Out on a Tax Reform Limb, the Economy Stays Strong : On Law’s First Anniversary, Many Forecasts Falling Flat

Remember last year’s predictions of gloom and doom if Congress passed the tax revision bill? Apartment rents would rise 20% as construction ground to a halt. Contributions to charities and colleges would collapse. More generally, the stock market would almost certainly crash, and the economy as a whole would be brought to its knees.

It hasn’t happened.

Like Sherlock Holmes’ dog that didn’t bark in the night, perhaps the most significant result so far of the massive overhaul of the nation’s tax code is how small the effect has been on the economic sectors that figured to be hit the hardest.

And as for the overall economy, it was chugging along a year ago next Thursday, when President Reagan signed the tax overhaul into law. And it is chugging along today.

Analysts will be debating the effect of tax revision for years, but nearly all of them now acknowledge that the widespread forecasts of disaster were wildly overstated.

“Nobody can understand the stock market,” fumed Norman Ture, head of the Institute for Research on the Economics of Taxation, who forecast a sharp plunge in the market after Congress raised the capital gains rate. “The market has been wrong before, and it can be wrong again.”

Even Lawrence H. Summers, a Harvard economist who is one of the strongest critics of the new law, admitted: “The economy is a very big battleship, and tax reform is a relatively small tugboat.”

Dire Predictions

From the moment in May, 1985, when President Reagan presented his own plan for rewriting the nation’s tax law, lawmakers were deluged by costly economic studies contending that any major tax overhaul would bring the economy to its knees and wreak havoc on a wide variety of industries and localities.

Nearly every high-powered interest group in the country hired a big-name consulting firm to marshal an authoritative-sounding case against elimination of its own tax preferences:

- The construction industry was going to lay off 350,000 workers because of a “dose of ‘Jonestown-type cyanide’ ” administered by the tax changes, according to one report.

- Oil firms, already hard hit by low energy prices, would lose another 69,000 jobs if Congress dared tamper with “intangible drilling expenses” and other tax breaks.

- Restaurants would be forced to throw 144,000 low-wage employees into the streets once any curbs were imposed on expense-account meals.

- Charitable giving would plunge by $13 billion because lower tax rates would reduce the value of the deduction for contributions to tax-exempt institutions.

- Worst of all, investors would go on strike in the stock market if the favorable treatment of capital gains were changed in any way that boosted the top tax rate on profit.

Somehow, all of these threatened groups have managed to keep their heads above water.

Most surprisingly, construction jobs are running ahead of a year ago despite the elimination of a host of special tax favors combined with rising interest rates and widespread overbuilding in some regions.

Indexes 35% Higher

The oil industry has begun to climb slowly out of its depression even though Congress trimmed several of its tax breaks.

The restaurant business shows no visible signs of collapse in the face of the requirement that only 80% of business meal expenses can be deducted.

Donations to charities have fallen only a fraction of the predicted $13 billion.

And stock market indexes, despite the boost in the maximum capital gains rate to 28% from 20%, are more than 25% above where they were a year ago, even after the market’s recent decline.

“All of the specific predictions of doom about investment, the stock market and the economy look pretty silly right now,” said economist Joseph Pechman, a longtime tax reform advocate at Washington’s Brookings Institution. “I believe the long-run outcome will be positive, but the truth is that other economic and financial trends are always going to swamp the tax effects.”

And while the initial shock to the economy from tax overhaul registered high on any economic Richter scale, the damage seems to have dissipated quickly.

Last December, for instance, as consumers rushed to buy cars and other big-ticket items before the expiration of the federal income tax deduction for state and local sales taxes, retail sales soared by a seasonally adjusted $6 billion to $127.6 billion. Then they plunged a stunning $9 billion in January--an unprecedented 7.1%--before rebounding sharply again to a more stable level in February.

Similarly, new orders to manufacturers fell a dizzying $10.6 billion in January but then recovered most of the loss in the following month.

Transition Year

The economy rode out the shock waves easily, though, with inflation-adjusted economic activity rising at a 4.4% annual rate in the first quarter of the year and 2.5% in the second quarter after a 1.5% gain in the fourth quarter of 1986.

It is far too early to offer any meaningful evaluations of the much more significant effects that the tax overhaul will ultimately have on the economy. This is a transition year to the new tax system, which will be largely in place by 1988 but not fully set until several years later.

The first major tax change--retroactively effective as of the beginning of 1986--was the elimination of the investment tax credit, which provided businesses with a tax rebate of up to 10% for new plant and equipment spending. But even the demise of the investment tax credit swayed corporate decision making for only a relatively short time.

Despite all the sound and fury, what seems clear is that tax revision actually represents a continuation of a decade-long trend toward reducing governmental interference with market forces.

To many economists, that means the new tax code will help promote economic efficiency by focusing investment decisions away from tax incentives and toward more important underlying considerations.

Martin C. Schwartzberg, president of a Rockville, Md., real estate firm, told a tax planning seminar earlier this year that real estate--which lost more tax advantages than any other industry--was finally going to face many of the same pressures affecting other business sectors. “All of a sudden,” he said, “we are going to have to listen to what the marketplace wants.”

‘Reward Success’

W. Bowman Cutter, a partner at the accounting firm of Coopers & Lybrand, said, “The tax element in decisions will be smaller.” That means, he explained, that “companies’ economic and strategic decisions are going to have to be harder-edged.”

That will end up helping most people, argues Joseph Minarik, a leading tax economist at the Urban Institute, a private research organization in Washington.

“The new tax code is going to reward success and no longer subsidize failure,” Minarik said. “Money will flow more easily to where it can get the highest return. That will be good for the economy.”

Other analysts, however, contend that the tax overhaul was a woefully misguided venture that will slowly crimp business investment and economic growth. It is perverse, they argue, to reduce taxes on already-existing investments by reducing the corporate tax rate to 34% from 46% while at the same time making it less attractive for business to undertake new investments by eliminating the investment tax credit and reducing allowances for depreciation.

“What people don’t seem to realize is that tax reform reduces the tax on old capital but increases the tax on new capital,” argued Harvard economist Summers.

“Let’s say you wanted more engineers. You could raise salaries for everybody or you could offer lots of scholarships for new engineering students. I think the latter approach is better because it gives you more bang for the buck. But that’s the system we have done away with in the name of tax reform.”

Both sides are undoubtedly right to some extent, but it is unclear whether the greater economic efficiency gained from weeding out many business tax incentives will outweigh any losses from reduced incentives for new investments.

And other, more powerful forces are at work as well, including the competitive pressure on business to adapt as rapidly as possible to changes in its economic environment.

John Rutledge and Deborah Oliver of the Claremont Economics Institute in Southern California contend that tax reform is part of a much larger process that has contributed to a dramatic restructuring of American industry in recent years.

“The dramatic changes in both inflation and tax policy in the 1980s have resulted in the destruction of wholesale blocks of American capital in the form of writeoffs, premature obsolescence and plant closings,” they wrote in the latest CEI forecast.

Money Magnet

The implication is that a major reshuffling of the investment deck is forcing business to work much harder to reallocate the limited capital resources at its disposal to the most productive uses.

This has “turned the U.S. into a giant money magnet, as foreign and domestic investors rush to redeploy their capital to capture the higher returns,” the report concluded. “While this has the positive effect of helping to get capital where it is most needed, it also leads to a long-lasting trade deficit and plays havoc with domestic industries both here and abroad.”

With so many complex forces at work, it is no surprise that analysts are capable of coming up with all kinds of justifications for why their original predictions have fared so badly.

For example, Data Resources Inc., the well-known economic forecasting firm in Lexington, Mass., is still waiting for events to prove it right. Last year, DRI, at the request of a dozen major firms, produced a widely publicized report contending that tax revision would sharply undermine business investment. Nigel Gault, an economist with DRI, says recent events do not disprove that conclusion.

“The first-round effects haven’t done serious damage to the economy,” he said, “but that doesn’t mean it won’t have an adverse effect in the long run.”