TIME: Almanac 1995

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<text id=93HT0675> <title> 1985: A Hard Look at the Fine Print </title> <history> TIME--The Weekly Newsmagazine--1985 Highlights </history> <article> <source>Time Magazine</source> <hdr> June 10, 1985 ECONOMY A Hard Look at the Fine Print </hdr> <body> 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 </body> </article> </text>