Sluggish Economy Seen in Tax Plan’s First Year : Experts Split Over Whether Nation Can Shake Off Initial Effects or Will Slip Into Lengthy Decline

Key economists predicted Monday that the tax overhaul plan approved by congressional negotiators initially would depress the nation’s economic growth, make industries less likely to build or modernize factories and make some business less competitive--all sour news in a year of trade deficits and stagnant output.

The first-year pain, they said, is an unpleasant side effect of the most convulsive tax change in decades--a $24 billion-a-year shift of the tax burden from consumers to businesses and the effective rewriting of a tax law barnacled with 73 years of loopholes, incentives and breaks.

But in a preview of the debate over the new tax package, economists split deeply over whether the nation would shake off the first-year pains of withdrawal from the old tax code and eventually benefit, or whether the downturn would develop into a more serious, long-term slide in growth.

The answer, they said, lies partly in what consumers do with the $121.7 billion in tax cuts they would receive over the next five years should Congress approve the plan, as most observers expect. Skeptics fear that they will spend it on foreign-made goods instead of saving it. Additional savings would free more money for business investment at home.

Equally important is whether the tax plan will deliver on one of its primary selling points: a pledge to make the economy once again a system in which profitability--and not a crafty tax lawyer--brings success at year’s end.

Several prominent economists said Monday that the legislation could have the opposite effect. Data Resources Inc., a Massachusetts forecasting firm, predicts that the bill, by denying business some cherished investment tax breaks, will push up the cost of raising investment capital by 10% to 15%. That, in turn, will discourage modernization and leave American industry less productive than it otherwise would be.

“We estimate that this bill, by 1990, will reduce the annual output of an average employee (in goods produced) by something like $500, compared to where it would have been. That’s still rising, but less than under present law,” said Roger Brinner, senior economist at Data Resources.

The gloom was echoed by Allan Meltzer, a political economist at Carnegie Mellon University in Pittsburgh. “This bill encourages us to solve our competitive problems not by more investment and production but by more consumption,” he said. “Those industries in which we’re not now competitive are going to be at an even greater disadvantage.”

Double Economic Tonic

But other nationally recognized economists said that fears of a tax-inspired economic downturn are groundless beyond the first year or two of the new tax system. They predicted instead that the tax overhaul eventually would boost both consumer spending and saving, giving a double dose of economic tonic to underused factories and their workers.

And they forecast that the abolition of much-abused corporate tax breaks would force business to spend its money more often on ventures that actually turn a profit instead of those that simply avoid taxes.

“It’s strange to hear arguments that you can increase incentives to work, increase individual incentives to save, lower interest rates and improve the allocation of resources--and that all this is supposed to hurt the economy,” said Walter Heller, a University of Minnesota economics professor who was the top economic adviser to Presidents John F. Kennedy and Lyndon B. Johnson.

As an example of waste under present tax laws, Heller and others cited the billions of dollars worth of empty office space in many large U.S. cities--the product of a building boom partly fueled by overly generous breaks in the 1981 tax revision law.

‘Some Disruptions’

“Sure, it’s going to cause some disruptions,” Heller said. “But I think one has to look beyond the period of economic adjustment and ask whether we’re going to have a better balanced economy as a result of tax reform. And the answer is unequivocally yes.”

The division among experts over the likely impact of the tax law more or less mirrors the Republican-Democratic split that once threatened to torpedo negotiations on a final tax package this summer.

Democrats led by House Ways and Means Committee Chairman Dan Rostenkowski (D-Ill.) argued that closing business loopholes and lowering taxes on the middle class and poor would make the tax code fairer and spur spending, which would stimulate the economy.

But some Senate Republicans, including John C. Danforth of Missouri and Malcolm Wallop of Wyoming, said that the $120 billion in increased business taxes would raise the prices of American goods, worsen the trade deficit and eventually close factories and increase unemployment.

Danforth and Wallop, both of whom voted against the final compromise, lost the battle.

The proposed overhaul of the income tax is an economic experiment unlike any since the tax itself was first levied in 1913. Experts on both sides say that there is no record by which to judge its impact.

Abolishing a Thicket

Consider: The proposal would reduce the maximum individual tax rate to its lowest point since the 1920s and the corporate rate to its lowest level since World War II. It would abolish a thicket of tax preferences, all designed to funnel dollars into separate and sometimes conflicting economic activities, that has grown virtually untrimmed since the 1940s.

It would abolish outright a tax credit for spending on new factories and equipment, a staple of the corporate tax code since the Kennedy Administration that will save companies $2 billion this year. And it would end most tax shelters, which investors have used to avoid taxes of upward of $15 billion a year.

And, for middle-income and wealthy consumers, the tax plan would curb or eliminate a short list of tax breaks that have become almost rote for those who toil over their Form 1040s each spring: the deduction for interest on credit cards and many loans; the sales tax deduction; some of the break for business and medical expenses; the charitable deduction for non-itemizers.

No one knows what effect those changes will have on either spending or saving in a society that measures its economic decisions by their effect on the bottom line of their April 15 tax filing.

The elimination of the personal deduction for interest on loans--excluding home equity loans--and credit card balances is a signal example of the uncertainty that pervades the economists’ view of the tax law changes.

“The tax law was subsidizing this kind of borrowing,” said Alan Blinder, a Princeton University economics professor. “Buy a refrigerator or a car, and deduct the cost of the loan from your taxes. But now that won’t be the case, and we don’t have any real indication of what will happen.”

Refrigerator and auto makers, most of whom backed the tax changes in Congress, are betting that the loss of the tax break will be more than offset by the extra dollars that the lower tax rates place in consumers’ pockets. But, if they are wrong, and the American love affair with credit is soured by the change, both industries could be headed for at least temporary doldrums.

Low Savings Rate

That sounds bad, Blinder said. But, in fact, it may be good in the long run: Consumers may begin saving for their purchases instead of borrowing money. And an increase in the notoriously low savings rate of Americans would make more and cheaper money available for companies to use to invest and expand.

“These sorts of things are never totally clear cut,” said Richard Rahn, chief economist for the U.S. Chamber of Commerce. “Remember, we’ve never had this kind of shift in tax rates, and nobody knows for certain what it will do.”

In fact, the economic fog has left experts able to divine clearly only a few major effects of the proposed tax overhaul.

The first, and most disturbing, is the initial adverse effect on business and the national economy at a time when industrial growth already is lagging. Rahn predicts that the legislation would trim total growth in the gross national product, now averaging about 3% annually, by 0.5% over its first year; Brinner predicts a 0.1% dip.

The predicted decline is rooted in decreased corporate spending on new factories and equipment in the first year under the new tax code. The bill sharply trims a tax break that allows firms to accelerate the annual deductions through which they recover the cost of property and equipment and it ends the 10% tax credit given firms that invest in equipment and factories.

The money generated by ending those tax breaks made it possible for tax writers to reduce the corporate tax rate to 34% from 46% and to finance some of the reduction in personal taxes. But even backers of the tax overhaul concede that the end of the preferences will create some hardship.

“Over a five-year period,” said Blinder, “the bill raises corporate taxes by $24 billion a year. It’s hard to imagine that being very good for investment.”

Experts agreed also that the bill will create at least a short-term drop in savings.

The end of some incentives for consumers to establish individual retirement accounts, and curbs on the increasingly popular 401(k) retirement plans, will discourage those sorts of savings. More important, the $120-billion transfer of taxes from consumers to businesses will take money away from companies that tend to have a high savings rate and give it to consumers who historically do not save much.

Brinner forecast that the tax shift alone will remove at least $60 billion from the national savings pool over five years. That, too, could retard business spending: “If savings are more scarce,” he said, “competition for them is more intense, and the price of borrowing is higher” than it might have been otherwise.

And the experts are united in agreeing that the corporate tax changes would hit the economy unevenly. The end of investment tax credits, for example, while making life tougher for heavy industries seeking to modernize, would barely nick department stores, banks and other service businesses with little equipment.

Young Businesses Hurt

The closing of loopholes in the current corporate minimum tax would capture revenue from some major firms that have all but escaped taxation in past years. But it would hinder young, fast-growing companies that would prefer to plow most of their earnings into expansion.

Beyond those points, however, the experts are divided. Brinner, Meltzer and others predicted that increased corporate taxes and the end of investment incentives would make it especially hard for American industries to make the sort of improvements that keep them competitive with lower-cost foreign producers.

“The only way we’re going to succeed in an increasingly competitive world,” Meltzer said, “is to encourage productivity and efficiency. This bill, by discouraging investment and encouraging consumption, moves in the wrong direction.”

Without a change in incentives, Meltzer said, American goods will become increasingly uncompetitive and eventually will be marketable only when the dollar is devalued--something that makes American money worth less and lowers living standards.

More optimistic economists, such as Joseph Minarik of The Urban Institute, a Washington think tank, say such reasoning ignores the free-market logic used by President Reagan and others to promote tax revision. They note that tax incentives have not helped the ailing steel and real estate industries and suggest that businessmen might start making sounder investments if Congress gave them fewer incentives to funnel their money into ventures that don’t make money but do avoid taxes.

Related tax stories on Pages 16-20, and in Calendar.