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The business situation.

ECONOMIC activity and prices increased moderately in the fourth quarter, according to the "flash" GNP estimates. A 3-percent annual rate increase in real GNP, in combination with a 1-1/2-percent increase in the third quarter, indicates a marked slowing in the second half of 1984 from a much larger increase in the first half. The GNP Fixed-weighted price index increased at an annual rate of 3-1/2 pecent in the fourth quarter, continuing the gradual slowing of inflation throughout 1984 (table 1).

The third- and fourth-quarter increases in real GNP were not markedly different; table 1 shows that the fourth-quarter increase was larger by only 1.2 percentage points, or about $5 billion. However, it should be noted that large swings in two GNP components tended to offset each other. Further, the two components--change in business inventories and net exports--are particularly difficult to estimate for the flash GNP estimate. Only 1 month of source data for these components is available, and the data show substantial month-to-month volatility, which masks any trend that would be a guide to projecting the missing months of source data. The flash GNP estimate in the fourth quarter includes a slowing in inventory investment that subtracted about as much from the change in GNP as the $10-1/2 billion pickup had added in the third quarter. The flash estimate also includes a substantial increase in net exports after a $15-1/2 billion decline--from a negative $11-1/2 billion to a negative $27 billion--in the third quarter. Both the fourth-quarter increase in net exports and the third-quarter decline were largely accounted for by imports.

Other components of GNP are, in general, less difficult to estimate for the flash estimate: Even if only 1 month of source data is available, the data show less volatility, and for some components--notably personal consumption expenditures (PCE)--more than 1 month of data is available. The measure that is the sum of these components--final sales to domestic purchasers--probably increased about as much in the fourth quarter as the 3-percent increase in the third. Earlier in 1984, this measure, which represents domestic demand, had been much stronger, registering increases of 6-1/2 percent and 11 percent in the first and second quarters, respectively. Within this measure, PCE increased somewhat more in the fourth quarter than in the third, fixed investment increased less than in the third, and government purchases increased about the same in both quarters.

Fourth-quarter developments in the components of real GNP, in GNP prices, and in personal income are sketched below on te basis of data available as of mid-December. * PCE increased moderately after a pause--an increase of only 1/2 percent--in the third quarter. Most of the pickup was in durable goods, where purchases of furniture and equipment increased substantially more than in the third quarter. In addition, purchases of motor vehicles declined less than in the third quarter; autos declined, as they had in the third quarter, but trucks strengthened. Purchases of nondurables declined again, about as much as the 1-percent declined registered in the third quarter. Several categories--food, in particular--declined and others changed little. Services increased about as much as the 4-percent increase in the third quarter.

* Nonresidential fixed investment continued to increase, but at only about one-half the third-quarter increase of 13-1/2 percent. In producers' durable equipment (PDE), the slowing was in both motor vehicles and other PDE. In the former, as in PCE on motor vehicles, the weakness was in the auto component, which declined after a third-quarter increase. In terms of unit auto sales to all final purchases, the drop was to about 9.9 million (seasonally adjusted annual rate) from 10.3 million in the third quarter. In contrast, until sales of trucks increased to about 4.4 million (seasonally adjusted annual rate) in the fourth quarter from 4.1 million in the third, continuing a strong rebound to record or near-record levels in several categories. In other PDE, the slowing was in computers and communications equipment. Structures strengthened after little change in the third quarter, when the increase in commercial structures had slowed. As discussed in the article that reports on BEA's October-November plant and equipment expenditure survey, which now includes plans for the full year ahead, business plans to increase capital spending in 1985 roughly one-half as much as in 1984. The smaller fourth-quarter increase in nonresidential fixed investment included in the flash GNP estimate appears consistent with these plans.

* Residential investment was down again, about as much as the 4-1/2 percent registered in the third quarter. Construction of single-family structures declined in both the third and fourth quarters, reflecting a one-third falloff in housing starts from their recent peak in February. A decline in mortgage interest rates since July has yet to work its way through to encourage construction. Construction of multifamily units increased about as much as in the third quarter, and the "other" component (largely additions and alterations, mobile homes, and commissions on house sales) changed little.

* Business inventories accumulated at a substantial rate, but less than the $30-1/2 billion accumulation in the third quarter. An increase in motor vehicle inventories--the only part of inventories for which more than 1 month of source data is available for the fourth quarter--reflected automakers' rebuilding of inventories after extensive plant closings in the United States and strikes in both the United States and Canada. Only fragmentary information is available about farm inventories; it appears that accumulation was roughly the same as the $4 billion in the third quarter. Nonfarm inventories other than motor vehicles appear to have increased, but less than the $26 billion in the third quarter. Reflecting the substantial additions to inventories in the earlier quarters of 1984 and the variability of the increases in final sales, inventory-sales ratios had turned up in the first quarter, dropped back in the second, and increased in the third. In the fourth quarter, it appears that the ratios held at about the third-quarter level.

* Net exports, as mentioned earlier, appear to have increased substantially. The increase, the first in 3 years, reflected a decline in imports after a huge--$18 billion--increase in the third quarter. In merchandise imports, where the decline was concentrated, declines were widely spread across end-use commodity categories, as the increase had been in the third quarter. The average change for the third and fourth quarters, appears to have been a substantial increase, indicating that imports continue to reflect the effects of cumulative dollar appreciation. Investment income payments also appear to have declined, partly reflecting lower interest rates on portfolio investment. In exports, both agricultural and nonagricultural merchandise exports increased, but the increases were more than offset by a decline in investment income receipts.

* Government purchases increased about as much as in the third quarter, when the Federal and the State and local components had contributed about equally to a 5-1/2-percent increase. In Federal purchases, defense purchases increased after a slight decline. Commodity Credit Corporation (CCC) activities continued to dominate quarterly changes in nondefense purchases. A higher rate of increase in CCC inventories added to purchases in the fourth quarter, but not as much as the $2 billion addition in the third. In State and local purchases, a smaller increase than in the third quarter was largely in structures.

* The GNP fixed-weighted price index increased 3-1/2 percent, down from 4 percent in the third quarter. The fourth-quarter increase in PCE prices as measured by the fixed-weighted price index was slightly larger than the 4 percent registered in the third quarter; food prices increased slightly more than in the third quarter, and energy prices increased after a small decline. Prices of structures--both residential and nonresidential--showed little change after third-quarter increases in the range of 1-1/2-4 percent, and prices of PDE slowed from a 3-percent increase.

* Personal income increased about $50 billion, compared with $62-1/2 billion in thie third quarter. Most of the slowing was in personal interest income, which was up only about one-half as much as the $23-1/2 billion increase in the third quarter. The smaller increase largely reflected the widespread decline in interest rates. Other components of personal income increased about as much as they had in the third quarter: wage and salary disbursements and farm proprietors' income slightly less, and nonfarm proprietors' income slightly more.

The smaller increase in personal income in the fourth quarter than in the third was augmented in its effect on disposable personal income by a slightly larger increase in personal taxes than in the third quarter. Although prices of PCE as measured by the implicit price deflator increased less than in the third quarter, the increase in real disposable income slowed further--down about 2 percentage points from the 4-percent increase in the third quarter. Earlier in 1984, the increases in real disposable income had been substantially larger--8-1/2 percent and 6-1/2 percent in the first and second quarters, respectively. The fourth-quarter increase in personal outlays--in which PCE predominates--was about the same as that in disposable personal income, so personal saving changed little. The saving rate held at about the third quarter's rate of 6.3 percent. Throughout 1984, the saving rate varied only slightly around 6 percent, as the slowing in disposable income was accompanied by a similar slowing in outlays.

Corporate Profits

Revised third-quarter estimates show that profits from current production--profits with inventory valuation adjustment and capital consumption adjustment--declined $8 billion, to $283 billion, following a $13-1/2 billion increase in the second. The preliminary estimates, presented in November, had shown a decline of $9-1/2 billion.

The revisions generally reinforce the picture of widespread declines in domestic profits described in the November "Business Situation." The revisions show sharper declines in profits of manufacturers and financial corporations, but show trade profits, which had been down in the preliminary estimates, as unchaged. (A discussion of manufacturers' gross profits shares follows.)

The revised estimates show a picture for rest-of-the-world profits sharply different from that presented in November. Revised profits from the rest of the world increased $3 billion in the third quarter, to $24-1/2 billion, following at $4-1/2 billion decline in the second. (Preliminary estimates of rest-of-the-world profits had been down $1/2 billion.) Both receipts on U.S. assets abroad and payments on foreign assets in the United States were up, but receipts were up more. (See the article "U.S. International Transactions, Third Quarter 1984" in this issue and table 1 on page 11, which reconciles the balance on goods and services in the balance of payment accounts with next exports in the national income and product accounts.)

Manufacturers' gross profits share

Manufacturers' economic performance has been debated in recent years, some alleging that performance has been deteriorating and others disputing this allegation. The debate is important because proponents of certain policy measures--for example, industrial development banks and tax incentives for investment--cite the alleged deterioration to support their recommendations. Others, who dispute the idea of general deterioration, take the position that sustained economic growth will automatically create jobs and investment in manufacturing. The following discussion suggests gross profits as a share of gross product as a rough measure of industry performance, and uses it to evaluate the record in manufacturing since 1947.

Gross profits as a share of gross product.--Industry gross product is defined as sales or receipts plus change in inventories less inermediate goods and services purchased. (The last item is also called current account purchases; in the context of industry measures, it is the output other than plant and equipment purchased for its own use by one industry from other industries.) Industry gross product is also defined as the costs of production--that is, the compensation of employees, net interest, depreciation and other capital consumption allowances, and indirect business taxes--and business profits, of which corporate profits are the largest category. The national income and product account (NIPA) estimates of industry gross product are prepared by implementing the second definition. It is in the framework of these estimates that gross profits as a percentage of gross product--hereafter called the gross profits share--is calculated.

Gross profits is defined for this discussion as corporate profits with inventory valuation adjustment plus two components of the costs of production--net interest and corporate capital consumption allowances. It would be desirable to use a measure net of capital consumption allowances with the capital consumption adjustment--that is, a measure of capital consumption that has been adjusted to reflect uniform service lives and depreciation formulas and valued at replacement cost; however, such an adjusted measure of capital consumption allowances is not available by industry. A measure gross of corporate capital consumption allowances does maintain the desirable characteristic of being unaffected by changes in tax law that affect depreciation; for example, it is unaffected by the introduction in 1981 of the accelerated cost recovery system. The inclusion of net interest in gross profits provides a measure that reflects returns to both debt and equity capital, and is thus unaffected by changes over time in their proportion.

In one respect, the coverage of the gross profits share as calculated for this discussion is not fully consistent. Net interest covers both corporate and noncorporate establishments, but the other components of gross profits cover only corporate establishments. Gross product also covers both corporate and noncorporate establishments. (Corporate gross product is available for some, but not all, of the 1947-83 period.) For a measure of the corporate gross profits share, the lack of full consistency does not affect the results appreciably, because the noncorporate shares of net interest and gross product are very small.

Gross product and the components of gross profits, except net interest, are on an establishment basis rather than a company basis. Net interest is on a company basis because information for allocating it to an estabishment basis is not available. Establishment-based measures are appropriate indicators of industry performance because, unlike company-based measures, they allocate to each industry only the results of activities in that industry. The difference between the two bases can be illustrated with reference to an integrated company that maintains petroleum extraction operations, a pipeline, and a refinery. In establishment-based estimates, the gross product and gross profits from the three kinds of establishments would appear in mining, public utilities, and manufacturing, respectively. In company-based estimates, all the company's operation would appear in the industry that constitute the company's primary activity.

The rough measure of industry performance that the gross profits share provides does not indicate performance in the sense of ability to maintain past levels of output or market share. For example, a shrinking industry that maintains its gross profits by closing plants could record a constant share. The gross profits share does, however, indicate performance in the sense of ability of an industry to remain profitable under changing circumstances.

Manufacturers' performance, 1947-83.--The gross profits share for all manufacturing, durable goods and nondurable goods manufacturing, and selected manufacturing industries for 1947-83 are shown in charts 1 and 2. Although the shares show pronounced cyclical fluctuations, in most cases some underlying trend is discernible. For all manufacturing, the share appears to have been relatively stable, lending little support to the hypothesis of declining performance in manufacturing. Nondurables manufacturing shows a relatively stable share until 1973 and a slight uptrend thereafter. Durables manufacturing, in contrast, shows stability until 1965 and a slight downtrend thereafter.

The slight deterioration in the performance of durables manufacturing since 1965 reflects, in part, substantial deterioration in the gross profits share of manufacturers of primary metals. A downtrend in the share of manufacturers of motor vehicles from 1965 to 1980 also contributed. Since 1980, however, the share of this industry has improved, strengthening the durables share.

The slight improvement in the performance of nondurables manufacturing since 1973 reflects, in part, the improvement in the gross profits shares of two large industries--food and kindred products and petroleum and coal products. These industries began to record markedly higher shares in the 1970's, when world prices of their outputs shifted upward.

Employment and Hours: Two Years of Postrecession Growth

LAbor input to production--as measured by employment and average weekly hours--increased strongly over the 2 years following the third-quarter 1982 trough in real GNP, but the growth was not among the strongest in post-World War II recoveries. The following discussion highlights the industries where the growth in employment and hours was the strongest and weakest in the 2 years following the 1981-82 recession. It also compares growth during that period, 1982-84, with growth in the 2 years, 1975-77, following the 1973-75 recession. The period following the trough in real GNP in the first quarter of 1975 is used for comparison because it followed a recession similar to the 1981-82 recession in depth and duration. In addition, quarterly employment growth in 1975-77 was the median of the seven (post-World War II) recoveries preceding that in 1982-84.

Employment by industry

Nonfarm employment as measured by the Bureau of Labor Statistics establishment survey increased 5.3 million, or 3 percent at an annual rate, over the 2 years following the 1982-84 recession. The increase was one-half percentage point larger than that over the 2 years following the 1973-75 recession (chart 3). In both recovery periods nonfarm employment regained prerecession peaks in most service-producing industries, both public and private, but did not regain prerecession peaks in most goods-producing industries (table 2).

Despite an initial decline, total nonfarm employment regained the prerecession peak by the fourth quarter of 1983 and expanded in the first three quarters of 1984. More than three-fourths of the 2-year increase in employment occurred in the second year--a larger proportion than in any other post-World War II recovery. In 1975-77, slightly more than one-half of the increase had occurred in the second year.

The increase in nonfarm employment was broadly based; employment increased in every major industry group--albeit slowly in some--except mining (table 3).

Private service-producing industries. --A little over one-half of nonfarm employment is in private service-producing industries, which accounted for 3.5 million, or about two-thirds, of the total 2-year increase. Relatively higher growth rates during the 1982-84 postrecession period--an annual rate of 3-1/2 percent--continued a long-term shift towards these jobs. The 1982-84 growth rate matched that in 1975-77 for these industries. Of the four private service-producing industry groups, employment in two--transportation and public utilities and wholesale and retail trade--more than regained prerecession peaks over the 2-year period. Employment in finance, insurance, and real estate and in services had increased over the recession and increased more rapidly in the recovery.

Goods-producing industries. --A little over one-quarter of nonfarm employment is in goods-producing industries, which increased 1.5 million and accounted for about one-third of the overall increase. Manufacturing employment grew at an annual rate of 3 percent, a slightly higher rate than that following the 1973-75 recession. Durables employment grew at twice the 1975-77 rate, and nondurables at about two-thirds the 1975-77 rate. All of the growth in durables and most of the growth in nondurables occurred in the second year.

Employment in both durable and nondurable manufacturing did not regain prerecession peaks in 1982-84, just as it had not in 1975-77. In durables, notable exceptions were electronics, motor vehicles, lumber and lumber products, and furniture; these industries regained prerecession peaks in 1982-84, but had not in 1975-77. Growth in the electronics industry--a "high technology" industry--reflected strong sales of microcomputers and telecommunications equipment. A rebound in sales of automobiles and trucks accounted for much of the employment growth in motor vehicles, and a rebound in sales of new homes accounted for much of the employment growth in lumber and lumber products and in furniture. In nondurables, the printing and publishing industry and the rubber and miscellaneous plastics products industry both regained prerecession peaks in 1982-84; in 1975-77, the former had regained the prerecession peak, the latter had not.

Construction employment grew sharply--0.5 million, or 6 percent at an annual rate--in 1982-84 and exceeded the prerecession peak. In contrast, construction employment had been unchanged in 1975-77. The strong 1982-84 growth, which was centered in special trades (e.g., carpenters, masons, plumbers, and electricians) and in residential construction, reflected the sharp recovery in new home building.

In mining, employment declined 0.1 million, or 3-1/2 percent at an annual rate--in sharp contrast to the 4-1/2-percent rate of increase following the 1973-75 recession. Mining employment had increased over the 1973-75 recession and had continued to increase in 1975-77. Much of the contrast in growth in the postrecession periods is tied to energy markets--coal, natural gas, and crude oil.

Government.--Employment increases in government were sluggish in comparison with both private service-producing and goods-producing industries; it increased only 0.2 million, or 1/2 percent at an annual rate, over the 2 years. Government accounted for about one-sixth of total nonfarm employment, but only 4 percent of the 2-year increae--reflecting efforts to hold down employment levels. Employment did regain the prerecession peak as it had in 1975-77. In contrast to that period, 1982-84 growth was slow in both the Federal and the State and local components; in 1975-77, Federal Government employment had declined, and State and local government employment had increased more rapidly.

Average weekly hours by industry

Despite an initial decline in the fourth quarter of 1982, average weekly hours for private nonfarm production and nonsupervisory workers increased 0.5 hours in the 2 years following the third-quarter trough in real GNP (chart 4). The increase was strong in comparison with the 0.1-hour increase in 1975-77. As with employment, private nonfarm hours regained the prerecession peak--35.2 hours--in the fourth quarter of 1983; hours reached 0.1 hours above that level in the first three quarters following the 1981-82 recession occurred in the first year; increases in the first year following the 1973-75 recession had more than accounted for the 1975-77 increase.

The increase in average weekly hours was broadly based; hours increased over the postrecession period in all but one major industry group; hours in services were unchanged. The lagest increases were in goods-producing industries, which had suffered the largest drops in the recession. In 1975-77, no industry group had regained its prerecession peak; in 1982-84, however, most regained their prerecession peaks.

Private service-producing industries. --Average weekly hours increased slightly, on average, in service-producing industries in 1982-84; hours had declined in 1982-84; hours had declined in 1975-77 (table 4). Hours regained prerecession peaks in transportation and public utilities. Hours in finance, insurance, and real estate and in services had increased over the recession. Hours in the former continued to increase in 1982-84, while those in the latter were unchanged. Hours did not regain prerecession peaks in wholesale and retail trade. None of the groups had regained prerecession peaks in 1975-77; in fact, hours declined in all but transportation and public utilities.

Goods-producing industries. --Average weekly hours increased even more strongly in manufacturing, construction, and mining in 1982-84 than they had in 1975-77. Prerecession peaks were regained in manufacturing (including that for overtime) and in construction. In manufacturing, almost all of the increase occurred in the first year, and probably reflected employers' use of increased hours rather than recalls or new hires to boost production early in the recovery. The increase in construction continued an increase over the preceding recession. In mining, where the prerecession peak was not regained, most of the increase in hours occurred in the second year. Hours had not regained the prerecession peak in any goods-producing group in 1975-77. Comparison of the overall (net) increase in construction hours in 1982-84 with that in 1975-77 conceals sharp fluctuations in hours within each period; early in the 1975-77 period, hours had regained the prerecession peak.

Summary

The recovery and expansion in employment and hours for the nonfarm sector was strong in the 2 years following the 1982 trough in real GNP, but not among the strongest of the post-World War II recoveries. The 1982-84 increase in total labor input to production was more concentrated in the second year. Most of the increase in hours occurred in the first year, but most of the increase in employment occurred in the second. In 1975-77, the increase in total labor input had been more concentrated in the first year due to a strong increase in hours.

The recovery and expansion in employment was about the same as that following the 1973-75 recession, which was the median for the post-war period. Employment levels that had existed prior to the 1981-82 recession were, in general, regained in service-producing industries but not in goods-producing industries--about the same performance as in 1975-77. The strongest increases were registered in construction and services; employment declined in mining and increased only slowly in transportation and public utilities.

The recovery and expansion in average weekly hours was stronger than that in 1975-77. Prerecession hours levels, which had not been regained in the 1975-77 recovery, were regained in most industries in 1982-84. The strongest increases were registered in the three goods-producing industries--manufacturing, construction, and mining. Hours remained unchanged in services, after increasing over the recession, and increased only slightly in wholesale and retail trade.

Federal Fiscal Developments: The Tax Reform Proposal

In late November, the Department of the Treasury released the proposal for tax reform requested in the President's State of the Union message last January. The proposal is designed to make the tax system more equitable, simpler, and more conducive to economic growth. If enacted, it would be a significant revision of the tax system, including a substantial modification of the progressivity of the rate structure.

Before formulating the proposal, the Treasury completed a study of four options: a pure flat tax, a modified flat tax, a tax on income consumed, and a general sales tax, including a value-added tax and a Federal retail sales tax. The study laid out the following major objectives:

* Revenue neutrality. Reform would leave revenues essentially unchanged from what they would be under current law.

* Economic neutrality. Reform would not unnecessarily distort choices about how income is earned or how it is spent. It would not unduly favor leisure over work, or consumption over saving and investment.

* Equity. Reform would not place significantly different tax burdens on taxpayers in similar economic circumstances.

* Lower tax rates. Reform would keep tax rates as low as possible, given other objectives.

* An unchanged distribution of tax burdens across income classes. Reform would not significantly change tax burdens across income classes, but would alter the distribution of tax burdens within income classes.

* Fairness for families. Reform would assure that families with incomes below the poverty level would pay little or no tax.

* An inflation-proof tax law. Reform would provide inflation adjustments--indexation--in the measurement of taxable income.

The proposal--for which the modified flat tax is the basis--is essentially revenue neutral (see table 5), it does provide lower tax rates, and, according to the Treasury, it does not significantly change tax burdens across income classes. However, in designing a tax system that is simpler, the proposal may have been only partly successful. Some aspects of the proposal--such as the reduction in the number of tax rates and brackets and the repeal of many deductions--worked toward simplification, but other aspects--such as the indexation of capital gains, interest, inventories, and depreciation allowances--may have worked toward complication.

According to the Treasury, the proposal is an integrated package; changes are mutually dependent and must occur together to avoid inequities, distortions, complex administrative rules, and increased compliance costs. Any change in the package means that either the proposed rate structure or another proposal must be redesigned in order to meet the objectives mentioned above.

The proposal would reduce the average individual's income taxes by 8-1/2 percent while raising corporation income taxes by 37 percent. Under the proposal, 78 percent of individual taxpayers would experience no tax change or a tax decrease, and 22 percent would experience higher taxes. Of individuals with higher taxes, more than one-half would have an increase of less than 1 percent of income. The gainers under the Treasury proposal are likely to be low-income families and middle-income individuals who have few deductions or credits. Losers are those who have many deductions and credits, or who live in States with high income taxes. Among corporations, gainers are likely to be in service and high-technology industries, while those in capital-intensive industries, petroleum companies, and banks would be losers.

Effective dates and transition rules

The Treasury proposal recognizes the difficulties in implementing such a sweeping revision to the tax system. The proposed effective dates and transition rules assume that legislation is introduced in early 1985, enactment is July 1, 1985, and the general effective date is January 1, 1986. The proposed transition rules can be divided into four general categories.

1. Immediate implementation. In many cases, the Treasury recommends that the proposals be implemented immediately. Changes in the zero bracket amount, personl exemptions, and a variety of credits and deductions fall into this category; changes in individual and corporate tax rates would be delayed 6 months to achieve the goal of revenue neutrality in the initial year after enactment. The special preferences for energy and natural resource industries would be repealed immediately. To reduce the impact of immediate implementation, the repeal of the windfall profit tax would be accelerated by 3 years, with the scheduled three-quarter phaseout beginning on January 1, 1988 instead of January 1, 1991.

2. Immediate implementation with grandfathering. Grandfathering provisions--that is, provisions that exempt commitments entered into prior to the legislation--are recommended to avoid reform-induced windfall gains and losses. Permanent grandfathering is recommended, for example, for existing commitments to accelerated cost recovery and the investment tax credit. Temporary grandfathering is recommended, for example, for fringe benefits. For most, the new rules will apply as contracts expire or, at the latest, January 1, 1989, but in the case of the two largest fringe benefits--employer-provided health care and life insurance--the new rules will be fully effective January 1, 1990. In addition, for those cases where tax-sheltered income is brought into the tax base, it is recommended that the increase in income tax be spread evenly over a fixed number of years for tax purposes.

3. Phased-in implementation. The Treasury recommends phased-in implementation for dividend relief, elimination of the deduction for State and local taxes, the limit on charitable contributions, elimination of the graduated corporate tax rates, the limit on interest deductions, and elimination of the business deductions for entertainment expenses and for meal and travel costs in excess of a limit.

4. Delayed implementation. For various reasons, the Treasury recommends delayed implementation for many of the changes in the taxation of estates, certain military cash compensation, and unemployment and workers' compensation (January 1, 1987); interest indexing (January 1, 1988); indexing capital gains on nondepreciable assets (January 1, 1989); and repeal of the individual and corporate minimum taxes (January 1, 1990).

The remainder of this article will discuss the major features of the Treasury proposals (see tables 6 and 7). The effect for the year 1990 is referred to in order to encompass the full implementation of the proposals.

Individual income taxes

Individual income taxes are reduced $37.7 billion in 1990 by the Treasury proposal, the net result of $161.7 billion in tax reductions and $123.8 billion in tax increases. Changes in the tax rate structure (including the effect of indexation of rates, exemptions, and the zero bracket amount) account for the bulk of the proposed reductions. The current set of 14 rate brackets, ranging from 11 percent to 50 percent, is changed to a modified flat tax with 3 rate brackets (see table 3 for proposed rates and brackets). The indexation of interest income and expense, capital gains, and the earned income tax credit accounts for $19.2 billion of the reductions. The proposal to index interest introduces some complications into the tax code. Mortgage interest on an individual's primary residence is fully deductible. Other interest expense is then netted against interest income to derive net interest income (or expense). If the taxpayer has net interest income, a portion--the fractional interest exclusion--of this net income would be excluded in determining adjusted gross income (AGI); the remainder would be included in AGI. If the taxpayer has net interest expense, the first $5,000 would be deductible, and the excess of $5,000 would be subject to the fractional exclusion rate in determining the amont that would be deductible. Other provisions of the interest indexation proposal place limits on the total amount of net interest expense that can be deducted in 1 year. The fractional exclusion rate, announced each year, is to be set to reflect the relationship between the current rate of inflation--measured by the percentage increase in the Consumer Price Index over the previous 12 months--and the longrun real interest rate. The desired relationship is approximated by dividing the inflation rate by the nominal interest rate. For example, assuming an inflation rate of 4 percent and a nominal interest of 10 percent, the exclusion rate would be 40 percent. Thus, 40 percent of nominal net interest income will not be taxed.

The repeal and limiting of deductions account for the largest share--$50.3 billion--of the proposed increases and include: (1) repeal of the deduction for State and local government taxes, and (2) limiting the deduction for charitable contributions to those above 2 percent of AGI. The repeal and limiting of exclusions account for $20.2 billion of the increases and include taxing: (1) employer-paid health insurance premiums in excess of $70 per month for a single person and $175 per month for a family, and (2) workers' compensation, but with a special credit for the elderly and disabled. The proposal to repeal the accelerated cost recovery system (ACRS) for depreciation and replace it with an indexed economic depreciation--the real cost recovery system--increases taxes $12.9 billion.

The proposal to provide relief from double taxation of dividends by allowing a 50-percent dividend-paid deduction to corporations increases individual income taxes $7.4 billion (based on the assumption that more dividends will be paid by corporations).

Corporation income taxes

Corporation income taxes are increased $44.7 billion in 1990 by the Treasury proposal, the net result of $109.5 billion in tax reductions and $154.4 billion in tax increases. Changing the rate structure from a graduated tax rate, up to 46 percent, to a flat rate of 33 percent accounts for the bulk of the reductions. The major increase occurs from repeal of ACRS and replacing it with indexed economic depreciation. Repeal of the investment tax credit and applying uniform rules for multiperiod construction increase taxes $31.7 billion and $13.9 billion, respectively.

Other taxes

Estate and gift taxes are reduced slightly by a proposal to unify the estate and gift tax structure by conforming the computation of the gift tax base to that of the estate tax. Excise taxes are reduced $3.1 billion in 1990 by the proposal to accelerate the phase-out of the windfall profit tax.

Third-quarter NIPA revisions

The 75-day revisions of the national income and product accounts estimates for the third quarter of 1984 are shown in Table 8.
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Title Annotation:fourth quarter 1984
Publication:Survey of Current Business
Date:Dec 1, 1984
Words:5851
Previous Article:Regional shifts in personal income by industrial component, 1959-83.
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