TIME: Almanac 1993/TIME Almanac 1993.iso/time/caps/85/85.5

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                                                                                June 10, 1985

ECONOMY

A Hard Look at the Fine Print


Unsnarling the present tax code is a complex business


For a plan that aims at a radical simplification of the Internal
Revenue Code, Ronald Reagan's tax reform seems remarkably
complex. To explain it, the Treasury last week issued a
paperback volume of 461 pages studded with charts and at times
singularly opaque prose. Sample:  "A customer of a contractor
making progress payments or advance payments would be treated as
self-constructing the property under construction by the
contractor to the extent of such payments."

There are three main reasons for this Orwellian simple-is-
befuddling approach. One is that the present tax code is such a
hideous snarl. By Treasury count, under the new plan, "more than
65 categories of preferential tax treatment would be eliminated
or curtailed."  Just describing what they are is no easy task.
Another reason is that the plan is balanced on a knife edge to
make it "revenue neutral."  To offset the sweeping reductions in
individual and corporate tax rates, Treasury planners had to come
up with some complicated revenue-raising ideas. One particularly
involved provision would tax businesses on sums they had deducted
under current depreciation rules. It was added just days before
the package was announced largely because an extra $20 billion
was needed to make the plan revenue neutral in 1988. Finally,
during the six months between the Treasury's trial balloon last
November and the formal presentation to Congress last week, the
Administration listened to dozens of lobbyists contending, in the
sardonic words of Treasury Secretary James Baker, that "if we go
forward with a particular provision or another, it is the end of
the Western world as we know it."  In the political interest of
producing a plan with a fighting chance of becoming law, the
Administration introduced complicated softenings of provisions
that originally were straightforward and harsh.

Despite all that, the main thrust of the Reagan plan is entirely
clear. It would reverse a 20-year trend of tax cuts for business
that has resulted in individuals shouldering a proportionally
heavier load of the burden. The basic mechanism remains clear
too:  lowering rates but making more income taxable by scrapping
or reducing exemptions and deductions. Within that grand design,
though, there are hundreds of provisions varying widely in
impact. Details:

Individual rates. The move to a three-stage, 15%-25%-35% rate
structure would by Administration calculations reduce taxes for
58.1% of all American families; 21.2% would see no change except
in the way that they compute what they owe, and 20.7% would pay
more tax. Most families in every income group would get a
reduction, but it would be greatest proportionally at the very
bottom and the very top:  35.5% for families with incomes of less
than $10,000 a year; 10.7% for those enjoying incomes of $200,000
or more. Families in the upper middle class would get the
smallest cut, an average of little more than 4% in the $50,000-
to-$200,000 bracket. In the lower groupings, while the cuts
would be larger in percentage, many will be quite modest in
dollar amount. The Treasury estimates the average reduction for
all taxpayers earning $50,000 a year or less would be about $200
a year.

Baker strongly denies that the plan favors the rich. Says he:
"Any time you reduce the top rate, people who have been paying
the most are going to get a substantial reduction. But let's not
forget that a lot of these people use shelters" that will no
longer be available under the reform plan, and thus will be
paying tax at lower rates but on more of their income. Still,
even though the amount of income subject to tax for people in the
$200,000-and-up bracket will rise an average 18.5%, the effective
tax rate on the total incomes of the rich will drop
substantially.

Taxable Income. Middle-class and lower-income families would
have to pay tax on many types of income that now escape federal
levies. Unemployment compensation, workmen's compensation for
injuries, and miners' black-lung benefits would be fully taxable,
while at present, unemployment payments are taxable only to
families whose income exceeds $18,000 a year and the other two
types not at all. Employees would have to include in taxable
income $120 a year of medical-insurance premiums paid by their
bosses if single, $300 if married and filing joint returns. Of
particular concern to the middle class, individuals would have to
pay tax each year on the increase in cash-surrender values of new
life-insurance policies and on interest credited to new deferred
annuities, to the extent that those exceed their premium
payments. Policies and annuities already in effect, however,
would not be touched. Example:  if a policyholder paid a $1,000
premium on a new life-insurance policy during a year in which its
cash-surrender value rose $1,500, he or she would pay tax on the
extra $500. Under present law, tax becomes due only when the
policy or annuity is actually cashed in. Even death benefits
paid by an employer to a worker's family would be taxed under the
Reagan plan. But Social Security pensions would be taxed no more
heavily than now, and veteran's disability payments would
continue to go untaxed.

Exemptions and deductions. The personal exemption for each
taxpayer, spouse and dependent would nearly double at the outset,
to $2,000 from $1,040. In later years the exemptions would, as
now, be "indexed" for inflation; that is, the exemption would
rise each year by the same percentage that consumer prices go up.

The so-called zero-bracket amount would be raised to $4,000 for
couples filing joint returns, from $3,670 now. That is the
amount of income, after personal exemptions, that is freed from
tax. For people who do not itemize deductions, it is equivalent
to the old standard deduction.

The combination of lower rates, a higher personal exemption and a
higher zero-bracket amount would mean that nearly all individuals
and families below or just above the poverty line would pay no
federal income tax at all. In 1986, the poverty line for a
family of four is expected to be $11,400. Under present law, if
that family had one wage earner, it would pay tax on any income
above $9,575. Under the Reagan plan, taxes would start only if
its income exceeded $12,798. Another tax break would give a
family with one working spouse the opportunity to escape taxes on
$4,000 deposited in Individual Retirement Accounts. The current
limit is $2,250. IRA contributions by families in which both
spouses work would remain deductible at $2,000 a person.

What might be called the sacred trinity of deductions for many
taxpayers - mortgage interest, charitable contributions and
medical expenses - would be retained, but in two cases modified.
Mortgage interest could be deducted in full on a principal
residence, but would be strictly limited on a second or third
home. Charitable contributions could be deducted in most cases
in full, but only if a taxpayer itemizes expenses; present law
allows a deduction of as much as $300 next year, even if the
taxpayer has no other itemized deductions. Medical expenses
would continue to be deductible to the extent that they exceed 5%
of gross income.

Deductions for interest on personal loans, and on loans to buy
cars, boats, furniture or a second or third home would be capped.
If a taxpayer collects investment income, such as rents and
interest on savings accounts or certificates of deposit, the cap
would be $5,000 in excess of that income. For example, if the
taxpayer collects interest of $2,000, he or she could deduct no
more than $7,000 in interest paid. Taxpayers, who have no
investment income would be limited to a straight $5,000 deduction
for interest paid out.

Just about every other deduction would be abolished or reduced.
The most bitterly controversial provision:  no deductions for
state and local income, sales or property taxes. This provision
alone would raise $40 billion in extra taxes by 1990 and is
justified by the Administration only partly on grounds of equity;
a compelling reason is that the Administration just plain needs
the money to pay for the rate reductions.

The special deduction of as much as $3,000 for families in which
both husband and wife earn income would be wiped out. That would
amount to reinstituting the so-called marriage penalty; the
spouses would in many cases pay more tax than if they were
single. The Treasury replies that because of the rate
reductions, they probably would pay less than they would under
current law.

The present tax credit of as much as $4,800 enjoyed by parents
who pay for care of their children or elderly dependents while
the wage earners work would be changed to a deduction. That
makes the provision much less generous, since a credit is a
straight subtraction from tax due while a deduction is only a
reduction in taxable income. A credit of $1,000 reduces a
family's tax bill by $1,000. A $1,000 deduction would lower
taxes by $150, $250, or $350, depending on whether a family was
in the 15%, 25%, or 35% tax bracket. Barbara Kennelly, a
Democratic Congresswoman from Connecticut, objected that though
Reagan billed his reforms as "pro-family," the child-care, IRA
and other provisions seemed tilted toward just one kind of
family; the classic one in which only the husband works and the
wife stays home and takes care of the children.

People whose annual income fluctuate widely would no longer have
the benefit of income averaging. They would have to pay tax each
year on that year's income at standard (but in most cases lower)
rates.

Investment taxes. The big item here is the capital-gains tax
imposed on profits realized by selling stocks, bonds, land,
buildings, jewelry or nearly any other asset held for six months
or more. The maximum tax rate on such profits would in effect be
lowered to 17.5%, from 20% now. That is a giant concession from
the Treasury's original proposal, which would have taxed capital
gains at full ordinary-income rates that could have been as high
as 35%. The Administration was persuaded that preferential
treatment for capital gains not only is necessary but should be
made still more generous in order to spur investment,
particularly in new high-technology ventures whose founders
expect to derive most of their reward not from salaries or
dividends but from the rise in the asset value of their
investments.

There are some catches, however. From enactment of the law until
1991, capital gains would not be indexed for inflation, as they
would have been under the Treasury's first proposal. Thus, an
investor who sold stock for 15% more than he had paid to buy it,
after a period during which prices also rose 15%, would get no
offset; he or she would still pay capital gains tax on the
nominal profit. In 1991 and later years, a taxpayer could elect
either to pay tax at the preferential capital gains rate, or to
subtract the inflation rate from his or her profit and pay tax at
ordinary-income rates on the remainder, but could not get both an
inflation adjustment and preferential capital-gains treatment
besides.

Also, and possibly more important, the rules on what income
qualifies for capital-gains rates would be tightened as part of a
general attack on tax shelters. Profits from certain investments
in mining, timber and agricultural properties, for example, would
be taxed at ordinary-income rather than capital-gains rates.
Also, no capital gains would be allowed on the sale of property
on which depreciation deductions have been taken. That proposed
rule would weigh heavily on real estate operations. A builder
who erects an office tower, say, takes depreciation deductions on
it and then sells it at a profit would pay tax on that profit at
ordinary-income rates.

That is one of several provisions in the Reagan proposal that
strike especially hard against real estate. Another is the
extension to real estate of the "at risk" rule concerning tax
shelters. Generally, an investor can deduct form his regular
income only amounts that equal the sum he has invested plus
whatever debts he is personally liable for. Real estate
investors, however, have been allowed much higher deductions.
The Treasury plan would treat real estate just like other
investments.

Another important proposal would split municipal bonds issued by
states, cities and localities into two classes. Those sold for
"public purposes" -- to finance the building of roads, schools,
and sewers, for example -- would continue to pay interest exempt
from federal tax. But buyers of "private purpose" bonds would
have to pay tax on the interest they collect. That would
severely crimp the practice of issuing tax-exempt bonds to
finance industrial development, for instance, by using the
capital raised to put up industrial buildings that are leased by
a locality to private companies at low rents. The provision also
might hinder the construction of low-cost housing, much of which
is now financed by the sale of tax-exempt bonds.

Corporate tax rates. Profits of $75,000 or more would be taxed
at 33%. Then the rates would descend in three steps:  25% (on
profits of $50,000 to $75,000), 18% ($25,000 to $50,000), 15%
($25,000 or less). The present rates are 46% on profits of
$100,000 or more, 15% to 40% on smaller profits. The cuts are
supposed to give a special lift to small, growing enterprises.
For many businesses, however, the benefits will be far out-
weighed by changes in other tax rules, since very few big
companies actually pay tax at anything like a 46% rate. They
avoid some taxes, and sometimes all taxes, by taking advantage of
credit and deduction rules.

Business credits and deductions. The investment tax credit,
which allows businesses to subtract from their tax bills amounts
equal to 6% to 10% of what they invest in new plant and
equipment, would be killed outright. That is the single biggest
revenue raiser in the tax plan, after the provision to end
deductions for individuals on state and local taxes. Ending the
investment credit would bring an additional $37 billion into
federal coffers in 1990. It also would strike a blow at tax
shelters, many of which are partnerships or syndicates formed to
invest in property qualifying for the credit.

Depreciation deductions would be less generous than now, but
would not be restricted quite so much as the Treasury had
originally planned. Under the tax law passed in 1981, businesses
could write off the cost of property in periods ranging from
three years (for automobiles, light trucks and lab equipment) to
18 years (for buildings). The new plan would lengthen the periods
to a range of four to 28 years. That is a less drastic stretch-
out than had been contemplated in the Treasury's November
proposals, but still enough to raise federal revenues by $15
billion in 1990, because businesses would be allowed smaller
depreciation deductions, and thus would pay more tax, than under
present law. A "recapture" provision added to the bill shortly
before it went to Congress would force businesses to pay tax on
some of the income they have sheltered by taking the accelerated
depreciation write-offs allowed under the 1981 law. The amounts
added back into taxable income would be taxed at the present 46%
corporate-income rate rather than the proposed 33%.

Some changes are beneficial to business:  corporations would get
a new deduction equal to 10% of the dividends they pay out (as an
offset, though, the stockholders receiving those dividends could
no longer exclude up to $200 from their individual taxable
incomes). A "research and experimentation" credit equal to 25%
of qualified expenditures would be extended through 1988; under
present law, it would expire at the end of this year. Also, the
credit would be made applicable to more kinds of corporate
outlays. Though this provision would apply to all companies, it
would especially benefit young high-tech firms, whose executives
also are exulting about the prospective cuts in tax rates on
profits and capital gains. "We got more than we asked for,"
Ralph Thomson, vice president of the American electronics
Association, told the Washington Post.

Special rules. Some provisions of the plan are designed to
squeeze more taxes out of industries thought to be treated unduly
mildly now. Banks and other financial institutions generally
would have to pay more. For example, they could no longer defer
tax on money added to reserves to guard against future loan
losses. For the most part, they could deduct only actual rather
than estimated future loan losses, and then only in the year that
the loans prove to be uncollectible.

Oilmen would finally lose their long-cherished depletion
allowance. It would be phased out over five years, except on the
very smallest wells (those producing 10 bbl. a day or less). But
oil operators saved a far more important tax benefit. The
Treasury had originally wanted to make them stretch out over a
period of years write-offs for "intangible drilling costs,"
including everything from engineering studies to geologists'
expenses. The final plan, however, allows the oil operators to
continue taking all the write-offs immediately. While industry
lobbyists still protested the impending death of the depletion
allowance, some individual oil executives were pleased to fend
off a much harder blow. "There is a lot of relief in the oil
patch," said J.C. Walter Jr., chairman of the Texas Mid-Continent
Oil and Gas Association.

As a final catchall (or, more accurately, catch-a-bit), the
Administration proposes to tighten somewhat the minimum tax on
both individuals and corporations. At present, corporations
supposedly pay a tax of 15%, and individuals 20%, on income that
otherwise would escape federal levies, but there are so many
exceptions that a fair number of millionaires and highly
profitable companies still pay no tax at all or very little. The
Administration intends to make the rate 20% for both types of
taxpayers, and to subject more kinds of income to the minimum
tax. But though President Reagan made a major point of this
proposal in his TV speech last week, the Treasury's numbers
indicate that its application would still be sharply limited.
Main reason:  many tax breaks even under the new law would escape
the minimum tax. The new minimum-tax rules are expected to raise
a mere $1.1 billion of additional federal revenue in 1990.

Besides financing tax cuts for individuals, the reforms in
business and investment taxes are supposed to work toward
equality by reducing the enormous disparities in effective tax
rates for different industries, and sometimes for different
companies in the same industry. For that very reason, however,
the changes would hit different industries and companies with a
widely varying impact.

While high-tech executives are jubilant and oilmen sigh with
relief, builders and real estate operators are aghast. The tax
changes specifically targeted at their industry, such as the
extension of the "at risk" rule for shelters and new guidelines
on what profits qualify for capital-gains treatment, are just the
start of their troubles. Like other businesses, they will get
less generous deductions for depreciation,and that is an
especially important item for them, since their business consists
so heavily of dealings in those highly depreciable properties,
buildings. Adding up all the ways in which realty taxes will be
increased, Chris D'Ambra, a San Francisco insurance broker who
has been reducing her tax liability by investing in limited real
estate partnerships figures that strategy will no longer be
advantageous. Says she:  "My empire is on hold."

Such prospects leave advocates of tax reform dry-eyed. Says
M.I.T. Economist Lester Thurow:  "We have some industries like
real estate that basically pay no taxes."  But real estate
operators insist that the public also would be hurt. The costs
of owning a house, cooperative apartment or condominium would
rise under the new tax plan because property taxes would no
longer be deductible and the interest deduction on principal
residences, even though it would be retained, would be worth
less. A $10,000 deduction saves the homeowner as much as $5,000
in federal taxes at a 50% top income-tax rate, but no more than
$3,500 under a schedule with a 35% maximum.

Real estate people think that house prices would come down by
perhaps 5% to 10%. That would please buyers and help to contain
the inflation rate but hurt owners with large savings tied up in
homes they are trying to sell. Even at lower prices, fewer
buyers may be tempted and fewer homes built. Kent Colton,
executive vice president of the National Association of Home
Builders, figures that housing starts might drop 300,000 units
below last year's level of 1.8 million, a matter of concern to
the economy because housing construction spurs sales of wood,
glass, furniture, appliances and many other goods. Scott
Slesinger, executive vice president of the National Apartment
Association, foresees "Strong upward pressure on rents" because
landlords would need money to replace tax breaks they would no
longer get. Says he:  "When the plan is fully implemented, rents
are going to go up much more than taxes [on apartment renters]
are going to go down."

Economists and executives in other industries are more divided on
the likely impact and merits of the tax-reform plan. Aside from
real estate, the plan would weigh most heavily on "smokestack"
industries such as steel and autos with heavy investments in
plant and equipment that could no longer qualify for the
investment tax credit or speeded-up depreciation write-offs.
These are the very industries threatened most by foreign
competition. The plan, said a Ford Motor Co. statement, "will
have an adverse effect on capital formation in the creation of
new jobs in the industrial sector ... Overall, the tax plan will
appear to be detrimental to the nation's trade balance."

General Motors Corp., in contrast, went on record as favoring
even the original Treasury proposal that would have raised taxes
on business more than the plan finally unveiled last week. Its
reasoning:  the tax reforms taken as a whole would spur economic
growth, increase incomes and jobs, and what would be good for the
country would be good for General Motors, which could sell more
cars.

Whether the reforms really would promote growth is a major
imponderable. Certainly that is one of the major aims. The
economy is supposed to speed up partly because individuals who
save on taxes will have more money to spend, save and invest, but
more because money would flow into constructive investments
rather than disappearing into tax shelters, many of which serve
little or no productive purpose. The Treasury estimates that if
the tax plan is enacted, the gross national product, or total
output of goods and services, would rise 1.5% faster by 1995 than
it would under current tax law. But it pointedly did not factor
that calculation into any of its estimates of revenue to be
gained or lost, implicitly recognizing that the number at best is
a guess. Even if growth did increase at that rate, probably no
one would ever be able to calculate how much if any of the rise
was attributable to the tax changes, and how much to other
factors.

Still, the prospect of a more productive and efficient economy is
bright enough to attract -- of all people -- a few real estate
executives, Larry Levy, a Chicago developer, says, "The current
tax law has put a safety net under real estate. You can sell
your mistakes by selling tax benefits."  As a result, he adds,
"there are way too many buildings and too many amateurs in the
game."  Eric Joss, another Chicago real estate executive, expands
on the thought. If the President's plan passes, he says, the
industry can stop concentrating on tax benefits and "will be able
to get down to economics, to supply and demand and meeting the
needs of the marketplace."  Which is exactly what Reagan's tax
planners intend.

By George J. Church. Reported by Christopher Redman/Washington,
with other bureaus