VIEWPOINTS : Escalating the War on the Tax Reform Front

To many who find themselves in the 40% to 50% tax brackets, the Tax Reform Act of 1986 is troubling. Even though tax rates may eventually fall, tax-avoidance gimmicks definitely will be cut back. This severely curtails one’s weapons in the yearly war with the Internal Revenue Service--no more individual retirement accounts, no more tax deductions for interest on consumer loans, no more limited partnerships, no more two-earner deduction, no special breaks on capital gains income.

Big business, too, will be hit hard in the pocketbook by tax reform. And, like high-income individuals, business strategists are less than pleased with its ramifications.

But while professionals, doctors, lawyers, dentists and executives trying to protect themselves from tax reform will take a defensive approach, big business can be counted on to take the offensive.

This latest skirmish in the name of tax reform constitutes far more than just a war game to business. It is war. Business stands to lose not thousands but billions of dollars--about $129 billion a year, according to congressional estimates. That’s real money, and we can expect a serious business response.

How will business strategists plan their war? Military history tells us that winners never let the enemy define the rules of engagement. American colonists rejected formal battle lines and open-field warfare in favor of hit-and-run tactics. In World War II, Germany outflanked the invincible Maginot line and came at France through Belgium.

The United States fought World War II with heavy firepower, big bombers and aircraft carriers--we beat Germany and Japan by producing more and bigger weapons faster. The Viet Cong fought guerrilla warfare from tunnels and engaged in conventional battles only when they had overwhelming numerical superiority. The lesson is to adopt the strategy that best suits your capabilities and resources.

The difference between you and me on the one hand and big business on the other is that big business has the resources to renegotiate the tax law. Business strategists fight tax wars by persuading Congress to rewrite the code. President Reagan has already announced the strategy--pass reform now, rewrite it later.

While you and I think “this is the new law; how will I live with it?” businesses view it as just another battle in the never-ending war with government. After all, this is the eighth tax reform since 1954.

The questions are: What will Big Business try to change, how will it proceed and will it succeed?

The biggest blows for Big Business will be in the elimination of the investment tax credit (ITC) and in the creation of the new alternative minimum tax (AMT).

Consider: While statutory tax rates on business would be reduced to 33% from 46%, the tax burden on business increased by $129 billion. How? Most businesses have been able to arrange their books so that the 46% tax rate only applied to a small fraction of their income. The principal vehicle for doing this was the ITC. Thus, loss of the ITC was a major hit. Were I a business strategist, I would try to get it back.

Policy-makers dropped another bomb on business with the creation of the new alternative minimum tax. Even after the new law is in effect, business can escape tax by sheltering income. Thus, the new 33% rate would apply only to a fraction of its income. But the AMT is a second business tax system, which will result in a new definition of taxable income. As a result, firms will have to pay taxes at a 21% rate on taxable income as defined by the AMT. Again, business can be expected to direct heavy fire at the rules governing the new AMT.

Basically, business lost the ITC, created under the 1981 tax bill, because it could not be shown to have stimulated investment, increased employment or improved America’s competitive position with Japan, as it was originally intended to do.

In fact, very little was really accomplished by the 1981 tax bill, which was supposed to have stimulated the economy. The Reagan years have been characterized by a sharp but conventional business cycle--a deep recession was followed by a long but typical expansion, with the proportion of investment to gross national product about normal.

Furthermore, the long-awaited increase in productivity, which the 1981 tax bill proponents promised, did not materialize. Productivity growth has been even slower in the 1980s than it was in the 1970s.

The bottom line is that despite all the rhetoric, business could not show that the ITC, and concomitant low effective tax rates on business income, worked for the economy at large.

Big business’ best tactic in recouping its losses will be to show that without the ITC and with the AMT the economy will be worse off. And since the late 1980s are beginning to look like the dull, sluggish late 1950s, this trick may work.

With the economy dead in the water, business can claim to need tax breaks. Whether the strategy works will depend in part on economic performance and in part on whether legislators can be prodded into remembering the logical flaw in the 1981 tax reform: If you cut tax rates and increase tax shelters, you lose revenue, raise deficits and force a Hobson’s Choice--either foreign borrowing, less consumption or sluggish growth.

Deflation Is Spreading

As the Federal Reserve Board tries to shock the economy forward with lower discount rates, deflation is spreading from primary products and agriculture. Deflation means lower incomes, downward revaluation of assets and lower demand throughout the economy.

The tax bill will contribute to this sluggishness over the next few years as we all try to figure out what’s going on. Since we still need to borrow from the rest of the world to finance our deficits, the trade balance is unlikely to improve very much. Furthermore, American firms will need time to recapture world markets lost during the strong dollar period of the early 1980s.

Thus, U.S. policy-makers and businesses will have the Japanese to blame for our ills. The foreign scapegoats will provide fodder for claims that we need the ITC and a weaker AMT so that American firms can compete.

And when the smoke clears, the Tax Reform Act of 1986 is not likely to be seen by big business as a watershed battle but rather as just another skirmish in a war that never ends.