Slowdown in Economy Seen Early in Year

Will the new tax law cause an economic slowdown early this year? In overwhelming numbers, economists are convinced that it will. To take advantage of several tax breaks that were repealed at the end of 1986, these analysts reason, consumers and businesses appear to have gone on a year-end buying spree. They will have to cut back in the months ahead, according to this argument, as a result of their depleted pocketbooks.

“There was a flurry of activity induced at least in part by the tax bill,” said A. Gary Shilling, a New York economic consultant with an excellent forecasting record. “Things should begin to deteriorate in the first part of 1987.”

And even the ever-optimistic Beryl W. Sprinkel, chief economic adviser to President Reagan, warned: “There is the possibility of some further short-run negative effects from tax reform.”

‘Time to Be Skeptical’

But to some economists, the unusual near-unanimity is disturbing. After all, one of the standard jokes in this profession holds that if you laid all the economists in the world end to end, they still wouldn’t reach a conclusion.

“I’ve been in the forecasting game long enough to know that whenever this many people agree on anything, it’s time to be skeptical,” cautioned Irwin Kellner, chief economist at Manufacturers Hanover Bank in New York.

Kellner concedes that the initial evidence for a 1987 letdown looks compelling. Domestic auto sales, induced in large part by the abolition of the state sales tax deduction as of Jan. 1, spurted by 16% in December to end the year at a record level. Scattered reports from car dealers since then indicate the predictable reversal.

In addition, construction spending appears headed for a fall. Millions of square feet of office space throughout the country remains empty, and the new tax law dramatically pulled the rug out from under the tax incentives that have propped up commercial construction despite vast overbuilding.

Nonetheless, a handful of skeptics continue to challenge the conventional wisdom. The sweeping new tax law itself, they note, only adds to the usual uncertainty over the near-term economic outlook.

‘Threat Wildly Exaggerated’

“The threat from the tax bill has been wildly exaggerated,” contended Larry Kudlow, chief economist at Bear Stearns & Co., a Wall Street investment firm. “It appears that the fundamentals of the economy are improving, and I see no reason why even the tax changes that are genuinely negative should outweigh those gains.”

Analysts of this school find evidence of only a relatively modest amount of tax-induced spending, almost exclusively in auto sales, at the end of last year.

Beyond that, they observe that most Americans will receive a healthy tax cut in 1987--estimated at an overall $14 billion for the first nine months of the year. Because built-in changes in withholding tables will exaggerate the tax reduction in the early months of the year, the tax cut appears likely to stimulate consumer spending.

Corporate Tax Hike

Congress offset the personal tax cut with a business tax increase. But there is widespread misunderstanding about the extent of the tax increase imposed on corporations.

The largest business tax preference--the 10% investment tax credit--had already been abolished retroactive to Jan. 1, 1986. That means there was no tax-induced upswing in business investment at year’s end, to be followed by a new year’s lull.

And the tax law’s new depreciation rules, instead of worsening the write-off schedules designed to compensate businesses for the aging of plant and equipment, are actually slightly more generous at first than the old law for most kinds of investment.

The skeptics are not convinced that the elimination of the sales tax deduction and the phase-out of consumer interest deductions will force debt-laden consumers to retrench early this year. Fewer than half of all consumers take advantage of itemized deductions in the first place; the majority who do not will not change their behavior to accommodate the new tax law.

Sales Tax Deduction

Moreover, contrary to popular belief, the abolition of the sales tax deduction should not have much effect on most purchases except cars. Sales taxes on most individual purchases were deductible only for those few consumers who kept detailed records of all their expenditures. The great majority of taxpayers relied on tables that allowed a standard sales tax deduction based on income and granted additional deductions only for the purchase of cars, boats, mobile homes and home-building materials.

Similarly, the elimination this year of 35% of consumer interest deductions appears unlikely to force a severe cutback in borrowing, largely because many taxpayers should find that they still have a number of tax-deductible alternatives. Banks and savings institutions across the country are already engaged in an intense bidding war to lure consumers to their home equity loans, which in most cases will remain fully deductible under the new tax law.

“It is an arguable point whether there are any significant long-term consequences from the elimination of such tax deductions,” said David Levine, chief economist at Sanford C. Bernstein & Co., a New York investment firm. “But a close analysis suggests the short-term cyclical consequences are practically nil.”

Possibility of Recession

Even Shilling, who thinks the odds slightly favor a recession this year, is having second thoughts about whether consumer spending will collapse.

“Few consumers really want to admit that the American dream of ever-increasing purchasing power is over for them,” he said. “We estimate households could borrow an additional $1.2 trillion through refinancing first mortgages, second mortgages or home equity loans. . . . The consumer may prove to have at least nine lives in this business expansion.”

The few analysts who foresee stronger economic growth ahead believe that consumer outlays will tail off from last year’s exceptionally high growth rates. But they expect that to be outweighed by other economic factors, such as a narrowing of the trade imbalance and a rebuilding of business inventories.

“If you look at all the leading indicators--factory orders, commodity prices, unemployment claims--they are all pointing up,” said Alan Reynolds, a leading “supply-side” economist at Polyconomics Inc. in Morristown, N.J.

“So what you’ve got is a lot of amateur supply-siders presenting a misguided theoretical argument about the structural effects of tax changes. My counter to their arguments is that the effect of the new law is more likely to be to push some production into 1987 from 1986, actually boosting real economic activity this year rather than depressing it.”