The Bottom Line on Tax Reform

Originally published November 26, 1984

I SUPPOSE I should say something about Secretary of the Treasury Donald T. Regan‘s recent Federal tax simplification proposals. As it happened, I was vacationing in Florida when they were announced and for a couple of weeks thereafter, so my initial information was limited to the local newspaper’s reports and the charismatic pronouncements of NBC’s Tom Brokaw.

The story filtering through to me and my neighbors was sufficiently vague on the interest-expense question to allow me to hope that one of my private ideas had a chance of becoming public law. It seemed that interest expense (with the exception of that on a primary-residence mortgage) would no longer be deductible. This certainly exercised the Sunbelt real estate operatives. It seemed, too, that the change would cover the interest expenses of businesses as well as of individuals. The latter, I have since discovered, is not the case. But I was briefly delighted for the following reasons, which I now offer in the event anyone asks you how the law should be revised.

Contrary to general opinion, the interest-expense deduction works mostly for the benefit of people with money to lend. It does nothing much for those with the need to borrow – especially not for those in the lower tax brackets. The first fact to bear in mind is that the interest rate is in one respect like other prices: It can’t go higher than the market will bear. You can’t get blood from a stone. If lenders attempt to set the rates too high, they will be left with idle money on their hands. If they do nothing with that money, they will be like the unfaithful servant in the Parable of the Talents. To get their cash out and working, they must lower the rates to levels that businesses and individuals are able and willing to pay.

Although borrowers are subject to euphoria, businessmen are restrained by the necessity to make a profit, or at the minimum to make ends meet. For some months now, despite the well -advertised recovery, profit rates have been falling. And so have interest rates. The connection between the two is indirect, not direct. Interest rates have been coming down partly because the Federal Reserve Board has slightly relaxed its control of the money supply, but mainly because there has been a declining demand for loans. Many businesses have not been pursuing loans for the simple reason that business isn’t good enough for them to afford the rates asked.

The second fact is that the corporate tax deduction for interest expense cuts the cost of business borrowing roughly in half, at least for the bigger borrowers. In other words, at the present time some businesses are able and willing to borrow money effectively costing them, say, 6 per cent, not the 10.75 per cent (or a point or two more) they pay their friendly bankers before taxes. It is consequently reasonable to foresee that, if the interest-expense deduction were abolished, the demand for loans at 10.75 per cent would truly plummet, callable bonds would be called, refinanceable loans would be refinanced, lenders would be drowning in money to lend, and the interest rate would have to drop until solid ground was reached again. For various reasons (including, we may be sure, inappropriate reactions of the Federal Reserve Board), the rate would probably not fall quite to the present effective rate of 6 per cent. Nevertheless, observe the outcome: Abolition of the interest-expense deduction would leave borrowers about where they were, while the take of lenders would be cut almost in half. To repeat for emphasis, the interest-expense deduction mainly subsidizes those with money to lend, not those eager to put it to work[1].

Obviously, introduction of the change in a hurry would hurt many individuals, businesses and banks. The suffering of most individuals and businesses would be assuaged by the promised reductions in the tax rates, but the crisis in banking might be acute. Don’t get me wrong.  If it were not for possible damage to the economy (and this could be mitigated by phasing in the change-over two or three years), I could regard a pit full of squirming bankers with a fair show of equanimity. My point has nothing to do with my feelings for bankers, some of whom are my best friends (though not always when I need them). My point is that the interest-expense deduction makes usurious rates seem tolerable. It is a prop holding up those rates for the enrichment of money lenders. I therefore thought Regan was absolutely right in trying (as I mistakenly understood it) to knock out this deduction.

Of course, I feared there wasn’t a prayer that he would prevail, despite the fact that everyone -everyone in the whole wide world (except for big lenders) – is longing for interest rates to come down. Last year, even with a more docile Congress and strong support from a not-yet-lame-duck President, the Secretary couldn’t get the banks to withhold taxes on interest – a measure that would have hurt only cheaters and the people who encourage cheating.

ALSO DOOMED (I thought, and still think) is Regan’s proposal to get a rein on the charity deduction. The churches and the colleges, the foundations and the funds, the museums and the libraries, the clinics and the think tanks – all the eleemosynary institutions in the land – are up in arms about this one. It is very sad and disillusioning. Many undoubtedly worthy, dedicated and, yes, necessary citizens have been tricked by the issue into making fools or hypocrites of themselves. Two pitiable examples turned up in the Florida paper I read.

An official of the local United Way observed that the median income thereabouts is $17,000, and he worried that the vast majority of its contributors would not be able to continue their generosity if the law were changed. The United Way does its supporters an injustice. For it is surely true that practically all taxpayers with a gross income of $17,000 take the standard deduction and make most of their contributions because they want to, not because it is a way of diddling the tax collector.

A local parson had a clearer under-standing of finance – and of his parishioners. He argued that Secretary Regan’s proposal to cut the top tax rate from 50 to 35 per cent would greatly reduce the value of the charity deduction to those in the top bracket. He is certainly right. Rich people are in (if the parson will forgive me) a hell of a fix. We’ve been told since New Deal days that high taxes sap their incentive to work and save. Now we discover that low taxes sap their incentive to be charitable. Of such is the Kingdom of Heaven.

The local Salvation Army made a more responsible observation. It noted that the talked – about budget cuts (a.k.a. “freeze”) in welfare programs would increase the calls on private charity, while the tax changes would reduce contributions. Indeed, one wonders (to introduce a little of the spice of argumentum ad hominem into the discussion) what the President himself might be expected to do in these circumstances. You will remember that the Treasury proposes to count only contributions in excess of 2 per cent of adjusted gross income. You will also remember that the President’s tax returns have rarely (if ever) shown contributions up to or much beyond that level. Add to this the fact that he promises to cut his own pay, and I am led to suspect that his favorite charities won’t be able to count on him (and on many like him) as they have in the past.

There is no doubt that the charity deduction is grossly abused (mostly in ways I haven’t discussed). There is little doubt that Secretary Regan’s modest proposals for its reform will fail. Then we have the matter of no longer allowing the Federal deduction for state and local taxes. Here I think the Secretary has his best chance of succeeding.

The proposal has drawn fire from New York’s Governor, Mario Cuomo, as well as from both of its Senators, Democrat Daniel P. Moynihan and Republican Alfonse D’ Amato, and it is easy to rally the rest of the country in opposition to the Empire State. I’m opposed to this part of Regan’s plan, too, however. As I have argued in this space (“Eliminating Frictional Unemployment,” NL, March 7, 1983), the most rational approach would make state and local taxes a 100 per cent offset against Federal taxes. In brief, that would put an end to the game of beggar my neighbor states now play as they try to lure corporations away from each other with inadequate taxes. No chance.

Perhaps the most important single change advanced by the Treasury would eliminate most of the corporation investment credits and rapid-depreciation dodges. These allow companies like General Electric to have profits in the billions and pay no income tax at all, but instead receive rebates of a hundred million or more. The change was not deemed worth mentioning by my Florida paper. Maybe the editor foresaw that lobbyists would not have much trouble explaining to the President that his major campaign contributors would hardly be amused.

THE FOREGOING are only the principal ways the Secretary of the Treasury has gotten people mad at him. An indicator of the wrath he has incurred is that as staunch an Administration ideologue as William F. Buckley Jr. finds the program a disaster. This being the case, why did Regan make his irritating tax proposals?

In answer, I’ll venture the guess that he is playing the game perfectly straight, yet that the result will neutralize the Democrats. For the Regan plan is very close to (actually more liberal than) the one put together by Senator Bill Bradley of New Jersey and Representative Richard Gephardt of Missouri (see “A Cautionary Tale of Tax Reform,” NL, January 23), which has wide verbal support, especially among neoliberals. It would thus seem that with a substantial majority of Republicans and a scattering of Democrats, a melding of the plans – including the somewhat similar scheme of Republican Representative Jack Kemp of New York – might have a good chance of sailing through.

If it does, the new law will certainly have the nice low rates that have been proposed. You should not be surprised, though, if the lobbyists manage to keep most of the loopholes open. For my part, I’d not be surprised if Republicans and Democrats started bidding against each other, as they did in 1981, to see who could give the lobbyists more of what they want. The not impossible result could be both lower taxes and wider loopholes.

What then?

The first consequence would be, as in 1981, an upward surge of the deficit. The second consequence would be, as in 1982, a move (over the obviously sincere opposition of President Reagan) to increase Social Security taxes (although they have no bearing on the budget deficit) and reduce Social Security and Medicare benefits. The third consequence would be, as in 1983, the realization that controlling the deficit requires some brave new taxes. It would be explained that the campaign pledges of no tax increase have after all been honored, since the income tax rates actually were lowered. But something had to be done.

What would it be?

Few fortunes have been made by people acting on my prophecies. Still, if I were a betting man, I’d wager that we would start hearing a lot more about the value added tax – how widely it is used in Europe, how invisible it is in comparison with the sales tax, how comparatively easy it is to collect, how it taxes consumption rather than production (a fallacy I have discussed more than once).

I know the smart money says that former Democratic Representative AI Ullman of Oregon was defeated in 1980 because he supported a value added tax; that references to it in the last campaign drew a strongly negative response; and now even the Treasury has come out against it. Nonetheless, with the income tax rates down and the loopholes wide open the pressure to act would be very great. On other occasions Secretary Regan has argued for a tax on consumption, and so have people as far to his left as Senator Gary Hart of Colorado. The American Enterprise Institute and the Brookings Institution similarly want to tax consumption.

My prophecy stands. What we get won’t be called a value added tax, but what’s in a name?

The New Leader


[1] Editor’s emphasis

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