Modest Effect Seen : Tax Reform: More Bark Than Bite

Campaigning for his massive proposal to overhaul the nation’s tax code last week, President Reagan compared the current system to a hornet’s nest and declared: “Our plan is an attempt to burn away the webs and the nest and let the sun shine in--to start new, start clean and start over.”

And in his nationally televised speech unveiling the new tax blueprint, he proclaimed that it “will create millions of new jobs for working people, and it will replace the politics of envy with a spirit of partnership, the opportunity for everyone to hitch their wagon to a star and set out to reach the American dream.”

Yet analysis of the complex proposal by economists and tax specialists representing a broad spectrum of views suggests that the long-term effects will probably fall well short of the “second American Revolution” forecast by the President.

Minor Alterations

Far from a grand design to remove the distorting influence of government in the economy, most specialists agree, the proposal is likely to make only modest alterations in the country’s economic landscape--even if adopted intact by Congress.

Shaped and reshaped on the drawing boards by compromises designed to enhance its political appeal, the Reagan plan would preserve some of the current law’s most significant special preferences, continue the federal tax code’s near-pervasive role in the economy and mandate an avalanche of changes that--while sweeping in scope--would probably leave no profound marks on the country over the next decade or so.

Paradoxically, some of the most prominent provisions of the Reagan plan also appear to be at odds with some of the President’s own most cherished convictions. His decision to ban deductions of state and local taxes, for example, seems opposed to his oft-stated desire to shift power and responsibility from Washington to state and local governments, and the abolition of rapid depreciation allowances seems at odds with his commitment to help make American industry more competitive in the world.

“It’s been turned into a real Rube Goldberg machine,” said John Makin, a senior economist at the American Enterprise Institute. “The Administration seems to have decided that sound, consistent economics will not carry tax reform.”

“Politics took over the process,” he suggested, voicing a widely held assessment among economists. “People thought about the economics and then said, ‘Let’s cut some deals.’ ”

“The new proposal is better than the current tax system, but it isn’t that much better,” said Sheldon Cohen, an Internal Revenue Service commissioner during the Lyndon B. Johnson Administration. “Everybody likes the idea of simplifying the tax code, but the world wasn’t invented yesterday. What the Administration is acknowledging with this proposal is that they just weren’t willing to slash the government’s intervention in the economy.”

To understand the likely impact of the President’s proposal over the next decade or so, it is necessary to understand the relationship between any tax system and the millions of individual and corporate decisions that influence the course of a nation’s economy. By taxing some kinds of economic activity more than others, a tax code encourages individuals and companies to take some kinds of actions and discourages others.

This country’s 10,000-page revenue code, for example, offers such favorable provisions for some businesses that such companies as General Electric, Boeing, Du Pont, Dow Chemical and Weyerhaeuser can earn hefty profits and still pay no federal income taxes at all. And the tax breaks for real estate are so great that commercial investors in new office buildings often come out ahead even if their gleaming skyscrapers stand virtually empty.

One Factor Among Many

For the most part, however, tax advantages influence economic decisions only at the margins. They are usually only one factor among many--nudging economic decisions in one direction or another but tipping the balance only when all other factors are close to equal.

And in an economy as enormous as the nearly $3-trillion-a-year U.S. juggernaut, a tax break--or a tax reform--must be very large indeed to have a significant impact on the nation as a whole.

Viewed in this light, how do major provisions of the Reagan tax proposal stack up in terms of any large-scale economic effects?

--Economic growth might increase under the Administration’s plan, but the improvements would be slight. According to White House estimates, the Administration’s proposal would boost the gross national product in 1995 by only 1.5% over the level it would otherwise reach that year--a gain of only about 0.1% a year.

Most non-government estimates of the plan’s impact on economic growth see even smaller gains.

--By reducing and simplifying individual tax rates (the maximum rate would fall to 35% from the current 50%), the plan would cut taxes for about half of all Americans and eliminate federal income taxes entirely for 2.5 million low-income persons. “The effect on the working poor may be the single most important part of the plan,” contended Joseph Minarik, an economist at the Urban Institute.

These tax cuts, and the increased purchasing power they carry with them, would tend to stimulate the economy. However, for all but a relative handful of the richest taxpayers, the cuts would be quite modest--no more than a few hundred dollars a year, hardly enough to reshape the economic landscape for individuals or the nation as a whole.

--To avoid a sharp drop in total revenues and a new flood of red ink in the federal budget, taxes for corporations would rise by about 22% in the short term. That could dampen business activity, offsetting some of the stimulation provided by the tax cuts for individuals.

Over the long run, corporate taxes would rise only about 9%, not a trifling amount but probably not enough to have a major effect on the overall course of the U.S. economy, many tax experts believe.

--By repealing the rapid depreciation allowances for businesses that build factories and buy new equipment, the Reagan plan would discourage investment in such basic industries as steel and automobiles, which require a great deal of capital, while encouraging investment in high-technology and service industries, in which huge amounts of capital are not required.

Snow Flurry on Avalanche

Yet, enormous economic forces are already at work shifting economic vitality away from basic industries and into high-tech and service industries. The Reagan plan seems likely to prove little more than a snow flurry falling on an avalanche.

--Gains in economic output, most economists believe, depend on weeding out tax incentives that divert investments into tax shelters and away from their most productive uses. And under Reagan’s plan, the real estate industry would lose some of its tax preferences.

That could make it somewhat easier for entrepreneurs in other fields to raise cash, but many special tax breaks remain untouched, and analysts contend that the White House plan falls far short of economic neutrality.

“Instead of generally sticking with a relatively consistent plan,” said Michael Barker, a tax specialist, “the Administration retreated from taxing all income equally and continues to allow loopholes to shave off large sections of real income.”

Moreover, some of the plan’s stated goals seem to be at odds with the apparent outcome.

Falls Short for Poor

The plan promises to shift money toward low-income taxpayers, for instance, and millions of the hardest-pressed taxpayers would indeed be entirely freed from federal income taxes. In most cases, however, the income tax savings would amount to only a few hundred dollars--certainly useful, but not enough to alter such Americans’ basic plight. And they would still face Social Security taxes that often exceed the present income taxes.

Meanwhile, the biggest individual gains would accrue to those at the top. For the nation’s wealthiest families--about 441,000 families with incomes above $200,000 a year--the tax proposal would mean a boost in after-tax income averaging 2.3%, according to the Center on Budget and Policy Priorities. By contrast, all other income groups would get an increase of less than 0.7% of their total income if the tax package became law.

And many economists remain skeptical about some of the Administration’s other claims.

Instead of simplifying the tax code, they say, Reagan’s plan would require nearly all businesses and most taxpayers who itemize their deductions to make even more complex calculations in preparing their tax returns.

The Administration argues that its tax plan would drive down interest rates because the combination of lower tax rates and a new limit on the deductibility of non-mortgage interest expenses would dilute the tax break for interest payments. But other features of the plan--particularly the continued deduction for mortgage interest--would continue to subsidize borrowing, and the economic forecasters are split on whether the net effect would be higher or lower rates.

Revenue Losses Seen

And, despite the Administration’s claim that its proposal would yield about the same amount of revenue as the current tax system, some analysts believe that it could lose $30 billion to $40 billion a year after about 1990, thus adding to federal deficits already forecast by the Congressional Budget Office to remain above $175 billion indefinitely. Congress, as it seeks to make the plan more attractive to interest groups, is likely to make further changes in Reagan’s tax plan that would result in revenue losses.

“Because of the inflation adjustments for depreciation, there could be large revenue losses after 1990,” Robert Eisner, an economist at Northwestern University, contended. “To the extent that Treasury is expecting any revenue gains, it turns around and loses them later on.”

Some, while conceding that the tax package may fail to meet the President’s sweeping claims, nonetheless hail it as a major step in the right direction and insist positive economic benefits will flow from it.

“No tax proposal could match the rhetoric,” said Jeff Bell, deputy director of Citizens for America, a lobbying organization established to build grass-roots support for Administration policies. “Nonetheless, I’m convinced that the more you cut tax rates, the better it should be. All in all, it should produce a tidal wave of improvement for the economy.”

At least as important, he added, “we’ve gone a long way toward making tax reform a motherhood issue.”

Political Payoff Cited

Reagan’s tax plan also could provide the Republican Party with a major political payoff. By appealing to millions of voters who are convinced that only the rich and powerful have benefited from today’s tax system, reform could help the party shed its country club image.

Moreover, by uniting the age-old liberal cause of closing tax loopholes with a conservative vision of greater individual opportunity through lower tax rates, tax overhaul cuts across traditional partisan categories to bring together such disparate politicians as Rep. Jack Kemp (R-N.Y.) and Sen. Bill Bradley (D-N.J.).

If agreement on the need to overhaul the tax code is widespread, disagreement over exactly how to do it remains vehement. And that unquestionably complicated the task of those who hammered out the final details of the President’s proposal.

While backing away from many of the economically bold but politically touchy provisions of the original Treasury Department proposal made public last November, Administration officials contend that they resisted other concessions that would have undercut reform.

They pruned dozens of tax preferences. And the revenue gained from eliminating breaks allowed Reagan to propose cutting tax rates, which in turn reduces the value of the remaining preferences.

Where the Administration retreated from the bolder Treasury plan, officials argue that most of the changes were made to avoid adverse economic consequences for particular economic sectors. For instance, top Treasury officials insist that the decision to maintain most of the oil industry’s special preferences, which would have been eliminated by the original Treasury proposal, was taken on national security grounds.

“The President judged this issue on the merits, and I think the merits are in some respects compelling on this issue,” Deputy Treasury Secretary Richard Darman said last week.

“It’s a national security interest. We can all recall the national problems associated with the Arab oil embargo, the gas lines, the very high inflation, the recession that followed ultimately. That’s a national problem well worth avoiding. We believe that incentives for energy production domestically are key to avoiding such problems.”

On at least one major issue, however--the taxation of employer-paid fringe benefits--Administration officials concede that political pressures outweighed economic considerations. Under attack from Senate Finance Committee Chairman Bob Packwood (R-Ore.), who threatened to kill any tax proposal that attempted to rein in fringe benefits, the White House agreed to tax only a small portion of employer-paid health insurance premiums.

The original Treasury proposal would have taxed most fringe benefits and placed a cap on the untaxed portion of health insurance premiums.

Treasury Plan Lauded

Treasury Secretary James A. Baker III told the House Ways and Means Committee last week that the original Treasury proposal “was the best approach” in helping to “prevent escalation of health care costs.” But he said Packwood’s opposition meant that “apparently, the health care cap is an idea whose time has not yet come.”

In another critical shift, Reagan decided against the original Treasury proposal to tax capital gains--the profits from the sale of stocks, bonds and similar assets--as ordinary income, adjusted for inflation. Instead, by agreeing to reduce the maximum tax on capital gains still further, from 20% to 17.5%, Reagan left open one of the tax code’s most prominent preferences.

“Some of the specific efforts are designed to take the edge off tax shelters,” the Urban Institute’s Minarik said, “but with the capital gains exclusion in, investors will continue to exploit the opportunities to convert ordinary income into tax-favored capital gains.”

Taken together, such compromises make the plan less sweeping and suggest that the White House has abandoned one of the key advantages of the original package--that, in Minarik’s words, “across the board, everybody’s ox was gored at least a bit.”

Bad News for Some

While stopping short of creating sweeping economic effects, some of the proposed tax changes could spell bad news for some individual sectors of the economy. For instance:

--Construction of apartments and office buildings, benefited now by a multitude of tax breaks that have led to overbuilding in many cities, would probably decline, eventually contributing to higher rents.

--The use of whole-life insurance policies, which gradually increase in cash value, would fall because of an Administration proposal to begin taxing the buildup in the cash value of new insurance policies and non-pension tax-deferred annuities.

--Charitable giving could dip, primarily because lower tax rates reduce the advantage of any tax deduction, but also because the plan would end the three-year-old provision allowing non-itemizers to deduct a portion of their contributions to charity.

--Real estate values in vacation home areas could fall in reaction to a provision gradually squeezing the now-unlimited interest expense deduction over a five-year period. Once the limitation was fully in force, taxpayers would be entitled to deduct only $5,000 more than the income they report from such “passive investments” as interest and dividends.

States Would Feel Pressure

--As a result of the loss of deductions for state and local taxes, relatively high-tax states such as California and New York would be under pressure to cut their own taxes to avoid adding to the tax burden of relatively affluent taxpayers who could move to states with lower taxes.

The tax plan would have its winners as well.

Besides ending federal income taxes for many low-income individuals and giving fat tax cuts for the nation’s richest, the plan would mean more money in the pockets of large families, particularly those with only one wage earner, because it would almost double the personal exemption.

Companies that have been paying effective tax rates as high as 46% because they lack tax preferences of their own would come out well ahead under the Reagan tax proposal. “We think the playing field may be a little more level,” said Kenneth Johnson, vice president and tax counsel for Pillsbury Co., which paid 44% of its income in taxes last year.

In addition, retaining the capital gains tax and lowering its maximum rate from the present 20% to a new ceiling of 17.5% would be a boon to small business and budding entrepreneurs.

It is primarily because of sentiments like Johnson’s that many Washington officials believe that some kind of tax overhaul will eventually be approved. What a final package might look like, and when it might be complete, are tougher questions.

“The Administration proposal, for all its faults, still would be better than the current system,” the American Enterprise Institute’s Makin said. “But I’m afraid that, by the time tax reform gets through Congress, it will be nickeled and dimed to death.”

‘Fair Shot’ This Year

With House and Senate tax-writing committees planning months of hearings on many of the controversial features of the tax package, few legislators share Treasury Secretary Baker’s assessment that “we have a fair shot of getting it through this year.”

House Speaker Thomas P. (Tip) O’Neill Jr. (D-Mass.) probably summed up the current mood on Capitol Hill when he testified to the Ways and Means Committee on Thursday. Congress will probably pass a tax revision bill next year, O’Neill said, but it could well be a package quite different from Reagan’s.

ON THE WHOLE, A MODEST IMPACT Chase Econometrics has projected the course of the economy with or without enactment of President Reagan’s tax package. Its projection, which is based on only the overall impact of the Reagan plan and does not take into account any offsetting changes that Congress might enact, shows relatively small changes except for after-tax corporate profits.

1986 1987 1988 1989 1990 After-inflation economic growth Without 2.4% 3.9% 3.3% 3.0% 2.9% With 1.3 4.8 3.7 3.0 2.7 Inflation rate (GNP deflator) Without 4.2% 4.8% 4.7% 4.8% 4.7% With 4.2 4.6 4.9 5.1 4.8 Unemployment rate Without 7.5% 6.9% 6.7% 6.5% 6.4% With 7.7 7.1 6.8 6.4 6.3 Interest on three-month Treasury bill Without 7.7% 8.4% 8.2% 7.6% 7.1 With 6.8 7.6 7.8 7.4 7.0 After-tax corporate profits (billions) Without $136 $146 $136 $143 $154 With 106 123 126 136 147