Tax Cuts Look Certain; Impact Is Another Matter
Whether it’s good will or good sense, the Christmas spirit will continue into the New Year, with tax cuts a virtual certainty in 1995. Ruling Republicans in Congress want to cut the capital gains tax rate and boost tax credits; President Clinton wants to expand tax-deferred contributions to individual retirement accounts and increase other deductions.
The betting in Washington is that any tax measure Clinton signs will include a cut in the capital gains tax, some IRA expansion and faster depreciation allowances so businesses can recover investments more quickly.
It sounds like a feast of political pork. But it’s more than that, says economist John Cogan of Stanford University. “All the current tax proposals--Clinton with IRAs and the Republicans with capital gains--support savings and investment. That represents a shift from soak-the-rich thinking,” says Cogan, who was tapped by incoming Republicans to run the Congressional Budget Office but turned the job down for personal reasons.
Cogan has spotted a trend. The next Congress will not only shift tax policy to reward saving and investment, it will begin a great debate over measures that would profoundly change the tax system--from the consumption tax favored by Sens. Sam Nunn (D-Ga.) and Pete Domenici (R-N.M.) to a “flat tax” proposed by Rep. Dick Armey (R-Tex.).
Meanwhile, Americans are likely to see the capital gains tax reduced from 28% to 15% and further encouragement of tax-deferred savings.
But those breaks will have to be offset by more than $50 billion a year in spending reductions or the federal deficit will balloon. That means spending cuts far deeper than the $12 billion a year Clinton proposed last week, when he revealed plans to trim the Departments of Transportation, Energy and Housing.
Cutting $12 billion a year from a $1.5-trillion budget won’t buy much in the way of tax relief. Only painful cuts in big programs--such as Medicare, farm subsidies, welfare and defense--would allow taxes to be cut without worsening the $170-billion federal debt.
And yet financial markets seem confident that painful choices will be made. Bond investors have reacted calmly--so far--to tax cut talk from both parties. If they sensed that real spending cuts were not forthcoming, interest rates would soar and the dollar would weaken sharply as foreigners concluded that Americans were going to throw a party without paying the bill.
So to test whether tax cut promises are real, watch for serious attempts to curb spending on:
* Medicare, which is expected to fall $57 billion into the red in the next four years
* Farm subsidies, which total about $12 billion a year
* Community Development Block Grants and other welfare and urban expenditures now costing $17 billion a year
* Defense. Decisions are going to have to be made to reduce the armed forces and the $64 billion plus that goes for military pay and maintenance.
If Congress and the White House address tough questions on such big programs, it’s a very good sign for a lesser deficit, lower taxes and a stronger economy.
Yes, but . . . . Tough questions have always been avoided in the past. Why should it be different now?
Because a political shift is evident in the land, based partly on long-term worries about the national debt and Social Security. Former Sens. Paul Tsongas of Massachusetts and Warren Rudman of New Hampshire are drawing sizable audiences of middle-aged and older people to their Concord Coalition meetings--including a recent one at Cal State Northridge--with a stern message of budget and tax reform, including limits on Social Security for future retirees.
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Short-term, there is a simmering tax revolt among the young, many of whom find they’re paying close to 40% of their incomes in combined federal, state and Social Security taxes.
The young people are not mistaken, either, says Lawrence Stone, a former tax adviser to the U.S. Treasury and now a partner in the Los Angeles law firm Irell & Manella.
“They simplified the tax system and cut the rates in 1986,” says Stone of that year’s tax changes. “But since then, rates have crept up and loopholes have crept in again.” He looks suspiciously on special tax breaks, including IRAs. “If they want to encourage saving, why not simply tax consumption?” Stone asks.
The answer is that Congress may take up that very idea in the coming session. The Nunn-Domenici consumption tax will be reintroduced and get a respectful hearing from new House Ways and Means Chairman Bill Archer (R-Tex.), who wants to reform the income tax.
Under the Nunn-Domenici plan, you would add up your gross income, subtract all savings and investments and income from savings, and pay tax on the rest--after deductions for mortgage interest, tuition or whatever is allowed.
Armey’s flat-tax plan would set the income tax rate at 17% and eliminate most deductions, both lowering the rate for many taxpayers and broadening the base of revenue collection.
The intent behind both would be to encourage saving and investment, to provide ample capital for U.S. industry and to spur the American people to save seriously for retirement in a time when Social Security benefits alone will be inadequate.
There’s no magic in either tax idea. Loopholes can always creep in. And if Congress tries to cut taxes without cutting government spending, as it did in 1981, you’ll see interest rates go through the roof and the dollar fall through the floor. Worry then about recession.
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But if the capital gains rate and the budget deficit can be cut together, watch houses move on real estate markets and stocks and bonds gain smartly on financial markets. “A 15% capital gains rate would add 15% to the stock market,” says one market watcher.
So 1995 may provide a simple test: whether tax cuts take the U.S. fiscal system down the road to ruin or the Dow Jones industrial average to 4,300. The answer will depend on political will.
