Kicking the Tax Loophole Habit

The real but unheralded story in the new budget proposal and President Bush’s economic plan accompanying it is the number of small tax increases peppered throughout.

That’s right, tax increases. In his State of the Union message Tuesday night, Bush talked about reductions in tax withholding and in capital gains taxes, along with tax benefits for real estate developers, home buyers, students and families with children.

But the actual budget, released Wednesday, contains small tax adjustments everywhere--mostly technical items affecting the way securities dealers value stocks and bonds or corporations treat insurance policy loans.

From such small hikes the Bush Administration hopes to help offset the revenue loss to the government from all the promised tax cuts, and so head off congressional demands for a new higher tax bracket for upper-income individuals--perhaps 35% for taxpayers with incomes over $100,000.

The situation reveals the frustrations of today’s economy and the consequences of past government policies. Whatever intelligent plans for long-term growth the President and Congress may have, the immediate reality is that they must deal with an economy paralyzed by past indulgence in tax shelters.

And the danger is that those tax abuses will return--along with multiplying tax brackets--for incomes in the $60,000 range and the $40,000 range, the way it used to be before the 1986 Tax Reform Act lowered tax rates, to 28% and 15%, on wage earners while collecting more taxes from those who had been sheltering income in real estate and oil drilling schemes.

Before it vanishes, it’s worth remembering that the 1986 tax reform was meant to benefit the middle class by equalizing the tax burden on wage earners and those with business and investment income.

Now, for good or ill, new brackets may be inevitable because the President’s new tax proposals are bringing back the loopholes, and putting politics and social policy back into the tax system.

“Economically, there’s nothing dramatic in the new budget,” says economist Barry Bosworth of Brookings Institution. “But politically it will inspire a big argument over equity.”

Making social policy may sound swell when worthy causes are involved----tax deductibility for interest on student loans for college or post-high school vocational school, for example. Everybody likes education, after all--although whether pushing student loans is the way to improve it is arguable.

But real estate developers, who would get to deduct losses that were disallowed in 1986, come in for perhaps the most significant benefits, politically and economically, in the President’s new program. And thereby hangs a cautionary tale.

In the old days, real estate was so favored by tax benefits that we ended up with too much of it--now a 12-year oversupply, according to David Shulman, head of real estate research for Salomon Bros. investment firm.

But when the economy tried to kick the habit and cut off those benefits in 1986, it started the long collapse of commercial real estate--and savings and loans, banks and insurance companies--that has caused today’s widespread recession. “It’s not only developers, but the whole financial system that is taking losses on real estate and therefore is unable to lend to small business,” says economist Murray Weidenbaum of Washington University in St. Louis.

So developers must get emergency aid in order to unlock the paralysis of the financial system and get the economy moving again. The economy is rather like a patient who has been too abruptly taken off life-support and must go back on.

But the restoration of tax benefits will be highly selective so as not to completely break the budget--which will have a deficit in fiscal 1993 of $352 billion, and much more than that in reality. The Administration is narrowly focusing the tax benefit on active developers and not opening the floodgates to tax shelter investors.

Similarly, to give a boost to residential real estate, there are narrowly focused tax credits for first-time home buyers, and deductibility of losses for folks who would like to sell their home. “That could be enough to get the real estate system moving,” says accountant David Eisner, head of West Coast real estate for Price Waterhouse.

As the tax increases are limited, so are the tax deductions. It’s as though the Administration, and Congress too, wants to keep the tax neutrality of the 1986 act--not to bring back the abuses of tax shelters while remedying problems those shelters left behind.

The President’s long-term measures for the economy don’t favor any particular group. Capital gains tax relief is open to stocks, bonds or real estate without favoring any one investment. The one-year depreciation allowance for investments in equipment is open to all industry--but specifically excludes real estate. And the research and development tax credit is open to all business.

One economist sums up the new budget package by calling it a “down payment on a long-term growth plan.” What it is as well is evidence of how, in politics and economics, we bob and weave and muddle through.