsche Mark
down, the Swiss Franc up, and the London
Financial Times even reported that it was incredible the amount
of capital that was suddenly leaving Germany for
That has not resulted in if you are in the financial industry,
you are better off working out of London. You cannot
do business in Germany.
If I were to go to Germany and answer a question on taxes to be
more competitive and if my answer can be
interpreted as helping someone avoid taxes, that is a 5 year jail
term for me personally now in Germany.
So you have to be very careful about the international tax code.
My lawyers go crazy every time I even have to go
to Munich. So I think there is a different side to that.
Now, a consumption tax with zero income tax, from an investment
perspective -- we are talking about interest
income, etc., investments in stock markets -- absolutely
positive, you would have capital flowing in here. This
would be like the Cayman Islands of the global economy.
Mr. Houghton. I guess the issues that I worry about are fairly
simple. They have to do with cash. The United
States generates about, I would say on the previous figures -- I
guess it was 1995 -- $800 billion in terms of
income taxes and about $600 billion in terms of other taxes, FICA
taxes, things like that.
So, all of a sudden, you really sort of throw that out and you
move towards a different tax system. You have got
to generate at least $1.4 trillion, and it will probably be up
now to $1.5 trillion or $1.6 trillion. How do you do
that? I mean, that is a real tricky question because somebody
sitting here or elsewhere has to make that decision.
We can talk about this thing intellectually, and we can talk
about it in terms of competitive reasons, but the
question is how do you make that switch. How can you make sure
that we don't end up with a $500 billion deficit
because we have miscalculated this thing? Maybe you would like to
make a comment on that, anyone.
Mr. Armstrong. We looked at some of those numbers to perhaps
answer that question, and we were looking at
taking the BEA numbers.
We found that if you instituted a 10% sales tax with also a 2%
sales tax on real estate transactions, that in
combination with only a 15% flat or fairer- type corporate tax
was actually scored revenue neutral, and it is quite
surprising when if you really start putting in some of the other
aspects which would be more dynamic
For example, the Internal Revenue Service itself claims that
close to 17% of the economy is underground. You
are never going to capture any form of an income tax from that
side, from the illegal aliens or things of that nature.
They will contribute to their local sales taxes, but they will
never file an income tax return.
So if you look at the income tax versus a consumption tax from
the total GDP perspective, the revenue would
actually increase because income tax will never capture that 17%
portion of the economy that the IRS says is
underground. The other problem is -- there is a very interesting
article on the front page of the New York Times
today where 600 are suspected in plots to evade taxes on income.
These are 600 government employees.
The income tax is, quite honestly, easier to avoid than the sales
tax. It is much easier to do so. If you really look at
the numbers objectively, I think that you are looking at least at
a potential of actually collecting more revenue.
Then, if you look at the income tax and its effect on interest
rates, I mean, we can supply you with a study of
interest rates for this country back for 200 years. Every time
the government raised income taxes, interest rates
rose basically in direct proportion. Capital invests on a net
basis. It doesn't want to hear, well fine, I will pay you
20%, but by the way, I want 95% of that back. Capital looks at
whatever it is going to have on the table at the
end of the day.
So, consequently, the points in my opening statement about
Japanese earning more money from us on investments
versus trade is very important to understand because, in effect,
we are paying more in interest expenditures on our
national debt than maybe is really necessary. We are paying a
higher rate to compensate Americans that are
paying a very high tax rate, but foreigners are buying our bonds
paying zero in income taxes.
Mr. Houghton. But you are not suggesting that the foreigners pay
a tax on interest.
Mr. Armstrong. No, no. They won't pay it. What I am suggesting is
that you perhaps even the playing field and
make at least interest paid on government bonds tax-free.
Mr. Houghton. Sure.
Mr. Armstrong. If you could reduce the interest rate itself on
the national debt by a third, you have created a
surplus, eliminating the deficit. You can create about a $150
Mr. Gibbons. Mr. Armstrong, you have more experience in exchange
rates than I do, and let me pump your
mind for a while.
What really controls the exchange rates? In the long, long run,
probably international trade has something to do
with it, but in the short run, is it more financial
considerations than it is trade considerations?
Mr. Armstrong. Yes. Quite frankly, trade is minimal.
Mr. Gibbons. That is my impression.
Mr. Armstrong. If you look at the U.S.-Japanese trade deficit, it
has not changed dramatically in 2 years. Yet,
the Japanese Yen went up 40% and down 40%.
If you look at, for example, Nippon Life, the largest insurance
company in Japan, they have a portfolio of about
$1.2 trillion. If they decided to move 10% of their portfolio to
the U.S. stock market, that is more than 2 years
worth of trade numbers.
The trade is more of a psychological impact, but in my opinion,
the currency markets have been reduced to the
fact of almost an international polling.
Mr. Gibbons. An international what?
Mr. Armstrong. An international poll where the markets and
capital is voting on the confidence of countries on a
So, consequently, you will find with the elections with Yeltsin,
the dollar restrengthened because of concerns that,
well, maybe if Yeltsin lost, then you are going to have problems
So you have capital movements that are taking place for a variety
of reasons: geopolitical security, financial
security, rules of law. Trade is also part of it, and the other
part of it is taxes and how they impact investment, and
that is the point I was trying to make about the national debt.
You really have foreigners paying no tax and penalizing
Americans. Then, you look at our American corporations,
we tax them on worldwide income. Nobody else does. It seems like
when you look at the broad scope of
everything, Americans are the number-one prejudiced people in the
entire world. Nobody else is as punitive on
their citizens as the United States, and it seems ironic that we
are supposed to be the leader of the free world, but
when it comes to tax code, we seem to be absolutely backwards.
Mr. Gibbons. I apologize for taking this extra time.
I am amazed that America has done so well when I look at our
system and the penalties that we put on our
people for jobs and for taxes and for everything else, and that
really concerns me. We have got a very expensive
system to administer.
I don't know how expensive, but it is horribly expensive,
probably the most expensive system in the world to
administer, and I worry about America's future when I see us
dragging along as economic baggage, useless
baggage, our horribly expensive tax system, and then not doing
perhaps as much as we should as far as education
is concerned because I think the future of our country depends
upon how well we educate our minds and how
efficiently we operate our economy.
I am very pessimistic that we seem to be headed in the wrong
Mr. Armstrong. I agree. I am always impressed by some of my
European friends whose little children may be
five or six and they are speaking four different languages.
Mr. Gibbons. Yes.
Mr. Armstrong. It is quite impressive to see, quite honestly, but
I totally agree with you.
Mr. McCrery. Mr. Armstrong, do you happen to know the current
percentage of public debt that is held by
foreigners? You said in your testimony that we have had up to 40%
Mr. Armstrong. I would have to check the 1995 numbers. The
highest number I have seen that fluctuate to is
Mr. McCrery. Was that recently?
Mr. Armstrong. Yes, within the last several years. It has been
coming down largely because of concerns about
the dollar. It has caused a lot of foreigners to sell government
bonds, particularly in the United States, also
Canada. One of the largest institutions in Japan lost so much
money on the foreign exchange on our bond markets
here that they actually announced that they are no longer going
to buy government bonds from anybody in the
Mr. McCrery. But it is still a significant portion. Is that your
Mr. Armstrong. I would only be taking a guess. I think it might
be down to maybe the 25-30% area at this
Mr. Portman. I wish I had more time, Mr. Armstrong, but maybe
someone else can go into this further. This
fascinates me, this notion of tax-free bonds because it would put
us in a level playing field with foreign investors
and government bonds.
You mentioned the figure of $250 billion. Where do you come up
with that? Our interest on the debt is, what,
about $200 billion a year?
Mr. Armstrong. We now, I believe are collecting close to $100
billion more than we are spending on actual
programs, which is being absorbed by interest.
Mr. Portman. Okay. so what would be the net effect of your
proposal in terms of government revenues' impact
on the budget?
Mr. Armstrong. It would really depend on how much of the national
debt you could shift over.
I can tell you in the financial community, there is something
else that has happened here, and that is that in 1993,
the Treasury began trying to take advantage of the steep yield
curve in this country, and they started shifting the
national debt short term. I will be glad to provide the
Commission with a chart on that. We are now 70%.
Mr. Portman. This was in 1992 or 1993?
Mr. Armstrong. In 1993.
Mr. Portman. Okay.
Mr. Armstrong. Yes. We are now funded 70% 5 years or less.
One-third of the entire national debt is funded 1
year or less. All right. This is why short- term interest rates
have doubled in the last 2 years, and we now have a
yield curve that is practically flat.
Initially, the Treasury was doing that, trying to save on
interest expenditures to bring the deficit down.