Avoiding a Fiscal Dunkirk

Agray-haired southern Democratic governor has won

the White House, in large part because the public concluded the incumbent

Republican president could not revive a sluggish economy. An important theme in

the race was the Democrat's call for establishing fairness in the federal tax

code, which, he said, the Republicans had stacked in favor of the wealthy.

Now suppose that once inaugurated, the new Democratic president quickly

proposes a middle-class tax cut. It fails to gain congressional or popular

support, however, and is dropped. The president then puts forth his plan for

tax reform, a confusing collection of limited loophole-closing measures, on the

one hand, and corporate tax breaks and rate cuts, on the other. Pressured by

interest groups, Congress finds the latter part of the plan much more

attractive. Ultimately, the president signs a tax bill that cuts corporate

taxes and slashes capital gains taxes on the rich. By the end of his term, the

deficit is growing and the economy is staggering. An unhappy public

overwhelmingly rejects his bid for reelection and ironically hands the White

House to a right-wing Republican explicitly committed to "trickle-down"

economics.

This, of course, is the Jimmy Carter story. But will it be the Bill Clinton

story too? Or can Clinton do better?


FOLLOW THE MONEY

When President Clinton takes office in January, he is likely to face a fiscal

dilemma similar to what paralyzed the Bush administration over the past two

years. With unemployment still high after the prolonged recession, Clinton

probably will want to prime the pump. But after twelve years of unprecedented

deficit spending in which the national debt has more than doubled as a share of

national output, neither the Federal Reserve nor the capital markets will stand

for a simple, old-fashioned economic stimulus program.

Tax cuts or spending increases on their own seem almost out of the question.

The Federal Reserve will warn that more deficit would mean higher interest

rates--a threat on which the Fed is equipped to deliver. Even the mention of a

simple stimulus program could provoke a sharp sell-off of the dollar, in

anticipation of the trade deficits that more rapid, demand-driven growth would

produce. Domestic stock and bond markets could collapse if interest rates rise.

Thus a new borrow-and-spend program might stifle rather than stimulate any

economic recovery.

Prevailing thinking has it that the only solution is to combine short-term

stimulus with credible long-term deficit reduction--and to enact both

simultaneously. But promises of future spending restraint cannot, in general, be

etched into stone. A Congress cannot, despite its best efforts, fully bind a

future Congress on spending. So given Clinton's commitment to increased public

investment, how can he make long-term deficit reduction credible? The answer

lies in the tax code.

Tax changes, designed both to raise revenues and to restore progressivity to

the federal tax system,

can be enacted on a credibly permanent basis. Once put into place, tax

increases do not have to be annually reenacted. Attempts by a future Congress to

repeal enacted tax hikes in response to interest group pressures can be

defeated, if need be, by a veto that takes only a third of the House or Senate

to sustain. And despite the complaints of Washington business lobbies, polls

show that progressive tax changes are extremely popular with the public. Thus

progressive tax increases, effective starting in 1994, are essential to

believable long-term deficit reduction in the Clinton economic package.



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RESTORING TAX FAIRNESS

In 1994, President Clinton will have his best--and perhaps his only--chance to

enact tax changes that make the wealthiest Americans again pay their fair share

in taxes. By so doing, he can also drive down future deficits, raise the

national savings rate, and help to promote lower long-term interest rates.

Revenue increases on the order of $70 billion a year beginning in 1994, or

about one percent of the gross domestic product, should be the goal of the

initial Clinton package. Not coincidentally, that $70 billion is about the size

of the annual tax cut the richest one percent of the population now enjoy,

thanks to the supply-side tax changes of the late 1970s and early 1980s. Such a

tax hike would reduce the projected budget deficit from about 3 percent of GDP

to about 2 percent. Moreover, the deficit would continue to decline in later

years, because federal debt would no longer be growing faster than the economy.

The nation's extended experiment with supply-side economics should establish

for all time the futility of tax policies that purport to help the economy by

helping the rich. Clinton has rightfully decried that trickle-down approach and

has pledged to reverse it. He has virtually ruled out tax increases on the

middle class and the poor, including the big gasoline tax hike that some of his

political opponents called for. But to achieve his goals of tax fairness and

deficit reduction, Clinton will need to reverse not only the decline in personal

income taxes on rich people but also the drop in corporate income taxes.

It's well known that the wealthy did well under Reaganomics. In fact, the

richest one percent of the population now pays 29 percent less in total federal

taxes than this group would pay had the tax code remained as progressive as it

was in 1977 (the year before the first supply-side tax bill, the 1978 capital

gains tax reduction, was enacted). What's sometimes not grasped, however, is

that this windfall for the rich was more a product of reduced corporate income

taxes than personal income tax cuts.

Since the 1970s, corporate income tax payments as a share of national output

have fallen by 40 percent. They are down by well over half since the 1960s. This

is no worldwide phenomenon. In fact, in other OECD countries, corporate taxes

are up by 60 percent as a share of GDP since the 1960s and 1970s (while

these nations have reduced their reliance on consumption taxes). Notably, in the

mid-1960s, corporate income taxes in the United States and Japan were almost the

same--each about 4 percent of GDP. Since then, Japanese corporate taxes have

almost doubled--to 7.5 percent of GDP--while U.S. corporate taxes have fallen to

about 2 percent of GDP.

Clinton says he wants to be "pro-business." That's good. Everybody

favors a growing economy. But the Reagan and Bush administrations' subservience

to organized corporate lobbies produced tax and fiscal policies that were

neither fair nor economically sensible. A truly pro-business policy would have

the government do its job--build the infrastructure, educate the work force, and

so forth (as Clinton wants to do)--without sapping the nation's savings to pay

for it, and let business do what it's supposed to do--invest and innovate in

response to market demands. This implies even-handed, economically neutral tax

policies that let the marketplace determine investment decisions and that

require everyone, including profitable businesses and successful investors, to

pay their fair share.


BUILDING ON CAMPAIGN IDEAS

So far, Clinton's program for restoring tax fairness includes about $20 billion

a year from increasing the top personal tax rate to 36 percent, raising the

alternative minimum tax rate on high-income people, and putting a surtax on

millionaires. In addition, Clinton says he can collect $11 billion annually by

hiring more IRS agents to investigate foreign-owned companies doing business in

the United States. And he also has proposed getting another billion dollars

annually from ending a few narrow corporate tax breaks. These are fine ideas,

but they cannot do the job alone.

Corporate Taxes. Increasing the top income tax rate on the wealthy is a

good start. But Clinton should increase the corporate tax rate as well. Applying

the same 36 percent top rate to corporate earnings, along with a 10 percent

surtax on companies with taxable income greater than $1 million, would cut the

deficit by an additional $14 billion a year.

Capital Gains Taxes. Current law provides a maximum capital gains rate

of 28 percent--3 points lower than the top rate on other income. If that 28

percent maximum is maintained with a 36 percent top rate on other income, then

top earners will enjoy what amounts to a 22 percent exemption for their capital

gains. This would not only forfeit substantial revenues directly, it would also

encourage the proliferation of wasteful tax shelters designed to convert

ordinary taxable income into capital gains. Thus it's important to raise the

capital gains tax rate along with the regular income tax rate. At the same time,

the program should eliminate a loophole in current law that totally forgives

capital gains taxes on inherited assets--and thereby encourages some people to

hold onto assets indefinitely (with special rules for ongoing small businesses

and farms). That reform would raise billions of dollars each year.

Closing Loopholes. Under present law, an alternative minimum tax limits

the ability of wealthy taxpayers to pile up loopholes. Increasing the

alternative minimum tax rate on otherwise low-tax, high-income people is an

essential adjunct to raising the regular income tax rate. But the corporate

minimum tax rate also should be raised, and even more important, the minimum tax

base should be significantly expanded. Reforms could include eliminating

deductions for interest payments to foreign lenders in tax havens, mortgage

interest on second homes and on more than $250,000 of debt, and "company

cars" (with minor exceptions). Executive fringe benefits should be subject

to the minimum tax, and exceptions to the "at risk" anti-tax-shelter

rules should be eliminated. The revenue potential from these kinds of minimum

tax reforms and rate increases is enormous, offering as much as $15 billion a

year in deficit reduction.

Raising $11 billion a year in the international area is certainly possible, but

it will take structural changes in the way we tax multinational

corporations--change that will affect American-owned as well as foreign-owned

multinationals. In the 1960s, the United States led the rest of the developed

world into adopting the current "transfer pricing" system for

allocating multinational corporate taxable earnings among various countries.

That system has failed. The United States should negotiate with other nations to

replace the current approach with a simpler, formula apportionment system that

is less prone to abuse.

There is no shortage of additional potential deficit-reducing tax reforms. In

fact, despite the 1986 Tax Reform Act, business and investment tax breaks are

expected to cost the Treasury more than $600 billion over the next five years.

The $300+ billion of that amount going to corporations equals half of total

projected 1993-97 corporate income tax payments. One good, but not greatly

lucrative change already endorsed by Clinton would end tax breaks for "runaway

plants." (Interestingly, although Hewlett-Packard vociferously supports the

current loophole for moving plants overseas, that company's CEO nevertheless

endorsed Clinton.)

A more significant step would be to curb the excessive business depreciation

write-offs enacted under Reagan to better reflect real equipment wear and tear

and obsolescence. The new administration could start with a Treasury Department

study on what the economically correct depreciation rates ought to be--with a

particular focus on heavily leveraged equipment leasing deals. Conceivably, some

businesses might even get bigger deductions, but overall, depreciation reform

could raise huge sums.

Other potential reforms include: ending tax breaks for mergers and

acquisitions; further limiting business meals and entertainment deductions;

curbing oil and gas loopholes; restoring the Reagan-repealed tax on interest

foreigners earn in the United States; closing business real estate loopholes;

and changing the way we tax the securities industry.


RESISTING NEW LOOPHOLES

An obvious corollary to this tax reform program is that Clinton must resist

pressures from interest groups and Congress to restore Reagan-style business and

investment loopholes as supposed "growth incentives."

Congress's pent-up demand for new loopholes is reflected in the two tax bills

vetoed by Bush in 1992. Among the proposals passed by Congress (and generally

supported, although vetoed, by Bush) that are sure to resurface in 1993 are

restored tax-shelter write-offs for real-estate developers, weakening of the

minimum tax on otherwise tax-avoiding corporations and rich people, tax breaks

for multinational companies that use American research and development to

support foreign manufacturing operations, and new loopholes for corporate

mergers.

Then-Senator Lloyd Bentsen's individual retirement account expansion plan,

which the full Congress passed in October, also is likely to reemerge. This

deficit time bomb would not only increase the income limits on deductible IRAs

to $100,000 but would also establish a new type of "back-loaded" IRA.

Rather than offer tax deductions for deposits, these new IRAs would make

permanently tax-exempt all interest, dividends, and other income earned in the

special accounts (after a five-year waiting period)--at an annual cost of $10

billion or more in the future.

Congress may also push for one or more of the Bush-inspired capital gains tax

cut plans it toyed with in 1992. For example, the Senate passed a measure to cut

the capital gains tax rate to zero on profits from selling stock in new

small-business investments. This plan is explicitly supposed to encourage

investments that are considered particularly fraught with danger. The underlying

premise--that we want the wealthy to invest in projects that otherwise make the

very least business sense--is hard to fathom. Moreover, supposedly

narrow tax breaks like this almost always tend to expand, either because sharp

tax advisors figure ways around the limits or because of special-interest

lobbying pressures.

Proponents of this and other proposals to focus capital gains breaks on

supposedly "long-term" investments (ones held for five years or more)

ignore the fact that most capital gains already stem from sales of assets held

for more than five years; the average holding period is seven years. Investors

could easily manage their portfolios to get the maximum tax breaks with little

real change in behavior.

Indexing capital gains for inflation--a proposal that passed only the House in

1992--is particularly dangerous. The government cannot reasonably index profits

from asset sales unless it also indexes borrowing costs. On its own, indexing

gains would be the equivalent of at least a 30 percent tax exemption for the

wealthy's capital gains, making it as costly as the capital gains tax cut Bush

originally sought. In fact, when fully phased in, indexing would make a mockery

of Clinton's proposed increase in the top tax rate on the affluent. And,

paradoxically, indexing would offer its largest benefits to profits from

short-term investments.

Ultimately, any cut in the capital gains tax would subvert Clinton's

tax fairness agenda and encourage the tax shelters that sapped the economy in

the past. And no matter how narrowly "targeted" a Clinton capital

gains proposal might be, it would likely open the door to a congressional

bidding war reminiscent of the 1981 Reagan tax bill debacle.


INEFFICIENT INCENTIVES

In the first half of the 1980s, the combination of excessive depreciation

write-offs and the investment tax credit allowed many of America's most

profitable corporations to escape all or almost all their tax liability. Wildly

varying, even "negative" effective tax rates encouraged businesses to

make unsound investments at the expense of more useful, market-driven ones. For

the first reason, if not the second, some corporate lobbies are now pushing very

hard for restoration of the investment tax credit--which was repealed in 1986.

But the history of the investment tax credit, which was on the books (with a few

interruptions) from 1962 until 1986, shows that this would be a terrible

mistake.

A 1978 analysis of the 1962-1976 experience with the credit by economists

Lawrence Summers and Alan Auerbach, for example, showed that the impact was

almost totally negative. They found that the credit didn't increase the total

amount of business investment but instead changed the composition and timing of

investments--away from what the marketplace otherwise would have demanded. Over

that period, they concluded, the investment credit led to economic distortions,

higher interest rates, more than half a million fewer housing units, fewer jobs,

heightened inflation, and an "undesirable effect on the economy."

Since then, it should be noted, Summers (but not Auerbach) has changed his mind.

Indeed, Summers coauthored a recent, controversial study claiming that equipment

investment is the key to productivity growth and that an investment credit could

be an effective way to stimulate it.

But when Congress repealed the investment tax credit in 1986, it offered a

strong refutation of the (current) Summers view. "As the world economies

become increasingly competitive, it is most important that investment in our

capital stock be determined by market forces rather than by tax considerations,"

said the official explanation of the 1986 Tax Reform Act. The Ways and Means

Committee report on the 1986 tax bill focused on the failure of the various tax

breaks to deliver as promised: "Proponents of massive tax benefits for

depreciable property have theorized that these benefits would stimulate

investment in such property, which in turn would pull the entire economy into

more rapid growth. The committee perceives that nothing of this kind has

happened."

In fact, during the heyday of corporate loopholes from 1981 to 1986, total real

business investment grew by only 1.9 percent a year, and far too much of that

investment went into excessive, tax-motivated commercial office

construction--leading to the see-through office buildings phenomenon all across

the nation. Despite what amounted to "negative" tax rates on equipment

investments, investment in industrial factories and equipment actually fell

over that period. Companies that got the biggest corporate tax breaks actually

had the poorest record in investment growth and job creation (but they sharply

increased dividends and executive pay, and corporate merger activities boomed).

In contrast, after many of the loopholes--including the investment credit--were

closed in 1986, money flowed out of tax shelters, and business investment

rebounded. Led by a resurgence in industrial investment, real business capital

spending grew by 2.7 percent a year from 1986 to 1989--42 percent faster than

the 1981-86 growth rate. In other words, tax reform worked exactly as

advertised.

Nevertheless, proposals to restore an investment tax credit continue to

surface. One approach is purportedly more sophisticated than past efforts

because it would allow the credit only on an "incremental" basis. In

other words, unless a business invests more than it used to--in nominal dollars

or as a percentage of sales or whatever measure is used--it won't get any tax

break. In theory, such a targeted, incremental investment tax credit could be

designed to cost only about $5 billion a year. It could also be scheduled to

phase out after a few years, to provide businesses with an incentive to

front-load their investment spending. Potentially, this might add to economic

growth in the early stages of recovery, while not increasing the budget deficit

later on.

A supposed economic advantage of an incremental credit is that it wouldn't

reward investments that would have been undertaken anyway. In fact, this is

dubious. But clearly, an incremental investment credit will be largest in years

of strong economic growth--when it is least appropriate--and smallest in

recession years, when it is supposed to be helpful. That is one reason why

proposals for an incremental credit have been considered and rejected in the

past.

The apparent political advantage of an incremental investment tax credit is

that it looks bigger than it is for what it costs. For example, if a 10 percent

credit applies only to investment spending greater than the average for the

previous three years, then the credit for a company that invests 5 percent more

than its three-prior-years base is the same amount as a 0.5 percent credit on

its total investment.

But whether an investment credit could actually be contained, either in size or

duration, is open to serious question. When John F. Kennedy proposed the

original investment tax credit back in 1962, it was supposed to be a relatively

small, temporary, two-year stimulus. Instead, it was beefed up in 1964,

temporarily suspended in late 1966, brought back in early 1967, repealed in

1969, reenacted in 1971, increased in 1975 and 1978, expanded again in 1981, and

then reduced somewhat in 1982. Only in 1986, almost a quarter-century after it

was "temporarily" established, was the credit finally repealed on a

sustained basis. At that point, the Treasury was borrowing some $40 billion a

year to pay for the credit--equal to almost two-thirds of all corporate income

taxes actually collected.

Already, Washington business lobbies are gearing up to expand any limited

investment tax credit proposal to a credit as large, as costly, and as

economically harmful as the old one. Clinton should resist.

If Bill Clinton hopes to be a pro-growth president,

then cutting the long-term budget deficit--and thereby lowering long-term

interest rates--will be essential. Ironically, to be truly "pro-business,"

he must steadfastly resist interest group (and congressional) pressures to

restore costly, discredited corporate and investment tax breaks that would

preclude serious deficit reduction and sabotage tax fairness. Indeed, unless

Clinton is prepared to abandon his pledge not to raise middle-class taxes, a
major program of closing loopholes seems virtually the only avenue open
to him to achieve a credible economic program and a successful term in office.



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