Interplay of Tax Code, Farm Laws Yields Odd Harvest

The ecologically fragile Sand Hills of Nebraska--grassy dunes that sprawl across much of that state’s midsection--offer only marginal growing land for crops. Yet, despite federal programs to conserve soil and reduce erosion, bulldozers have pierced the fragile top soil, toppling the cliffs and filling the ridges.

Now, ironically, corn grows on some of this land, contributing to the nation’s costly surplus.

That bizarre juxtaposition results from the interplay of a variety of federal laws: Programs that seek to curb production, for example, bump up against tax shelters and investment tax credits that encourage more production. The tax code entices into agriculture non-farm investors “looking not for profits but for deductions,” says Chuck Hassebrook, a tax analyst for the Center for Rural Affairs in Waltham, Neb.

For example, farm policy seeks to reduce the size of herds in an effort to dry up the nation’s sea of surplus milk, while the tax code adds to the surplus by providing investment tax credits for buying more cows--then enables investors to write off the animals over five years. Finally, when the cows are sold, the income qualifies as a capital gain, 60% of which escapes taxation.

“There’s no conscious effort to coordinate tax policy with farm policy,” says Hoy F. Carman, an agricultural economist at the University of California at Davis, who has studied the effects of the tax code on agriculture since the Tax Reform Act of 1968. His conclusion: “It’s a nightmare.”

While the effects of this phenomenon can thus be found across the United States, nowhere are they more stunningly strange than in the Sand Hills of Nebraska.

There, the subterranean water underlying the porous dunes is tapped to irrigate the superfluous cornfields, qualifying for a federal “depletion” allowance. Up above, the rotating irrigation booms and water pumps that make farming possible provide investment tax credits for equipment that also can be written off over just five years.

And--final irony--conservation credits are available for bringing the unique dunes under unneeded cultivation. “The tax code treated the earth-moving like a conservation expense, but it was more like an earth-raping expense,” Hassebrook claims.

Possibilities of tax savings--in effect, letting Uncle Sam spring for a part of one’s investment--are hardly inventions of the 1980s. What is new is a growing awareness, within government and without, that the interplay of farm programs and the tax code is not only costly but has unintended counterproductive consequences such as loss of federal tax revenues, overproduction of many crops, disruption of markets and dislocation of real farmers.

Congress, the Agriculture Department, the Treasury and the White House itself all have examined the situation recently. The White House concluded that the government is the loser: Claimed tax losses attributed to farming more than offset claimed farm income. As James C. Miller of the National Grange farm organization sums it up: “For every dollar collected in farm profits, two other dollars of income are sheltered.”

One congressional estimate projected the government’s tax loss over the next two years at $2.6 billion.

An Agriculture Department study showed how such losses can result. The USDA told of an audit by the Internal Revenue Service of 12,000 tax returns, each of which reported farm losses exceeding $50,000. Since non-farm income on these tax returns averaged $122,000 and farm losses averaged $104,000, these taxpayers had managed to reduce their adjusted gross income to just $16,000.

Sen James Abdnor (R-S.D.), who unsuccessfully sought to impose a $21,000 limit on how much off-farm income could be sheltered, calls this “farming by the tax code.”

“Current tax law encourages production on marginal lands, since investors are able to incur greater farming losses on these lands, thus aggravating our surplus production problems and adding to our soil conservation problems,” Abdnor explains.

Not only can such investment decisions increase erosion in such areas as the Sand Hills of Nebraska while increasing costly crop surpluses, they also can help undermine the financial foundation of those who earn their living from farming, adds Abdnor, who is vice chairman of the Joint Economic Committee.

“If farm investment by non-farmers occurs due to sheltering, and the resulting extra production occurs during a time of surpluses, prices can fall, jeopardizing farms that are in a cash-flow pinch,” the committee found in an investigation.

As a matter of fact, a Treasury study concluded that tax revenue lost through “farming by the tax code” totaled only 3% of the total revenue lost through tax shelters. The greater effects, it said, show up on the structure, output and economic well-being of bona fide farmers, particularly those in the middle-sized range.

Caters to Investors

Thus, the once-colorful world of the cowboy has all but given way to law-book-lined office of the tax adviser. Red River Feed Yards Inc., which is headquartered in Longmont, Colo., and operates a feed lot in Arizona, now caters to absentee investors willing to put money into fattening cattle for slaughter.

Whatever the eventual slaughter price, according to Red River, these investors can realize tax deductions amounting to 150% to 175% of the $125 they typically are asked to put up for each animal. By properly “structuring” their investment program, the company explains, part of an investor’s profits can be transformed into capital gains. Finally, the risk inherent in such an investment can be reduced through a variety of “hedging” techniques against fluctuations in the final sales price.

“The entire cattle industry is very much motivated by the tax code,” Kenneth E. Banwart, Red River’s vice chairman, acknowledged in an interview. “Cattle feeding is a high-risk business, and I assume that’s why Congress, at some point, chose to allow this industry to have favorable tax treatment.”

Those incentives may once have served some national need when beef consumption was growing rapidly, Banwart said, but they work against the industry now that beef consumption continues a 15-year decline.

Such tax shelters act as “magnets” drawing investment capital, Hassebrook says. The result: “You get more money, more production, and you get a lower price for that production because of investment decisions made for all the wrong reasons--for the tax benefits.”

Carman of UC Davis has run computer models of how the various provisions of the tax code influence farmers. He concluded that, to some extent, the tax code lured many farmers into their current financial trouble. Given the tax code as written in the 1970s, farmers who expanded their operations on credit behaved rationally, he explained. “They were buying land and buying equipment, and buying it all on credit, with no savings,” he said.

In the absence of tax laws, he found, these same farmers would not have bought land or accumulated excessive machinery capacity and would have generated savings.

Government Subsidy

Banwart of Red River Feed Yards--despite the fact that his company peddles tax benefits--concurs with Carman’s conclusion that agriculture would be better off without government interference. To Banwart, a third-generation cattleman, tax benefits are every bit as much a government subsidy as are crop price supports.

“Our business caters to it,” Banwart says, “but the cattle industry as a whole would be much better off if we had no subsidies whatsoever--either direct subsidies or tax subsidies.” Without those influences, he said, “you’d get back to real economics. You’d also eliminate the inefficient producer who is surviving only because of subsidies.”

A USDA study spanning 34 years through 1984 concluded that tax policy increased the price of farm land, encouraged expansion of individual farm firms, stimulated production of tax-sheltered crops, encouraged incorporation of some farm operations and creation of tax-free financial reserves, and favored purchase of equipment over the hiring of labor. A byproduct of such provisions was to modify farm management to take advantage of the tax code.

For example, a cattleman may figure that, in terms of cattle-breeding, heifers should be slaughtered after two years; but if he were to view the same animals as tax objects, he would find it preferable to slaughter them before two years so that development costs can be written off in the year in which they occur rather than be deferred, as the law then requires, until the animals generate income through slaughter or sale.

Farmers Use Provisions

When citrus and almond surpluses developed in the late 1960s and 1970s, public attention first seized upon the relatively recent phenomenon of tax-code farming by outside investors. “But, really,” Carman maintains, “the impact on agriculture is larger coming from the use of these provisions not by outside investors but by the farmers themselves.”

California has had adequate capacity in orchards and vineyards, for example, but the tax code encouraged development of additional acreage that could be written off as an investment tax credit and then depreciated over five years. It also bid up the cost of pasture land. “That may make sense in terms of tax benefits, but what the hell does that do for the economy?” Carman asks.

What it did in California, according to his analysis, was to disrupt markets by creating surpluses of apples, apricots, avocados, freestone peaches and olives.

Sometimes, thus, the disruption is self-inflicted and only intensified by non-farm investors. According to tax attorney Jan Rosati of Touche Ross’ Sacramento accounting office, farmers are always looking for “that one big crop,” be it--as it has been over the years in California--kiwi fruit, citrus, jojoba beans, wine grapes, avocados, almonds or even rice.

Financial success in a new crop invariably draws more growers into the field, eventually flooding the market and lowering prices, Rosati says. As a result of this “bandwagon effect,” he said, “it only takes about three years for farmers to ruin a good crop.”

Another case of such disruption was perpetrated by Midwestern hog farmers, Hassebrook says. Intent on obtaining a tax break after a string of tough years, they succeeded in having their breeding pens redefined in the tax code as equipment rather than buildings. This change qualified the pens for both investment tax credits and accelerated depreciation schedules, allowing them to be written off much more rapidly than their actual rate of deterioration.

Hog Production Soared

“There was just a rush of capital and a rash of new building, and there just wasn’t a market for that many hogs,” Hassebrook says. Between 1981 and 1983, 30% of the nation’s hog producers dropped out, he adds, and yet, in 1984, six major investment concerns announced plans to produce a million more hogs despite a market that has been a loser in five of the last six years.

(The hog producers succeeded in removing the now-soured tax incentive in the version of the pending tax legislation passed by the House.)

In economic terms, demand for food and fiber tends to be fairly inelastic at the farm level. As production increases, price inevitably declines because, as Carman puts it: “There are only so many stomachs, and they can only hold so much.”

Since the Great Depression, the nation’s farm programs have sought to sustain producers and bountiful harvests while delivering to consumers inexpensive food--accomplished by paying for subsidies from general tax revenues rather than from, for example, the value-added taxes common in Western European countries to subsidize producers.

“Tax law is more and more perceived as a vehicle of social change,” says Rosati of Touche Ross, “and they have created a monster.”

Adds cattleman Banwart: “We have taken the largest group of risk-taking entrepreneurs this country ever had--farmers--and turned them into welfare recipients. There’s no reason why we should keep the (inefficient) family farm alive any more than we should keep the motorcycle shop open down the street.”