Avoiding a Fiscal Dunkirk

By Robert S. McIntyre

A gray-haired southern Democratic governor has won the White House, in large part because the public perceived the incumbent Republican president as unable to deal with the economy's problems. An important theme in the race was the Democrat's call for establishing fairness in the federal tax code, which, he said, had been stacked in favor of the wealthy by the Republicans.

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 much better?

Solving the Fiscal Dilemma

When President Clinton takes office in January, he is likely to face a fiscal dilemma similar to what paralyzed the Bush administration in dealing with the recession over the past two years. If the economy remains in the doldrums in 1993, the Clinton administration doubtlessly will want to do something about it. But after twelve years of unprecedented deficit spending in which the national debt has more than doubled as a share of national output, both the Federal Reserve and the capital markets will stand in absolute opposition to 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 increases in the already huge budget deficit would mean rising interest rates--a threat on which the Federal Reserve is equipped to deliver. Even the mention of a simple stimulus program would be likely to 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 Reaganesque borrow-and-spend program might stifle rather than stimulate any economic recovery.

The prevailing thinking is that the only solution is to combine whatever short-term stimulus seems necessary with credible long-term deficit reduction--with both enacted simultaneously. Some of the various spending proposals endorsed by Clinton in the campaign--his $20-billion-a year infrastructure program, full funding of Head Start, expansion of the Women, Infants and Children program, a jobs/training initiative--could help create jobs fairly quickly, alleviate some of the worst economic hardships and help get a meaningful recovery going. And the investment-oriented parts of the plan should, as a bonus, enhance long-term growth.

At the same time, the enacted program must also include measures designed to cut the long-term deficit. Now, it would no doubt be prudent for Clinton to restate as firmly as possible his intent to hold down total future federal spending by paying for all his long-term new initiatives through health care cost control, defense reductions and other prudent and plausible expenditure savings. 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.

In contrast, tax changes, designed both to raise revenues and 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 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 in 1994, seem essential to the credibility of a long-term Clinton deficit reduction plan.

With appropriate revenue measures in place for 1994 and beyond, projected future budget deficits will fall sharply under standard assumptions of economic growth. Such a program will then provide a definitive test of the theory that long-term interest rates are too high because of expected future budget deficits. If the theory is right, long-term interest rates should decline. If long-term rates do not fall sharply on their own, then the administration will be in a position to deliver an ultimatum to the Federal Reserve: namely, "we've done our part; now get busy and do yours."

Restoring Tax Fairness

Next year will offer President Clinton his best and perhaps only chance to enact tax changes that make the wealthiest Americans again pay their fair share in taxes and by so doing, 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 now enjoyed by the richest one percent of the population due to the supply-side tax changes of the late seventies and early eighties. Such a tax hike would reduce the projected budget deficit from about 3 percent of GDP to about 2 percent. Further declines in the deficit would come in later years, because federal debt would no longer be growing faster than the economy.

Our 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 address 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 due more to reduced corporate income taxes than to personal income tax cuts.

Corporate income tax payments have fallen by 40 percent since the seventies as a share of national output, and are down by well over half since the sixties. 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 sixties and seventies (while these nations have reduced their reliance on consumption taxes). Notably, in the mid-sixties, corporate income taxes in the U.S. 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 has made it plain that he wants to be "pro-business." That's good. We all favor 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 workforce, 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 Clinton's Campaign Ideas

If Clinton is to achieve the long-term revenue increase that his economic program depends upon and if he is sincere about avoiding tax hikes on middle- and low-income families (not to mention cutting taxes on the poor and the middle class), then he will have to expand his campaign tax proposals to include closing more corporate and high-income tax loopholes.

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. He says that he can collect $11 billion annually by hiring more IRS agents to investigate foreign-owned companies doing business in the U.S. And he also has proposed getting another billion dollars annually from ending a few narrow corporate tax breaks. These are fine ideas, but they need to be refined and more items must be added to the list.

Increasing the top income tax rate on the wealthy is an excellent idea. But the corporate tax rate should be increased 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 $14 billion a year.

In conjunction with the increase in the top individual tax rate, we also need to worry about 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 lose 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 that the capital gains tax rate go up along with the regular income tax rate. At the same time, we 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. That reform (with special rules for ongoing small businesses and farms) would raise billions of dollars a year.

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 in 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 us. We should negotiate with other nations to replace the current approach with a simpler, formula apportionment system that is much less open 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-plus billion of that amount going to corporations is 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 the current loophole for moving plants overseas is supported vociferously by Hewlett-Packard, that company's CEO nevertheless backed Clinton.)

A more significant step would be to curb the excessive business depreciation write-offs enacted under Reagan to better reflect real wear and tear and obsolescence. We 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 earned in the U.S. by foreigners; closing business real estate loopholes; and changing the way we tax the securities industry.

Resisting New Loopholes

An obvious corollary to the above reform program is that Clinton must resist pressures from interest groups and Congress to reopen early-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 backed, 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 R&D to support foreign manufacturing operations and new loopholes for corporate mergers.

Finance Committee Chairman Lloyd Bentsen's individual retirement account expansion plan, which 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" IRAs. Rather than tax deductions for deposits, these new IRAs would make permanently tax-exempt all 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 several 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 (i.e., 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--which passed only the House in 1992--is particularly dangerous. You cannot reasonably index profits from asset sales unless you also index 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 originally sought by George Bush. 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.

At bottom, 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 be likely to 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, year in and year out. 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 1962-76 experience with the credit by economists Lawrence Summers and Alan Auerbach, for example, 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 a general "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 when it came to investment growth and job creation (but they sharply increased dividends and executive pay, while 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 claimed to be 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. But this alleged virtue is actually a defect. 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. Moreover, who's to say that a business that invests more this year than last is doing the right thing for the economy compared to a business that does the opposite? Why should the second business be punished if it is actually making the right economic decision? For these reasons, 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 be very reluctant to provide them with the potential vehicle to do so.

Conclusion

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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