The Tide of Tax Reform : Makeup of State Economy May Smooth Impact

Just as it may initially hurt the nation’s economy, the sweeping new tax reform bill is widely expected to hurt California’s economy in the first year. But the state may not suffer as much as the rest of the nation.

This is because California depends less than many other states on capital-intensive manufacturing industries that are expected to suffer most from the tax bill, experts say. Also, faster economic growth in this state is expected to help its industries adjust better to the adverse effects of tax reform, they say.

And because California’s economic growth already is faster than the nation’s, the lessened impact of tax reform could widen the state’s advantage even further, the experts say. California’s growth rate next year could be double that of the nation’s, Bank of America economist Michael Salkin suggested.

However, not all is rosy for California. Individual taxpayers in California initially may not fare as well as their counterparts elsewhere. They are expected to gain smaller federal tax cuts on average than other Americans, partly because California’s taxpayers rely more on tax shelters and other tax deductions that will be curbed under tax reform.

And while California’s revenue from state income taxes is expected to increase--barring a cut in state tax rates--that gain will be partially offset by higher costs of issuing tax-exempt bonds to finance public projects.

These and other predictions are part of preliminary analyses emerging from economists as they begin to assess the effects of the controversial tax bill on the nation’s most-populous state. However, the job of analyzing the bill’s impact on the state is agonizingly difficult and slow.

Many economists are not yet confident about issuing definitive projections, partly because congressional staffers have not yet written specific details of the bill to present to the full Congress and President Reagan for approval, expected to come later this month.

Many also say that it will be nearly impossible to separate the effects of tax reform from other forces shaping the state’s economy. Also, they say, their econometric models are not sophisticated enough to account for the bill’s sweeping effect on incentives to invest, save and spend.

“It’s going to be a mishmash,” Joseph A. Wahed, chief economist at Wells Fargo Bank, said of the impact of tax reform. It is “impossible” to tell how much change in economic activity is going to be caused by tax changes, he said.

But despite their difficulties, many experts share some common initial impressions.

They agree that after two or three years, as industries and individuals adjust to tax changes, the state and the nation should benefit from tax reform because it will lower tax rates and base economic decisions more on profitability than on tax benefits.

Tax reform may, in fact, help some ailing industries, such as construction of office buildings, shopping centers, apartments and other commercial buildings. Construction is likely to plummet initially because of less-generous depreciation schedules and reduced attractiveness of tax shelters, which account for much of the present investment in commercial projects. But reduced construction will eventually alleviate the oversupply and raise rents, stimulating construction later, some experts say.

The experts also generally agree that California’s economy will initially fare better than the nation’s, largely because it relies less heavily on the industries most likely to be hurt initially.

Construction, for example, represents 4.5% of California’s total economic output, compared to 4.7% of the nation’s, said Jeanette Garretty, senior economist at Bank of America.

Less Important in State

Similarly, manufacturing industries--such as chemicals, heavy metals, paper and industrial machinery--most likely to be hurt by the loss of the investment tax credit also are less important to California’s economy than to the nation’s. The investment tax credit--which helped subsidize construction of new factories and purchases of new equipment--will be repealed retroactive to Jan. 1, 1986, under the tax reform bill.

Chemicals, for example, comprise 4.6% of California’s manufacturing output, compared to 8.6% of the nation’s. Heavy industrial machinery accounts for 3.3% of California’s manufacturing, compared to 6.2% of the nation’s.

By contrast, the manufacturing industries relatively more important in California are generally those that, while also hurt by the loss of the investment tax credit, are faster growing and more in demand by firms wishing to modernize their operations.

Electric machinery, for example, represents 17% of California’s manufacturing output, compared to only 8.8% of U.S. manufacturing. And computers represent 10.5% of California’s output, compared to only 3.8% in the nation, Garretty said.

“Generally, a lot of the things companies want for capital spending involve such categories as information processing, communications technology and robotics” that California specializes in, Garretty said. She noted a recent McGraw-Hill survey showing that the bulk of capital spending plans by companies are focused on modernization and replacement of existing equipment and facilities, rather than expansion through new factories or offices.

California also has a larger proportion of retailing and many other labor-intensive service industries, Garretty said. These industries--currently with high relative tax rates and with less ability to use investment tax credits and depreciation--are expected to gain handsomely from lower corporate tax rates and higher consumer spending triggered by lower personal tax rates.

Already Growing Faster

Also helping California is the fact that it already is growing faster than the nation, thanks in part to a more diverse economy and faster population growth. California’s inflation-adjusted growth in this year’s first half was estimated at about 3.5%, compared to about 2.2% for the nation, Bank of America’s Salkin said. But California could top 4% next year, compared to less than 2% for the nation, he said.

Healthier economic growth, by providing more demand for goods and services, will help some industries adjust to any slump caused by tax reform. Such could be the case with office construction.

Even though average office building vacancy rates in the state and the nation are about the same, at more than 20%, it will take much longer for vacancies to decline elsewhere in the nation, Bank of America economists Salkin and Carl Mason said in a recent report.

They cite as an example the Houston area compared with California’s Santa Clara County. They note that 2 million square feet of currently occupied office space will become vacant in the Houston metropolitan area this year, while new tenants in Santa Clara County will absorb 1.8 million square feet of office space this year.

But while tax reform is expected to have a pervasive effect on some industries, it is but one of several factors affecting overall growth in the California economy, experts say.

“Other factors are so much more important than tax reform, such as national economic growth, energy prices, the direction of the dollar,” said Phillip E. Vincent, a senior economist for First Interstate Bancorp.

Stronger Growth Expected

Thus, while many economists expect tax reform to have a negative impact next year, not all agree that it will result in slower growth next year. Some experts, in fact, see stronger growth in 1987 because lower interest rates and other factors will offset tax reform.

First Interstate’s Vincent, for example, forecasts a 3.7% growth rate in the state next year, compared to his estimated 3.6% this year.

Larry Kimball, director of the UCLA Business Forecasting Project, said that if the economy slumps due to tax reform and other negative factors, the Federal Reserve Board is likely to expand the money supply to drive down interest rates.

“Give me 8% mortgage rates and housing is going to have a good year no matter what tax reform does” to hurt apartments and office buildings, Kimball said.

But Kimball, like many other economists, said he was not yet ready to quantify the effects of tax reform on the state’s economy.

Wells Fargo’s Wahed was the only economist interviewed willing to do so--although, he said, his numbers were “very rough guesses.” The state’s economic growth, which he predicted will be 3% this year, will slow to 2.5% next year, he said. It would have been between 2.7% and 2.8% next year without tax reform, he said.

Similarly, the national economy will grow at 2.5% this year and slow to slightly under 2% next year, he said. It would have grown 2.2% or 2.3% next year without tax reform, he said. He added that he does not see improvement next year for California or the nation unless overseas demand for U.S. goods improves and the flood of imports subsides--both of which he sees as unlikely.

Just as there is widespread uncertainty about the effect of tax reform on the state’s economy, no one has yet thoroughly measured the impact of reform on the state’s ability to raise funds for public projects through tax-exempt bonds. A spokeswoman for the office of state Treasurer Jesse M. Unruh said the office has yet to thoroughly study the issue.

Predicts Higher Costs

However, the Public Securities Assn., a trade group representing underwriters of municipal securities, said 41% of all municipal bonds issued nationwide in 1984 could not be issued as tax-exempt securities in 1991, thanks to curbs on several types of tax-exempts in the reform bill. The group predicts that costs to finance projects nationwide could rise by as much as $16 billion by 1991 as state and local governments are forced to issue bonds in the taxable market at considerably higher interest rates, among other things.

No one has measured the effect of tax reform on individual taxpayers in the state and whether it will stimulate increased saving or spending.

However, deSeve Economics Associates, an economic consulting firm in Troy, N.Y., completed in June a detailed analysis of the impact on California taxpayers of the Senate Finance Committee’s version of the tax bill. Because that version is very similar in key provisions to the version agreed to last month by a House-Senate conference committee, it can be used as a preliminary measure of the impact of tax reform on the state’s taxpayers.

The study, done for the state Franchise Tax Board, shows that Californians on average would benefit less from the Senate Finance bill than the nation’s taxpayers as a whole. Californians’ federal taxes would fall only 9.79% under the bill, compared to a 13.19% cut for all Americans.

For Californians, that translates to a decrease in federal taxes of $4.3 billion, or an average of about $341 per filer, based on the estimated 12.6-million returns Californians filed in the 1985 tax year. However, largely because federal taxable income would rise--due to fewer deductions under the new bill--Californians’ state income tax would increase by $1 billion, or an average hike of $79 per filer, because California is expected to adopt roughly the same deduction schedule used in the federal tax reform bill.

Numbers Are Averages

Franchise Tax Board spokesman James Reber noted, however, that these numbers are averages and that some taxpayers might pay a lot more or a lot less. Also, the deSeve analysis presumes that state taxes will not be reduced from the current 11% maximum rate to match federal tax rate reductions. A state tax rate cut is seen as a real possibility, as Gov. George Deukmejian has said he would oppose any hike in state taxes, presumably including one that would result indirectly from federal tax reform.

A detailed analysis by the Franchise Tax Board of the House-Senate conference bill will not be available until November at the earliest, Reber said.

However, despite the limitations of the deSeve report, it does illustrate generally how Californians may not be as favorably affected by the tax reform package as other Americans.

Because Californians tend to participate more in tax shelters, they will suffer more initially by the bill’s limitations on writeoffs on so-called passive losses from limited partnerships used as shelters. The limits will increase federal taxes on Californians by an average of 3.74%, while Americans in general will see their federal taxes rise by only 2.66%, the report said.

Californians, because they pay more in sales taxes than the national average, also will suffer more from the loss of deductions for sales taxes under the new bill. That will increase taxes for the state’s taxpayers by an average of 2.1%, compared to 1.36% nationwide, the report said.

The increase in the personal exemption to $1,900 in 1987, and higher in later years, from $1,080 in 1986, also will benefit Californians less. That is because a higher personal exemption benefits lower-income taxpayers more than higher-income taxpayers.

Itemizers Don’t Gain

Similarly, because a higher percentage of California taxpayers itemize, the replacement of the zero-bracket amount under current law with a standard deduction will help the nation’s taxpayers more than Californians. The standard deduction--which next year will be $3,800 on joint returns and $2,570 for single filers--can be used by non-itemizers in lieu of itemizing. Itemizers don’t really gain from it.

But Californians do not lose out on all provisions. The reduction in personal tax rates--to a top rate of 33% in 1988 from the current 50%--is expected to benefit Californians more because higher income individuals benefit more from the rate cuts.