Searching for the Bottom Line

By John S. DeMott

Reactions to the tax bill range from delight to horror

"Something of a minor miracle," said Michael Evans, a Washington, D.C., economist. "Fiscal graffiti" and "a huge disaster" were the capsule descriptions offered by Economist Joseph Pechman of the Brookings Institution. Both men were referring to congressional approval last week of the Reagan-endorsed tax bill. Reaction to the program ranged from sheer delight to unspeakable horror; business leaders were generally pleased, while angry labor chieftains charged that the program was a giveaway to the rich.

Compromised though it was by last-minute sweeteners designed to secure the votes of key Congressmen, the tax bill was essential to the Administration's radical experiment in Reaganomics. The key question, of course, was whether it would work. Will it, as the Administration hopes, create more jobs, increase productivity and incentive, reduce inflation and make American industry more competitive in world markets? Or will it, as critics charge, only make inflation worse, balloon the budget deficits, keep interest rates high, make the rich richer and hurt the poor? No one knows for sure, no more than anyone knew whether the equally controversial big spending, big deficit schemes of Franklin Roosevelt's New Deal would work when they were proposed in an earlier time of radical change. Some major provisions of the tax bill:

The 25% Individual Tax Cut. This, the centerpiece of the program, will start showing up in the paychecks of 98 million working Americans after Oct. 1, when federal withholding taxes will be reduced by 5%; this will be followed by two more cuts of 10% each in July 1982 and July 1983. The initial 5% cut will amount to only a few dollars for most individuals, but it will cost the Federal Treasury $25 billion during the first year. As further cuts kick in, the cost will rise to about $104 billion by 1984.

Will that money go toward a massive national spending spree, driving up inflation as too many dollars chase too few goods? Or will it go toward saving and investment? The Administration is betting that, given the certainty of three years of tax cuts, people will put away more than the 4.7% of earnings they now save. An increase of only 1% in the savings rate from U.S. personal income of $2.1 trillion would provide $21 billion in extra money for new plants and equipment, increase industrial output and jobs, making the economy grow.

But some critics have grave doubts that that will occur. One of them is Brookings' Pechman, who says that the cut, together with all the other goodies tossed into the package, will only increase the federal budget deficit without contributing to increased productivity. Says Pechman: "The zeal to cut taxes is so great that they [Congressmen] don't pay attention to the deficits." Among businessmen there seems to be a consensus that the first small returns from the cut will be spent and not saved: they will, after all, appear in paychecks some time before Christmas, and some retailers are already preparing "tax cut special sales."

The poor, claim Pechman and others, will be hurt since their benefits from the tax cut may be more than offset by cutbacks in funding for social programs that are incorporated in the budget portion of Reagan's agenda. Last week the Joint Committee on Taxation noted that about 35% of the total dollars in tax cuts will go to 5.6% of the people, those making $50,000 or more a year, while 31.7 million taxpayers earning $15,000 or less will get only 8.5% of the 1982 cut. The Administration's reply is that only those who earn $50,000 or more save enough to affect investments.

Rich or poor, most Americans will not find themselves much further ahead if those income tax cuts are offset by scheduled rises in Social Security taxes and the inflationary creep of wages to higher tax brackets. That is the view of Lacy Hunt, economist for the Fidelity Bank of Philadelphia, who calculates that such raises will total 21% during the next three years, all but wiping out the 25% cut (which would, however, save wage earners from being that much further behind).

Indexing. Slipped into the package during the last few days of debate, this would guard against "bracket creep" by indexing taxes to changes in the Consumer Price Index. For example, a person earning $20,000 who received a 10% raise at a time of 10% inflation would pay no extra tax. It would not become effective until 1985, when the 25% cut will have run its course.

In that year indexing will cost the Government an estimated $8.6 billion in revenues, jumping to $22.7 billion in 1986. There are those who fear that, for all its seeming virtues in protecting taxpayers' real levels of income, indexing would build even more inflation into the economy and dull the resolve to fight it.

Unearned Income. While the tax rates now vary from 14% to 50% on earned income, the rate on unearned income (stocks, bonds, real estate sales) goes up to 70%.

The bill would reduce that top rate to 50% on Jan. 1.

Along with that will go a reduction in the capital-gains tax on profits from the sale of stock or other property: the maximum tax, currently 28%, will go down to 20%. Late in the week, House-Senate conferees dropped a provision that would have decreased from a year to six months the time an asset must be held before qualifying for long-term capital gains treatment. That could have encouraged investment in common stocks at a time when high interest rates are luring money from the stock market.

Reduction of the "Marriage Penalty."

Under the current system, husbands and wives who both earn paychecks pay more taxes than if they were single people living together. Moreover, the first dollar of income for a wife who earns, say, $10,000, is taxed at the same high rate as the last dollar of her husband, who, for example, may earn $25,000. The Reagan package would allow a couple to deduct 5% of the smaller income up to $1,500; in 1983 the deduction rises to 10% or $3,000, whichever is less. Even Pechman favors this change. People should not be penalized by the Government, says he, "just for getting married." Cost to the Treasury by 1986: $8.7 billion. Administration officials argue that the price is worth it, since reduction of the marriage-tax penalty should encourage more nonworking spouses to enter the job market. Says a Treasury official: "The idea is that you get not more savings but more work effort."

Exemption from Estate and Gift Taxes.

Inheritance taxes would not come into play until the value of an estate rose to $600,000, vs. $175,625 now. To be phased in over six years, the provision was designed to prevent the disappearance of family-owned businesses and small farms, which often must be sold to pay inheritance taxes. Critics, however, charge that this provision will mainly benefit the wealthy. By 1987 only three-tenths of 1% of estates will be taxed, vs. 2.8% now. Gifts from parents to children or between spouses will be tax-exempt up to $10,000 annually, vs. $3,000 now, a long overdue correction for inflation. The $3,000 limit was set 40 years ago.

Savings Incentives. The bill attempts to get at a built-in bias in the Internal Revenue Code that exempts every penny of interest paid, as for a home mortgage, but taxes interest earned, as on a savings account, above $400 for a married couple. But the way the bill goes about ending this bias has met with wide disapproval. The bill authorizes the so-called All Savers Certificate, which will exempt the first $2,000 of interest (for a joint return) from federal tax. The one-year certificates will be issued for 15 months, starting Sept. 30, and 75% of the money from them must be invested by the issuing institutions in housing or agricultural loans. That will deflect savings out of stocks and municipal bonds, force up other interest rates and not actually increase the total amount of savings. What All Savers amounts to is a bailout of the nation's troubled savings and loan associations, and a costly one to the Treasury: $500 million in 1982, $2.8 billion in 1983. The certificates will be succeeded in 1985 by an exemption of up to $450 of interest income for single taxpayers, $900 for married people.

Business Tax Relief. The package allows for faster depreciation of investments by businesses: plants can be written off in ten years, equipment in five years and vehicles in three years. This "10-5-3" formula, strongly favored by corporations and their lobbyists, should theoretically encourage businesses to invest in new factories and replace obsolescent equipment. Some critics, however, worry lest companies use some of their tax savings for other purposes--to reward stockholders with higher dividends, say, or buy up other businesses in the current urge to merge. But Ted Eck, chief economist for Standard Oil Co. (Indiana), does not agree that business gets a windfall from the new allowances. Says he: "There are lots of goodies in there for small business. Big business wins some and loses some. The new depreciation formula looks good, but what we get back is not all that different from what we are getting now."

Windfall-Profits Tax Exemption. The bill chips away the Carter Administration's windfall-profits tax on oil producers, increasing the exemption from $1,000 to $2,500 for oil royalties in 1981, then to the profits from 2 bbl. of oil daily in 1982, then 3 bbl. in 1985 and thereafter. The tax on newly discovered oil will also drop, from 30% to 15% in 1986. Small independent oil producers who get crude from low-yield "stripper wells" will be exempted altogether in 1983. Despite Democratic protests that the provision is a giveaway to big oil, it benefits wildcatters far more than giants such as Exxon and Mobil. Treasury Secretary Donald Regan is probably right when he argues that the exemptions will help produce "whatever crude we can in this country."

The Administration has not yet spelled out the anticipated impact of all parts of its tax package. But in its July midyear economic review, it forecast an increase in real economic growth after discounting for inflation of 5% in 1983, vs. an expected 2.6% this year. Inflation too should come down, from a 9.9% rate through December to 7% next year, dropping to around 4% by 1986. Interest rates should go down from 13.6% now on 91-day Treasury bills to 5.5% in 1986. At the same time, contends the Administration, the federal budget deficit should almost disappear as rising productivity and increased employment combine to increase federal revenues and wipe out the loss to the Treasury from the tax cuts. By 1984, according to this rosy projection, the deficit should have shrunk from around $55 billion next year to a minuscule $2.2 billion--though even that could vanish with further refinements in the tax package.

Liberal economists are convinced that none of these things will happen, especially with such items on the Reagan agenda as vastly increased defense spending. Besides, they add, whatever good might have been done by a "clean" tax bill--one that allowed only the personal cuts and relatively modest breaks for business--has been muddied beyond salvation by all the other goodies stuffed in to win congressional support. In short, the bottom line is largely unknown, as Reaganomics faces its first test in the world's largest industrial democracy. --By John S. DeMott. Reported by Gisela Bolte and Gary Lee/Washington

With reporting by Gisela Bolte, Gary Lee

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