Out on a Tax Reform Limb, the Economy Stays Strong : Firms Still Worried Although Effect So Far Has Been Mild
George Wachtel will never be a fan of tax reform. “I will always believe it is bad for business,” said the League of American Theaters and Producers spokesman.
A common view, but, according to virtually every statistic that U.S. business keeps, wrong.
In Wachtel’s industry, entertainment, hotel occupancy rates were up 1.3% in the first half, attendance at Broadway shows is running 12% higher for the year and restaurants report that business seems as strong as last year. All were supposed to falter under a provision making business travel and entertainment only 80% deductible.
Capital spending by American business, a sure tax reform victim by the pundits’ reckoning, is on the rise again after a brief downturn. And capital appropriations--the amount that business has approved but not yet spent on investments in plants and equipment--rose a rousing 22% from the first quarter of 1987 to the second quarter.
Heavy industry, whose demise by tax reform was widely predicted, has instead added more than 100,000 manufacturing jobs, and profits are up and gaining steam.
“The fact is we’re really seeing a revival of the industrial sector, not its demise,” said Delos Smith, an economist with the Conference Board, a New York research group.
Even in the construction industry, which many thought would be blind-sided by the tax revisions, the damage has been less onerous than expected. According to the National Assn. of Home Builders, apartment construction is down 30% nationwide instead of the 50% decline that was forecast.
And small investors and institutions, much to the industry’s surprise, are pouring money into real estate investment partnerships--an investment that was written off as dead once the ink dried on the House-Senate conference committee tax bill 14 months ago.
In short, “the message to U.S. business is that we have lived with tax reform for a full year and it didn’t do us in,” said Allen Sinai, chief economist for the investment firm Shearson Lehman Bros. “In fact, business has had a very, very fine year.”
But Sinai, like the theater league’s Wachtel, is also convinced that American business “would have done even better without tax reform.”
The final verdict, however, isn’t in. Some provisions are being phased in over five years, and the economy takes many years to fully register the effects of tax code changes.
Harvard University economics professor Lawrence H. Summers, for example, still thinks tax reform will reduce the gross national product by 5%, inflation-adjusted, over the next 10 years and will significantly reduce business investments even though that has not been the case so far.
Restaurateurs, too, remain unconvinced that business won’t substantially cut back on business meals once “the fiscal year is over and business can truly gauge the effects of the tax change” on business travel and entertainment expenses, said Ann Papa, a spokeswoman for the National Restaurant Assn. Restaurants had expected to lose $8.9 billion once business meals were no longer fully deductible, but so far “we are hearing that companies are continuing to use meals as a marketing tool,” Papa said.
Overestimated Impact
Some industries need even more time to judge the full impact. Apartment rents, for example, lag changes in the pace of construction by several years.
“We’ll know as much as we’ll ever know by the end of next year,” said Douglas B. Diamond Jr., an economist for the National Assn. of Home Builders. “Right now, it’s clearly a mixed thing.”
Why were economists and tax analysts so wrong about the ramifications of tax reform for business? Some now concede that they overestimated the importance on business investment of the investment tax credit--which was repealed--and longer depreciation schedules.
But, by and large, the doom-sayers’ dire predictions have failed to materialize not because of faulty analysis but because of major changes in economic conditions having nothing to do with tax reform.
The dollar has weakened against both the Japanese yen and the German mark--a boon for U.S. exporters--and the U.S. economy has demonstrated unexpected strength.
“The tremendous devaluation of the dollar this year is something no one could have foreseen,” observed the Conference Board’s Smith. “Even though a lot of tax benefits were gone, manufacturers saw quite a rise in exports because of the lower dollar. That was much more important than tax reform.”
So, too, unexpectedly low mortgage interest rates helped buoy the multifamily housing and commercial construction markets. Conventional financing of such projects was available for about 9% in early 1987, down from 13% in 1984 and 10% in early 1986. (Only recently have interest rates begun rising again.)
Some Surprises
Many tax analysts and businesses also were caught off guard by the liberties taken in the regulations issued by the Treasury Department to implement the new laws.
“There were huge gaps in the law to be filled in by the regulations, but Treasury was given far more power in writing these regulations than they ever had in the past,” said Peggy Duxbury, director of taxation for the National Assn. of Manufacturers.
For example, after the legislation was signed into law last Oct. 22, the IRS regulations repealed a method of business accounting known as “practical capacity.” The change meant lost writeoffs for some manufacturers during unexpectedly soft production times and, according to Duxbury, came as a total surprise.
The change will add $3 billion over five years to government coffers but was “never once discussed through the entire tax reform process,” she said.
Such changes in accounting methods have been particularly difficult for mid-size companies, said Philip Spilberg, an economist with the Peat Marwick Main public accounting firm.
For example, the nation’s 86 metal-mining companies, all mid-size firms, expected tax-rate reductions averaging 13.6%, Spilberg said. What they didn’t count on were changes in accounting methods he estimates will boost their tax tab by 11%.
“This law increased our costs well over $100 million, and that makes it more difficult to do business. But if you want to know the truth, I am far more upset with this ridiculous, complicated mess of compliances we’re stuck with,” said John Loffredo, chief tax counsel for Chrysler Corp. “While we’re sitting around here making accounting changes, our (foreign) competitors are making cars.”
Nor did many companies realize until recently just how complex the new foreign tax credit rules are.
“A lot of companies had to come up with something by Sept. 15, but this international business is so outrageously complex that they just threw up their hands and said, ‘How on earth can we comply?’ ” said Duxbury of the National Assn. of Manufacturers. “I assure you there is going to be increased non-compliance.”
New Minimum Tax
With the top U.S. corporate tax rate now one of the world’s lowest--34% from next year on--many multinationals also have begun reviewing the location of their overseas operations, said J. J. Coneys, international tax partner in the Los Angeles office of Price Waterhouse.
Some companies also have been unpleasantly surprised to learn that they are subject for the first time to a minimum tax. The alternative minimum tax--designed to ensure that all taxpayers will pay a minimum amount of tax no matter how large their tax deductions--has been particularly hard on independent oil producers.
“The Arabs took our profits and the Congress took our incentives,” said C. Paul Hilliard, an independent oil producer in Louisiana. “What kind of tax law is it that penalizes you if you drill too much?”
Under the new law, producers who spend more than 65% of their oil, gas and geothermal income on drilling costs are penalized 25 cents for every dollar over the limit.
“The only way independents can build a company is to replace their reserves, and you can’t replace reserves if you can’t drill,” Hilliard said. “What we’ve got brewing here is a real problem because we’ve all been drilling less all year long knowing that AMT was coming.”
Another surprise for tax analysts came from corporate pension departments. Amid sharp cuts in the maximum contributions to so-called 401(k) company retirement plans, some analysts had predicted that these pension plans would become as unappealing as individual retirement accounts, whose earnings are no longer tax deferred for higher-income taxpayers who are covered by company pension plans.
Instead, 401(k) plans are more popular than ever, said Duane Bollert, manager of the Los Angeles office of the Hewitt Associates consulting firm. That is because many employers have added loan provisions amid complaints from employees that rules on withdrawing money from 401(k) plans are now more stringent than ever.
To compensate for the elimination of the more favorable tax on capital gains, many companies also have begun paying higher-level employees in cash instead of stock options. That trend will accelerate in 1988 because individual tax rates will fall even lower next year.
Even so, “the overall pension changes have not been as dramatic as some people predicted,” he said. “There have not been as many plan design changes as expected.”
Companies are devoting much more effort to rethinking their corporate structures in the aftermath of tax reform, said Andrew Harwood, a Price Waterhouse tax partner.
Individual tax rates, higher than corporate rates until this year, are now lower. So, hundreds of small and mid-size companies have reorganized so they remain corporations but their profits are taxed through their owners as individuals--an arrangement known as an “S” corporation.
Harwood predicts that this trend will accelerate in the wake of the California Legislature’s decision earlier this month to give S corporations the same tax advantages under state law as they have under federal law.
