Flat Rate Faces Uphill Struggle : Soaring Tax Breaks Peril Reform Plan

The Senate Finance Committee’s recent confirmation hearing for Secretary of the Treasury James A. Baker III was hardly a good omen for tax reform. One by one, committee members weighed in with ringing defenses of such tax breaks as special incentives for oil and gas drillers and tax-free fringe benefits, among many others.

Calling them “incentives for savings investment,” Sen. Spark M. Matsunaga (D-Hawaii) urged Baker not only to refrain from tampering with special tax provisions already in place but to create more of them. Were it not for a special tax exemption he pushed through the state Legislature some years ago, Matsunaga added proudly, Hawaii would never have become home to the booming macadamia nut industry.

“That is only at the small state level--the state of Hawaii,” he declared. “Just imagine what can happen nationwide.”

The Treasury Department has developed a tax reform plan designed to give lower rates to most taxpayers and to balance the lower rates by thinning out the myriad exclusions, credits and deductions in the tax code. That may seem a straightforward and politically appealing idea in a nation increasingly frustrated and irascible because of its complex, and costly, tax system. However, it is already clear that reform will be an uphill proposition at best.

Spurred by the kind of faith Matsunaga displayed in the payoff from all types of tax incentives, members of Congress and the executive branch--including President Reagan--have in recent years helped create a bushel of new tax breaks.

The amount of money saved by individuals and businesses through federal tax breaks mushroomed from $82 billion a decade ago to $322 billion last year and is expected to grow past $500 billion by 1989, according to the congressional Joint Tax Committee.

The use of tax preferences by corporations and individuals has become so widespread that “the zealous pursuit of these advantages has made the tax code resemble a vast leaky bucket, spilling as much revenue as it captures,” said economic analyst Michael Barker, editor of the Politics and Markets newsletter.

“For every dollar in personal and corporate income that is taxed, another 90 cents is now sheltered from taxation,” Barker said.

The explosion in new tax breaks occurred because “Congress finds it easy to respond to every crisis or problem with a tax incentive,” a staff member of the House Ways and Means Committee said. “The energy crisis spawned alternative energy tax credits; high unemployment produced the targeted jobs credit; apartment builders won tax incentives on the rationale that they were needed to make room for new families from the baby boom. And it’s politically sexy because you can respond to the problem, yet it looks like it doesn’t cost anything.”

Nevertheless, tax breaks, in their effect on the federal budget, are no different from any open-ended government spending program in that they provide benefits to various individuals or firms at a cost to the federal government. For that reason, they are sometimes known as “tax expenditures.”

Under the Treasury Department reform proposal prepared last year by Donald T. Regan, then Treasury secretary and now White House chief of staff, most tax preferences would be eliminated. For individuals, the goal is fairness: to impose approximately the same federal tax burden on individuals with similar incomes. For businesses, the goal is uniformity: to prevent the search for tax advantages from distorting investment decisions.

Many of the tax breaks now in the code are aimed at promoting particular social or economic goals such as owning a home, giving to charities and investing in business plant and equipment.

65% of Families Own Homes

And many of the tax provisions have achieved their goals. Thanks in large part to the deduction for mortgage interest, for example, about 65% of all families own their own homes. Sen. Bob Packwood (R-Ore.), chairman of the tax-writing Finance Committee, contends that reducing tax preferences for such things as employer-paid health insurance would merely force Congress to substitute more cumbersome government programs in their place.

Tax-free fringe benefits, he said, “substitute for social services that government would otherwise be providing at an infinitely greater cost than we now get them with employers’ providing them. . . . The bulk (of congressmen) like the idea of using the tax code for incentives.”

Even the White House is recommending several new tax breaks, despite the Treasury proposal to end most existing preferences. President Reagan would provide tuition tax credits for families that send their children to private schools and tax incentives to businesses that locate in depressed areas designated as “enterprise zones.”

‘Goodies for Friends’

However, critics contend that the use of tax incentives is out of control.

“Every time we write a tax bill, someone slips in a few goodies for their friends,” said California Rep. Fortney H. (Pete) Stark Jr. (D-Oakland), a senior member of the tax-writing House Ways and Means Committee. “Now there are so many different provisions that we don’t have any real idea what will happen when we make a change. It’s time to begin with a clean slate again.”

Stark and Sen. John H. Chafee (R-R.I.) have introduced a bill to scale back tax preferences across the board by 10% as a revenue-raising measure aimed at reducing the deficit.

More fundamentally, tax reformers have been encouraged by the Treasury proposal to challenge many of the incentives as simply a waste of money. Robert McIntyre of Citizens for Tax Justice, for example, recently studied the investment behavior of 250 of the nation’s major corporations from 1981 to 1983. He concluded that companies which “enjoyed the most tax incentives cut their investment the most.”

GE Profits of $6.5 Billion

General Electric Co., for example, earned $6.5 billion in U.S. profits during those years but avoided all federal income taxes and actually received $283 million in tax rebates by taking advantage of many of the incentives established in 1981. Over that same period, General Electric cut its investment in new plant and equipment by 15%.

In contrast, Whirlpool Corp., which competes with General Electric in the household appliance industry, paid 45.6% of its $650 million in profits to the federal government during those three years but actually increased its investment in new plant and equipment by 7%.

McIntyre contends that companies find tax incentives largely irrelevant to their investment decisions, compared to market forces. Whirlpool, encountering greater demand for its products, invested in new equipment, and General Electric, faced with less demand, decided not to invest.

Low Tax on Capital Gains

Similarly, a few voices are questioning the widespread belief that the low tax rate on capital gains--the top rate was reduced from 49% to 28% in 1978 and 20% in 1981--was chiefly responsible for the explosion of investment in venture capital in recent years.

Barker points out that most venture capital funds, which provide the seed money for risky new companies, come from investors who are unaffected by the capital gains tax. Tax-exempt investors such as pension funds put up nearly 60% of all venture capital funds, and much of the rest comes from insurance companies and banks, which pay comparatively low taxes.

Wealthy individuals, who are the main beneficiaries of the capital gains exclusion, also boosted their commitment to venture capital from $140 million in 1978 to $467 million by 1984. But private investors subject to the capital gains tax contributed just 15% of the total venture capital pool of $3.2 billion last year, down from 32% in 1978.

‘A Crazy Quilt System’

“The tax on capital income has been turned into a crazy quilt system,” said Dale Jorgenson, an economics professor and tax expert at Harvard University. “The changes in recent years did indeed stimulate investment, but a lot of the thrust was blunted and the money misallocated because of these unnecessary distortions.”

Ron Pearlman, assistant Treasury secretary for tax policy and a key architect of the original plan, concedes that “the politics of tax reform are difficult. But I think people recognize that we went way overboard (in providing tax incentives). We’ve created a tax system that’s so distorted and is perceived as being so unfair that it is really troublesome in terms of the health and vitality of our basic economic system. I think people are prepared to take on some tough issues to try to deal with that.”

In any event, the creation of new tax breaks is beginning to slow, due in no small part to the “indexing” provision of the 1981 tax law. Under that provision, tax brackets will grow with inflation beginning this year. No longer will inflation-driven wage increases force individuals into higher tax brackets--and no longer will government reap the resulting “fiscal dividend.” In the past, Congress was able to divert much of the extra tax flow into new tax breaks.

“Indexing really puts the squeeze on because there is no longer any extra money to dole out,” said John E. (Buck) Chapoton, Pearlman’s predecessor as the Treasury Department’s top tax official. “From now on, for every additional incentive Congress wants to put in, they are going to have to find some other one to take out.”

IMPACT OF TAX BREAKS LOSS OF REVENUE FROM MAJOR TAX BREAKS, 1985

Estimated figures in billions of dollars.

Personal Corporate Exclusion of employer pension and medical contributions $72.9 Investment tax credit 5.4 $29.4 Deduction for state and local taxes 31.2 Exclusion of 60% of capital gains 23.8 3.0 Deduction for home mortgage interest 25.5 Exclusion of municipal bond interest 7.5 17.1 Accelerated depreciation of business investment 4.1 19.4 Exclusion of Social Security income 17.8 Deduction for charitable contributions 11.9 0.8 Special treatment of individual retirement accounts 11.4 Deduction for non-mortgage interest 7.0 Exclusion fo interest on life insurance savings 5.2 Tax breaks for research and development 0.1 4.8 Exclusion of unemployment benefits and workers’ compensation 4.0 Tax breaks for oil and gas drilling 1.9 1.4

LOSS OF REVENUE FROM ALL TAX BREAKS, 1974-1988

For every dollar of corporate and individual income that is subject to taxation today, another 92 cents escapes taxation through exclusions, deductions and other tax breaks, up from 57 cents a decade ago.

For every dollar of corporate and individual income that is subject to taxation today, another 92 cents escapes taxation through exclusions, deductions and other tax breaks, up from 57 cents a decade ago.

Source: Joint Committee on Taxation