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"
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
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.
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
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
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
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
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.
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
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
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
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
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
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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