(FORTUNE Magazine) – AMERICANS don't save enough, and they don't invest enough in plant and equipment. Say that to almost any economist or politician -- liberal, conservative, progressive, supply-side, or neo-whatsit -- and you won't get much argument. Agreeing on how to change things is another matter altogether. The innovations that would most strongly stimulate investment -- a value-added tax, a flat tax, sharp federal deficit reduction -- seem out of reach politically. Three steps that are achievable should be taken immediately: reviving the investment tax credit, eliminating double taxation of dividends, and indexing capital gains. All three have drawbacks, but each will encourage some new investment while generally hewing to the Hippocratic rule of policymaking: Above all, do no harm. The presidential candidates are sort of talking about saving and investment. But they don't want to face this stark reality: The U.S. can sustain its present pace of public and private consumption only at the expense of the nation's well-being later on. Yet spending a smaller share of income and saving more isn't really as painful as it sounds. The resulting investment would eventually lift income and lead to more consumption than under present policies, thereby refurbishing the American dream of ever-rising living standards. But neither Bush's dogmatic insistence on lower capital gains taxes to pull economic growth from a hat nor Clinton's faith in a magical world of highly educated workers amid lots of shiny new public infrastructure will do the trick. The chart at right tells the lugubrious statistical story of saving and investment. Over the past decade and a half, Americans have put less and less of their income into bonds, stocks, certificates of deposit, and other forms of saving. As a result, U.S. companies have had a smaller pool of funds to draw on to buy the machines and factories that help the economy grow and thus raise living standards. Investment held up better than savings, but only because Americans mortgaged part of their future to foreign investors. Most developed countries save and invest a far greater share of their income than the U.S. does. Says Laurence Kotlikoff, a fiscal policy expert at Boston University: ''If our nation's paltry rates of saving, investment, and growth are not very rapidly raised, they will lead inexorably to second-rate economic status.'' Okay, that's settled. Now to turn things around. Taxes are clearly at the fulcrum. In the early and middle Eighties, lawmakers believed so ardently in trying out new tax policies that they passed major legislation nearly every year -- the Economic Recovery Tax Act in 1981, the Tax Equity and Fiscal Responsibility Act in 1982, the Social Security Act in 1983, the Deficit Reduction Act in 1984, and the Tax Reform Act in 1986. Sadly, the bulk of the research shows that all this sound and fury had negligible impact on savings, investment, and growth. Seems unbelievable, doesn't it? Consider the individual retirement account, which took point-blank aim at raising personal savings. Expanded in 1981, IRAs proved immensely popular, attracting $30 billion a year from 1982 to 1986. But for consumers as a whole, the savings rate as a share of disposable income fell from 8.8% in 1981 to 6.0% in 1986, the last year everybody was eligible to make fully deductible IRA contributions regardless of income or pension coverage. By the fourth quarter of 1986, the rate was down to 4.8%. The declining savings rate is not proof positive that IRAs were ineffective. But it casts great suspicion on them, because other conditions at the time -- high real interest rates and lowered marginal and capital gains tax rates -- should also have bolstered savings. Detailed studies by economists generally conclude that IRAs were a wash. Most who took advantage of them were in upper-income brackets and would have saved the $2,000 maximum anyway. Time for another whiz-bang? To transform the ugly-frog U.S. economy into a handsome prince resplendent with fresh investment, supply-siders and many businesses consider a lower capital gains tax the policy without peer. For liberals, however, it's a giveaway to the robber barons. Thus, while George Bush has plumped for the gains cut throughout his presidency, Congress has consistently rejected it. The President's current version would reduce the 28% rate to 23.8% for assets held one year, 19.6% for those held two years, and 15.4% if they are held three years or more. This phase-in undercuts criticism that stock-market speculators would benefit unduly. But it doesn't fully address the ''fairness'' issue: As of 1990, the 1% of tax returns showing incomes over $200,000 reported 60% of all capital gains. Apart from the politics of income distribution, lowering the gains tax would seem an ideal way to bake a bigger economic pie. Savers such as buyers of stocks and bonds would settle for a lower market return than at present, the theory goes, because their after-tax return would be higher. Companies' costs of raising both debt and equity would decline, making a greater number of investment projects attractive. Investors in startups would expect higher returns eventually and so be quicker to stake their funds. Higher after-tax returns should also stimulate saving, further lowering interest rates. A quick look at the Eighties, however, suggests that capital gains tax cuts don't work as advertised. Effective in 1981, the top rate dropped from 28% to 20%. As with IRAs, though, whatever benefit stemmed from capital gains alone was not enough to keep the personal savings rate from declining. Capital investment by business, hamstrung by the deep 1981-82 recession, resumed growing in 1983 and 1984, powered in part by the ill-starred office construction boom. But investment started to weaken in 1985 and fell sharply in 1986 while the lower gains tax was still in effect. After the rate went back up to 28% in 1987, investment picked up briskly through 1988. While those numbers aren't conclusive, they plant seeds of doubt. What's more, sophisticated statistical analyses generally support the evidence that cutting the capital gains rate is ineffectual. Laurence H. Meyer & Associates, a St. Louis consulting firm, found in a simulation that completely eliminating the capital gains tax would raise the capital stock 1.8% and GDP 0.6% in ten years. That is, GDP would grow a minuscule 0.06% a year faster. A simulation by Regional Financial Associates, in West Chester, Pennsylvania, shows that the positive effect on GDP growth of a 40% reduction -- close to the Bush plan -- peters out after less than two years. The investment tax credit for equipment gets better marks than the gains cut, but it's no magic wand either. The Meyer model simulates a credit of 10%, like the one in effect before 1986. That raises the capital stock 3.8% and real GDP 1% after ten years. A comparable dollop of accelerated depreciation, which also lowers the cost of capital, yields the same result. In the Regional Financial Associates model, a 10% investment credit has little short-term effect but after several years raises GDP growth by half a percentage point. That would be welcome in an economy stuck with 2% annual GDP increases, but it wouldn't change your life a lot. An examination of the 1980s doesn't bolster confidence in the effectiveness of investment tax credits. Real business purchases of equipment, excluding computers, fell for two years after the tax credit was broadened in 1981. (Personal computers started becoming a must in the early 1980s, so their explosive growth owed little to the credit.) Spending roared ahead during the economic recovery of 1983 and 1984. But it didn't get much beyond its previous peak and stopped growing by mid-1985. Paradoxically, it took off again for two years after the tax credit ended in 1986. Do Taxes Matter? is the apt title of a book of academic papers analyzing the Tax Reform Act of 1986. Joel Slemrod, the editor and a University of Michigan professor, concludes that tax changes most affect the timing of transactions. For example, when the capital gains tax increase was enacted, people rushed to declare their gains in 1986 before the higher rate took effect. Tax law also affects portfolio decisions. People transferred their borrowing to home equity loans and second mortgages as consumer-interest deductions were phased out. Despite all this tax-related froth, says Slemrod, real decisions to save and invest were little changed. Inadvertently, though, the tax lab of the Eighties did show how strong, narrowly focused incentives can cause portfolio shifts that in turn affect the economy. The 1981 tax law provided highly attractive depreciation schedules for buildings, giving birth to the tax-shelter boom that left the country littered with office buildings and shopping centers nobody wants. So the only clear-cut response to tax changes was one that misallocated capital and hurt the economy. IF SPECIALIZED tax changes don't do much to help saving, investment, and growth, what about a general across-the-board tax cut? President Bush has talked of a one-point reduction in marginal rates, and Governor Clinton proposes middle-class cuts. Both should stimulate savings because the after- tax return on investments would rise, right? Nope. When marginal rates were cut in the 1980s, saving fell. The fancy statistical research shows little if any response of personal saving to changes in real rates of return. Worse, a tax cut would expand the federal deficit, sucking up more of the nation's savings pool. Both candidates naturally talk about spending cuts to accompany tax cuts. But after four years Bush hasn't been able to control spending. Clinton has vowed to increase it, and he probably hasn't taken into account the prospect that a presumably Democratic Congress will expect some pork from the first Democratic President in over a decade. Clinton, of course, doesn't talk pork. He talks investment, though not so much private investment as public spending on education and on infrastructure like roads and bridges, plus such exotica as bullet trains and fiber-optic communications networks. But the weight of economists' opinion does not support the Clinton-camp contention that these investments will significantly boost economic growth. The revenue for Clinton's programs supposedly would come from higher taxes on foreign corporations and on high-income Americans. The foreign tax seems destined to get scaled back as the home countries of the targeted companies threaten retaliation and the companies themselves threaten to pull back from creating the jobs that Americans so desperately need. And while the rich can't make a public political row, they can quietly go to their accountants and rearrange their affairs to reduce taxes. Business owners, for example, will take more untaxed fringe benefits and less taxable salary. Others will put more into municipal bonds and tax-deferred annuities. Rob Shapiro, a key Clinton adviser and vice president of the Progressive Policy Institute in Washington, says the top marginal rate would rise only a few points, from 31% to 36%, well below the levels that prevailed for most of the postwar period. (The top marginal rate peaked at 92% in 1952 and 1953.) Still, says John Castle, former head of the investment firm of Donaldson Lufkin Jenrette, ''Every time rates rise the accountants become more imaginative. I've invested in creative stuff, some of which other investors didn't understand and probably the IRS didn't either.'' So while politicians speak of fiscal sobriety, they are really only giving a head fake to the one thing most policy thinkers across the spectrum agree on -- deficit reduction. Cutting the deficit would increase the funds available for private investment and reduce upward pressure on long-term interest rates. Economists M. A. Akhtar and Ethan S. Harris of the New York Fed calculate that growing deficits in the past 20 years caused more than half the decline in the national saving rate. If the deficit hadn't swelled in the 1980s, they figure, the capital stock available for productive investment would be about 7% larger today and output would be 3% higher. The Congressional Budget Office says ; there is little prospect that the private saving rate will rise -- witness the failure of all the incentives in the 1980s. Hence, the only way to lift national saving is to reduce public dissaving. Getting this done is another matter. What will most likely happen: Taxes eventually will be raised because the political will to slash spending will fail. Scheduled military reductions will help. But even speeding up those spending cuts won't offset what all analysts agree is the program that ate D.C. -- Medicare. Absent significant action on that front, other programs will be nickeled and dimed, but the deficit won't be tamed. So what are the best tactics on the revenue side? Just lifting marginal rates is a bad idea. Survey after survey shows Americans feel they are taxed too heavily. Given their strong sense that government wastes their hard-earned dollars, they will use higher rates as further justification for tax avoidance and evasion. Raising marginal rates is also a bad idea because, in contrast to the savings-investment response, research has established that Americans do work a little more when their taxes are lower. While the unemployment rate is now high, the economy will need the extra effort later as the meager numbers of the baby-bust generation slow the growth of the labor force. Taking political attractiveness into account along with economic consequences, one policy clearly deserving support is the investment tax credit for equipment. Not only does it perform tolerably well in the economic models, but also new equipment often embodies new technologies and helps improve worker skills. Indeed, recent research by Harvard professors J. Bradford DeLong and Lawrence Summers points to equipment investment as key to economic growth. And in turn, of course, economic growth raises tax revenues. Both Bush and Clinton include variants of the credit in their programs. Capital gains should be indexed to encourage business startups and help existing small companies, where the jobs of the future will be born. Indexing would eliminate unfairness to people who work for years to build a business only to reap little real profit when they sell it because of taxation on inflated assets. A taxpayer would use a government inflation gauge, like the consumer price index, to adjust the purchase price of an asset upward before calculating the capital gain. Also, corporations should be allowed to deduct dividends as an expense, just as they do interest. That would increase the cash flow available to invest in new plant and equipment, and reduce the tax code's bias against equity financing. How to prevent a wider deficit before new growth kicks in? To discourage consumption as well as raise significant revenue, the gasoline tax should be increased. Following the principle that tax laws should not favor special activities, the whole array of itemized deductions should be trimmed back. The process has already begun. The 1986 tax bill phased out deductions for consumer interest; in 1990 the value of itemized deductions decreased for filers above certain income levels. But taxes already weigh heavily on most people's lives and should not be the main route to a lower deficit. The bigger dollars must come from spending cutbacks (see the following story). Now, forget nuts-and-bolts pragmatism and consider tax policies that might really crank up saving and investment. Not too far off the political map is the value-added tax, commonly called VAT and used throughout the European Community. At every stage of production and distribution, businesses are taxed on the value they add. When the consumer pays the VAT, it amounts to a sales tax on goods and services. Hence, it would raise saving by discouraging consumption as well as by reducing the budget deficit. But unlike income taxes, it wouldn't discourage work because it doesn't hit wages. Conservatives worry that extra taxes would just fuel more government consumption. Liberals worry that lower-income people would get hurt because they spend most of their earnings. State governments fear encroachment on existing sales taxes. Thus, VAT is perennially whispering in the wings but never gets a speaking part on stage. That could change. It is again being bruited in congressional committees. Both the liberal Brookings Institution and the conservative American Council for Capital Formation view VAT as key to deficit reduction. The standard quip has become: As soon as Democrats understand that VAT is a money machine and Republicans realize it's regressive, it will pass. When the budget crunch becomes truly enormous later in the 1990s, it could get its shot at stardom. Better than a VAT would be a flat tax -- yes, that wacko idea Jerry Brown mentioned during the primaries. In the version developed by Hoover Institution fellows Robert E. Hall and Alvin Rabushka, a 19% tax on all individuals and companies would raise as much revenue as the current system does. Even a , slightly higher rate -- say 21% -- to gain extra revenue should still be low enough to get entrepreneurial juices flowing. Nowadays, a successful entrepreneur pays a 34% marginal corporate tax, and if he reaps all the reward as capital gains, he's socked with another 28%. The flat tax would directly promote saving and investment by excluding from personal taxation interest income, dividends, and capital gains. Don't expect a windfall, though. It also eliminates your favorite deductions -- including mortgage interest, property and state income taxes, and charitable contributions. That's part of the idea -- no special favors for the likes of real estate, or a high school swimming pool, or the Metropolitan Museum of Art. With no such breaks, investment decisions would be based on economic return rather than on tax angles, which lead to distortions like those see- through office buildings. SUCH SIMPLICITY results in a tax form the size of a post card. That holds even if you run a business -- even a giant corporation. A business would deduct the cost of materials, wages, and capital expenditures from revenue to determine taxable income. That's right, you write off plant and equipment immediately, a boon to investment. Interest expense would not be deductible, but don't forget that individuals would no longer pay tax on interest income. No deduction for fringes either, so business owners will provide only those deemed truly essential. Critics say a flat tax is unfair to the middle class, and many -- homeowners, for example -- would scream bloody murder. Hall and Rabushka counter that it would more thoroughly tax business income earned by richer people and that transition rules would minimize dislocation. This no-nonsense plan should appeal to the millions who slave away at their own tax returns and the other millions who pay someone else to do them. It should also appeal to students of tax policy: If the influence of taxes on the economy is ambiguous, let's get rid of all the bells and whistles in the tax code, all the mess, distortion, and hassle. Instead, let's create a flat -- er, level -- playing field for everybody.

BOX: INSIGHTS

-- Saving and investment must grow for living standards to rise. -- The best near-term policy: Bring back the investment tax credit. -- Let's index capital gains and stop taxing dividends twice. -- Longer term, to cut the deficit and boost investment, adopt a value-added tax or -- even better -- a flat tax.

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