Some Firms See Benefits, Others Don’t : Service Sector Faces Uncertain Tax Fate

WASHINGTON —  Hulking industrial capitals like Cleveland and Detroit may be mourning the Reagan Administration’s tax proposal, with its slashed credits for investment in factories, machinery and such. Scottsville, Ky., thinks it is just fine, thank you.

Scottsville is home of Dollar General Corp., a 23-state discount retailer that has good reason to hope Congress enacts the President’s reforms.

Dollar General leases its stores instead of buying them and outfits each outlet in Spartan style, so the loss of investment and depreciation breaks under the plan matters little. And, because the company pays close to the maximum corporate income-tax rate of 46%, Reagan’s plan to lower the corporate tax ceiling to 33% would produce a bonanza.

As if that were not enough, the company even stands to gain from Reagan’s intent to funnel individual income-tax savings to the poor.

“Low- and middle-income families--that’s our targeted customer,” said Edward Burke, Dollar General’s vice president for finance. “The taxpayer we deal with would come out better. To that extent, the plan would presumably benefit us.”

At first blush, what’s good for Dollar General would seem good for the rest of the nation’s service sector, that agglomeration of merchants, real estate brokers, bankers and others who sell things but do not generally make them. And, because the service sector employs seven of every 10 Americans and generates more than half of the country’s economic output, that should make the Reagan reforms a boon to most Americans.

If the Reagan package is approved by Congress, that may or may not prove true over the long haul. And the answer, economists and tax experts agree, is not as clear as it seems--not for Dollar General and not for other service companies.

“This plan is so incredibly complex that it’s very, very hard to reach any conclusions,” said Robert G. Dederick, undersecretary of commerce for economic affairs during Reagan’s first term and now chief economist for Chicago’s Northern Trust Corp.

“You think you’ve thought of 18 provisions that’ll help you, but then you find a 19th that offsets everything else.”

In this, the service sector is like the economy as a whole. The multifaceted tax package would leave the broad economic landscape largely intact, but it would work countless small changes in nooks and crannies all over the economy, breeding opportunities for some and erecting barriers for others.

Many service companies could expect the Administration’s much-touted tax reforms and simplifications to sprout a forbidding thicket of financial brambles and legal thorns.

Banks, for example, could no longer take an age-old tax break on losses they have not incurred. But they would be taxed on profits they have not made.

Similarly, in real estate, the changes would probably lower the price of homes and give potential buyers more money. At the same time, they would lessen tax incentives to build houses--and to own them.

For both banking and real estate as well as some lesser service businesses such as professional sports and high-priced restaurants, the changes would probably mean higher taxes or smaller profits, or both.

A Secondary Effect

But for many others, the effect of the changes cannot be clearly estimated. If Dollar General and most other retailers will not be hurt by the Reagan plan’s cuts in real estate depreciation rates, for example, economists say they could still be hit by a secondary effect of the reforms--a sharp rise in rental rates for store buildings.

On the other hand, while forecasts are chancy, one economist predicts that retailers--who enjoy perhaps the sunniest tax climate under the reform plan--might see sales jump an extra $40 billion by fiscal 1987. The figure seems staggering, but it is less than 3% of the $1.5-trillion retailing gross in 1984.

Most experts agree that enactment of the Reagan tax plan would not produce any sweeping changes in either the profitability or the structure of most service businesses.

Housing starts--and, indirectly, some real estate sales--would plummet by up to 150,000 units in the first two years after the changes were enacted, and then recover slowly, predicts Data Resources Inc., a Lexington, Mass., forecasting firm. But “while that sounds bad, in the recession of 1981 we lost a lot more than that,” said Scott Hazelton, a research economist with the firm.

Bankers “will probably pay a lot more taxes if a (tax) bill is passed,” said Chuck Wheeler, tax counsel for the American Bankers Assn. “But I’m not sure our profitability would be all that different.

“The biggest concern we have is whether the basic reform is going to stimulate the economy. If it does, then banks are going to benefit, because banks always do well in a healthy economic climate.”

In that, Wheeler echoes the views of most other experts, but this is not to say the tax plan would change nothing. If the basic profitability of most industries would be little altered, the ways in which money is invested--and taxes are incurred--would change, in some cases substantially.

The so-called reforms that would trigger such shifts are largely arcane and obscure revisions in the current tax code. But in a few cases, their effects could loom large.

Businesses across the entire services spectrum could be affected--adversely, in their eyes--by an Administration proposal to switch most of the accounting processes used to calculate taxable income from the “cash method” to the “accrual method.” What sounds like a minor change, skeptics say, would effectively allow the government to tax businesses for money they have not made.

Here is the difference: The cash method allows a business to declare income when it is received; under the accrual method, income is sometimes recorded even when it is not in hand. For example, a law firm might not be paid until it completes an 18-month courtroom battle, but under the accrual method, a lawyer might record some of the expected income from that trial as accruing each month.

When it comes to paying taxes, the cash method is especially attractive to service businesses, whose major expenses, such as rent and labor, must be paid up front and whose revenues often are not received--or reported--until later. But to appear more solvent, the same businesses often use the accrual method when applying for loans.

Using Both Called Unfair

The Administration argues that using both methods is unfair. The Reagan proposal would force any business with gross receipts of more than $5 million to use the accrual method on its tax forms if it uses it elsewhere.

Donald C. Wiese, partner in the Washington office of the accounting firm of Touche, Ross & Co., said the rule could hit thousands of service businesses in the pocketbook--and hit them hard.

“Large accounting firms like ours, large law firms, virtually all financial institutions would be subject to the change, and it’s probably going to push up their tax liability quite a bit,” he said.

A second, equally arcane, shift in real estate rules could force important changes in the way construction projects--from office towers to shopping centers--are financed.

That change would repeal the “at risk exception,” which since 1978 has allowed limited partners in real estate investments to deduct more money than they actually have personally staked on a project.

The clause made big-time real estate “the king of tax shelters,” said Lawrence Axelrod, Touche, Ross tax reform expert. Its repeal, he said, “will face investors with the choice of actually going at risk--putting their savings and homes on the line when the partnership borrows money--or delaying deductions.”

That, in turn, could trim the booming office-building market or force most financing for such projects to come entirely from insurance companies and banks instead of rich individual investors.

A third potentially sweeping reform is directed at banks but could have a broad effect on local governments and private investors as well.

The proposal would bar banks from deducting the interest expense on funds they use to buy tax-free municipal bonds for investment--innocuous enough, except that banks held $158 billion in state and local government bonds at the end of 1984 and claimed roughly $11 billion in deductions that year.

Money Would Go Elsewhere

The loss of that tax break would probably lead many banks to place their money elsewhere, and cities and states may discover that the bonds cannot be sold elsewhere unless their interest rates go up--meaning that government financing costs would rise.

“The fact that bank portfolios would look a lot different after the adoption of this plan is not in doubt,” said John Danforth, a partner with Golembe Associates, a Washington financial consulting firm. “And cities would be very much affected by the proposal. . . . But then, the whole Reagan plan is based on the assumption that people should stop making so many decisions on the basis of avoiding taxes and start making economic-based decisions instead.”

Many provisions of the Reagan tax plan would have significant effects on particular industries:

Banking and Finance: The financial industry is bemoaning Reagan’s threat to begin imposing taxes on breaks that have long been the financial industry’s alone. But the fact that many banks and savings institutions have lately begged Congress for freedom from federal regulation--so that they can behave like ordinary businesses--weakens their pleas for special tax treatment, experts say.

And even many banking industry specialists say most financial businesses will not be seriously affected by the provisions of the Reagan plan aimed specifically at the financial industry, even if their taxes rise.

The Reagan plan would deny commercial banks their long-held ability to deduct from their taxable income much of the billions that they keep in reserves for bad debts, even when actual loan losses prove far below the reserve. Thrift institutions would lose their even more generous tax treatment of debt reserves.

Golembe Associates’ Danforth predicts the actual effect would be minor, in part because most institutions have already taken as much advantage of the break as the current law allows.

Carrying Losses Forward

Thrift institutions, which lost more than $8 billion in the recession year of 1982, are rallying hard to thwart the repeal of a special rule allowing them to carry their losses forward--and use them as deductions--in years, such as 1984, when profits are lush. And large credit unions--those with assets of more than $5 million--are protesting the proposed repeal of a special clause that exempts them from taxes altogether.

The life insurance industry complains that it would fare even worse than other financial institutions, because the Reagan plan would tax the accumulated cash buildup of whole-life insurance policies.

“There’d be a slow death of whole-life,” said a spokesman for the American Council of Life Insurance. Prudential, for example, complains that it would have to lay off all but 5,000 of its 22,000 whole-life agents if the Reagan plan became law.

Despite such dire forecasts, economists and tax experts agree that the real effect of the Reagan reforms on the financial industry would be not in the institutions’ profits, but in how those profits are generated.

The ABA’s Wheeler says the elimination of special tax treatment for thrift institutions and credit unions would reduce competitive differences between the businesses and allow competition to rise.

Changes elsewhere in the tax code would redirect corporate investment and borrowing policies, affecting bank loan and deposit portfolios. But what form those shifts will take is not clear.

The change in revenue bonds policy, to cite just one example, could leave banks with large sums to invest elsewhere. So could changes in Individual Retirement Account rules, which allow couples with one non-working spouse to shelter up to $4,000 each year, compared to $2,250 under current rules.

‘Money on the Margin’

“Remember, banks are always making money on the margin,” Danforth said, “and when they’ve got a dollar they’ve got to figure out what to do with it to make some money.

“They’ll buy other debt instruments, or they’ll make other loans they wouldn’t have made before. They could marginally reduce rates on consumer loans or commercial loans to make them more attractive. . . . The effects would go in every direction.”

Real estate and construction: It is one measure of the complexity of the Reagan tax simplification plan that the reforms appear likely to raise rental rates, depress home prices, give people more pocket money for home buying and reduce the value of the tax deductions they would reap by actually purchasing a home--all at once.

Rental rates could rise because the tax incentives that make apartment buildings attractive investments--speedy depreciation, generous deductions for maintenance expenses, deductions for property taxes--all would ebb or vanish.

Making Up Cash Flow

“A landlord’s gotta make up that cash flow some way,” said Touche, Ross’s Axelrod. “And the easiest way is to raise his rents.”

The shift to accrual tax accounting could rob home builders of tax benefits from the $5 billion in construction loans they take out annually, said Hazelton of Data Resources Inc.

Still, home prices could fall, at least initially, because buyers also lose some of the juicy deductions--such as property taxes and interest on second-home mortgages--that stimulate sales.

Potential buyers would get more pocket money for house-hunting from the general lowering of the personal income tax rate, said Data Resources’ Hazelton, but the value of deductions--such as that for mortgage interest--declines as the tax rate declines.

“The perverse effect of the tax plan,” Hazelton noted, “is that the lowering of tax rates reduces the after-tax value of owning a home.” That loss means buyers cannot afford to pay as much for housing as they can now, which in turn deflates the overall housing market by putting all houses beyond the reach of some who can now afford them and notching down the quality of the housing other buyers can afford at every level.

Data Resources estimates that the tax plan would cause an immediate drop in new home starts of up to 150,000 units a year, during fiscal 1986 and 1987. That is about 8% of the 1.8 million to 2 million units built annually, enough to throw some small home builders out of business and weaken related industries such as lumber and appliances.

The effect would be regionally isolated, with boom towns feeling little and depressed areas being hit unusually hard. And sales would be helped if, as some experts predict, the tax package produces lower interest rates.

At any rate, the housing industry would bounce back by the mid-1990s, according to forecasters, and the long-term effects would be negligible. For the driving force behind home and apartment construction and sales is not tax policy, but procreation policy.

“In the short term, you can postpone marriage, live with your parents or do any number of things to prevent forming a new household,” Hazelton said, “but you can’t in the long term.”

Retailing and specialized services: “If anybody is helped by the plan, it’s retailers,” said David Ernst, a forecaster with Evans Economics, a Washington consultant. “It puts money in their customers’ pockets, and it lets them keep more of the money that goes into their cash registers.” Stores will eventually acquire about 45 cents of every personal tax-cut dollar that consumers get, he estimated.

Retailers agree that they will be helped. “We don’t have any of the investment tax credit provisions (that) manufacturers do. We don’t own much property, so we’re not involved with depreciation schedules,” said Bob Stevenson, vice president for government affairs for K mart Corp. in Troy, Mich. “And on the individual side, we think it puts money in our customers’ pockets. So we’re in favor of the plan.”

Would that all sellers were so lucky. Restaurateurs and entertainment companies--pro sports franchises, for example--are expected to suffer from proposed curbs on business expense deductions. The current unlimited deduction for meals, for example, would be sliced to $25 per meal, plus half of any cost over $25.

Entertainment-expense deductions would be outlawed entirely--a blow against pro baseball teams, which sell fully one-third of their tickets to businesses, and hockey teams, which depend on corporations for half their ticket sales.