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Essentials of tax reform.

ESSENTIALS OF TAX REFORM

Cynics said it could never happen, but Congress is on the verge of enacting real tax reform. Last December, the House passed a monumental bill; this May, the Senate Finance Committee approved its own terrific version. If a good bill emerges from the House-Senate conference and the President signs it into law, then taxpayers can celebrate and doubters of the democratic process can begin rethinking their opinions.

But the conference promises to be one of the most heavily lobbied ever, so let's keep in mind the danger that in the horsetrading, certain key reforms--the ones that end the worst abuses-- may be trampled on. Here are those essential reforms and the horrors they will end. Without these reforms, we won't have true tax reform.

Cut taxes for the poor

Horror Story #1: While the rich have enjoyed the President's 1981 tax cuts, working poor families have watched their tax rates skyrocket. In 1979, a couple with two kids and one spouse working 51 hours a week at minimum wage had a gross annual income of $7,395--exactly the proverty line. Their total tax burden was $128, or 1.7 percent. By 1985, a family living on the same income (after inflation) made $11,016, but they paid $1,176 in taxes. That's an effective rate of 10.5 percent--a five-fold increase over 1979.

Supply-siders in the White House and on Capitol Hill caused this experiment in regressive taxation in 1981 when they refused to adjust three key tax provisions for inflation.

The first was the standard deduction. This is the sum--currently $3,540 for couples--you get to deduct if you don't itemize. The second was the personal exemption, the $1,040 you can deduct for yourself and each member of your family. The third item was the earned income tax credit, a tax rebate to working poor families that offsets part of their Social Security tax. Together, these three provisions kept the effective tax rate on working poor families low before 1981. Not raising the value of these provisions as the cost of living rose, inevitably meant vastly higher tax rates for these families. Having argued that welfare gave the poor an incentive not to work, the Reagan administration turned around and gave them another one.

Essential Reforms #1: Raising the value of these three crucial tax breaks and permanently indexing them for inflation is the surest way of giving needed relief to the poor. Both the House and Senate bills do this. Either bill, if passed, will reduce the combined income and Social Security tax rate on a poverty-level family of four from what would have been 11 percent in 1988 under current law to less than 3 percent. A higher personal exemption will also give relief to large families who, because the exemption hasn't kept up with inflation, have also been hard hit.

End corporate freeloading

Horror Story #2: in 1983, General Electric's subsidiary, General Electric Credit Corporation, discovered that Union Pacific, the railroad conglomerate, had millions of dollars worth of investment credits and depreciation tax deductions from its new refinery in Corpus Christi, Texas. But because Union Pacific had already used other tax breaks to reduce its tax rate to around 1 percent, these extra write-offs were all but worthless to it. So G.E. Credit Corporation and Union Pacific cut a "sale-leaseback' deal. G.E. paid Union Pacific a fee in exchange for receiving title to the refinery, which G.E. then leased right back to Union Pacific. Union Pacific continues to operate the refinery as before; but since G.E. Credit "owns' the facility, it can use all the tax credits and deductions it generates to offset G.E.'s income tax liabilities. G.E., in essence, bought Union Pacific's surplus tax breaks.

Creative accounting like this has worked wonders for G.E. In 1978, the company paid about one-third of its U.S. profits in federal income taxes. From 1981 through 1984, however, G.E. paid nothing at all, despite domestic earnings of $9.6 billion. Indeed, G.E. used those breaks to get Uncle Sam to rebate $98 million in taxes the company had paid prior to 1981.

While the working poor saw their tax rates zoom after 1981, corporations shrank their taxes dramatically by behaving much as G.E. did. Two tax law changes in 1981 made this possible. The first expanded the use of investment tax credits--a provision that lets companies deduct ten cents for every dollar they spend on new equipment. The second let businesses write off the costs of new buildings and machines far faster than they actually wear out--a practice called accelerated depreciation. Business autos, for instance, can now be written off over two and a half years, even though a typical car lasts almost ten years; business machines, in general, can be deducted in four and a half years, usually a fraction of their actual working lives.

G.E. is hardly alone in having used these gimmicks to avoid paying taxes. A Citizens for Tax Justice survey of 275 of America's largest and most profitable corporations found that almost half managed to pay no income taxes in at least one year between 1981 and 1984. Fifty of the companies--among them such household names as Boeing, Dow, and ITT--paid nothing for the entire four year period. In fact, they gained billions of dollars in tax rebates. Whole industries now pay little or nothing in corporate taxes. Eight of the top 12 defense contractors, paid less than 1 percent of their profits in federal income taxes from 1981 to 1984. The tax rate on big banks and insurance companies was a negative 3 percent. If that's not enough to pique your outrage, consider this: five American oil companies still pumping oil in Libya, including W.R. Grace & Co., paid a total of nothing to the U.S. Treasury, while providing several billion dollars a year in taxes to the Qadaffi government.

Wait a minute, you say. Maybe there's something to supply-side arguments that these kinds of tax cuts provide incentives for investment and create jobs. Well, let's look at the facts. Since 1981, business investment in the new equipment that was supposed to have been stimulated by the cuts has increased at an annual rate of just 1.9 percent--less than one-third the rate of increase in such investment from 1976 to 1980.

In fact, the companies that enjoyed the biggest tax write-offs actually performed the worst. Those giant, profitable firms in the study that paid no tax between 1981 and 1984 cut investment by 4 percent, cut employment by 6 percent, and cut exports by 15 percent--even as they splurged on mergers, paid out higher dividends, and raised top executive salaries by 52 percent. On the other hand, those companies that used tax breaks the least--and paid the highest taxes--increased their capital spending by 21 percent and their workforce by 6 percent.

Essential Reforms #2: The first step towards bringing corporations back back into the tax-paying fold is to eliminate the investment tax credit--a $34 billion item in 1990. Both the House and Senate bills do this.

But when it comes to taking on the other big corporate tax loophole, accelerated depreciation, they diverge widely. The House bill is very effective: it requires companies to write off their capital assets as they actually wear out. The Senate plan, on the other hand, makes depreciation write-offs more generous than current law for equipment--although less lucrative for buildings. By 1990, the House depreciation reforms would raise more than $15 billion a year, while the Senate changes wouldn't raise a nickel. The Senate also left open holes in the tax code for the benefit of defense contractors, oil and gas producers, and others.

Both the House and Senate bills try to plug leaks with a minimum corporate tax provision. Here, too, the House's 25 percent minimum tax is tougher than the Senate's 20 percent version. Some corporations would be sure to figure out accounting techniques that let them legally avoid paying even this minimum tax. No corporate executive who wants to keep his job, however, would dare not report profits to shareholders. A nifty feature in the Senate bill exploits this fact and would therefore be the ultimate corporate tax dragnet: a requirement that companies pay no less in taxes than 10 percent of the income they report to shareholders. Added to the House's corporate tax rules, this feature would put an end to corporate freeloading.

Cracking down on tax shelters

Horror Story #3: The Valley Mall in Washington County, Maryland, isn't an egregious example of a tax shelter, but a typical one. Built in 1974 in classic This Could Be Anywhere In America style, the 95-store mall was sold in 1983 to 188 tax shelter investors, none of whom lives in Washington County. A New York City lawyer named Alan C. Winick is the brains behind the deal. He sold limited partnerships to 187 doctors, lawyers, businessmen, and to one-time presidential candidate, George McGovern.

McGovern initially invested $23,000 in Winick's deal. That money, plus contributions from the other 186 investors, gave Winick $2 million--2 percent of what he needed to buy the mall. The rest he borrowed; some from the previous owners (who were also using the mall as a tax shelter), some from a bank. The first key to real estate tax shelters was thus in place: leveraging. For each dollar put in by an investor like McGovern, the firm borrowed $20: McGovern's $23,000 initial investment allowed Winick to borrow $460,000. Because it was what bankers and shelter promoters call a non-recourse loan, McGovern himself is not liable for that extra $460,000 should the deal somehow go sour. Nevertheless, a special loophole for real estate lets him take tax write-offs based on the whole $460,000 "investment' against his personal income taxes.

This ability to leverage his losses lets McGovern claim a 20-fold write-off on the biggest post-1981 tax break: accelerated depreciation. The federal government used to figure a commercial building deteriorated and lost its value after 35 years-- which isn't necessarily the case, since commercial properties tend to increase in value over time. The 1981 tax changes let owners pretend their properties depreciate in 15 years (Congress later increased this to 18 years). That more than doubled the depreciation "loss.'

Once the paltry income from the mall's rent was taken into account, depreciation deductions and interest write-offs produced a $57,600 tax "loss' for McGovern in the first six months. Since he is in the 50 percent bracket, he saves roughly $28,800 in taxes. That's $5,800 more than he put into the shelter. This netted him a 37 percent annual rate of return after taxes, or about ten times better than what he could have gotten in a good money market account at current rates.

But we're not done yet. Because of the tax breaks, Winick's investors happily paid more for the Valley Mall than it would otherwise be worth, Because interest and maintenance costs are greater than the rent from the 95 stores, the partners agreed to contribute additional money each year to make up the difference. McGovern, for instance, kicks in an annual $41,475 extra--and takes out another $104,000 in tax deductions.

After seven years, the partnership plans to sell the Mall. If the partnership can sell the Mall for a price high enough to return McGovern's money--making the investment the functional equivalent of stuffing money into a mattress for seven years--then McGovern gets another huge bonus. Remember, he's already written off his $313,000 investment as a loss. That means any money he gets back from the building's sale should be taxable as income. But because it comes from the sale of a building, that income is technically a "capital gain' and therefore qualifies for the capital gains exclusion. This break exempts investors from paying taxes on 60 percent of what they make when they sell stocks, bonds, real estate, and so forth. In McGovern's case, the break saves him another $87,000 in taxes and boosts the shelter's rate of return to almost 54 percent.

A confident David Stockman predicted in 1981 that lowering the top individual tax rate from 70 to 50 percent would "eliminate' tax shelters like these by reducing the wealthy's incentive to shelter their money. Instead, investments in tax shelters jumped 140 percent from 1980 to 1983.

The chief cause, once again, was the 1981 tax code. Accelerated depreciation and increased investment tax credits, the same breaks that failed as productivity incentives for corporations, inspired instead a burst of creativity from tax shelter promoters like Alan Winick. And the rate drop combined with the capital gains deduction created a double-decker tax break for investors rich enough to take advantage of shelters such as the Valley Mall.

Tax shelters may be great deals for the rich, but they're terrible for the rest of us. For one, they increase the deficit--you and I each pay $300 a year in extra taxes to cover tax shelter losses. They also undermine the basic fairness of the tax system--last year, for instance, Treasury found almost 30,000 people making over $250,000 who used tax shelters to pay virtually nothing in income taxes.

Tax shelters also squander valuable capital. Llama raising, embryonic cattle breeding, treasure hunting partnerships, foreign stamp speculation--if these don't strike you as especially promising or prudent investment opportunities, you're right. While the appeal of most other investments is profit, the appeal of these tax shelters is the "losses' they generate. Wealthy investors write these paper losses off against their high-bracket incomes and come out saving great sums of tax money. For instance, your income may be $1 million, but if you can claim a $400,000 "loss,' you only have to pay taxes on $600,000. If you're in the 50 percent bracket, you've just saved $200,000 in taxes. That's fine if you actually lost the money, but as the Valley Mall example shows, tax shelters allow you to claim losses you didn't personally suffer.

Tax shelters aren't just unproductive; sometimes they're destructive. In the Sand Hills region of Nebraska, for instance, tax shelter developers, using fast depreciation and special agricultural tax breaks, irrigated thousands of acres of grazing land. They then parceled out the land to shelter-seeking investors across the country. The promoters and investors--most of whom knew nothing about agriculture--though the tax savings on the irrigation equipment would tide them over until the land could produce crops, after which they could sell out for a profit. Local ranchers, however, warned that the soil was too thin and sandy to ever support crops. The ranchers were right. Irrigation and cultivation caused the topsoil to blow away in the wind, ruining much of it even for grazing purposes.

The problem with tax shelters--and all business tax "incentives'--is that they encourage investments that make no economic sense in the absence of a tax subsidy. Indeed, that's the very purpose of the "incentives'--since projects that do make sense will be undertaken anyway. For instance, commercial real estate limited partnerships--the biggest tax shelter bonanza these days--has led to an office building glut that has even die-hard civic boosters blushing. The national office vacancy rate, 3.8 percent in 1980, now hovers around 18 percent. This is after four years of economic growth.

Essential Reforms #3: George McGovern probably doesn't think of himself as a sleazy tax avoider for investing in Valley Mall. Indeed, he would doubtless be the first to thank Congress for ending their corrupting influence. Several provisions in the House tax reform bill help a lot: strong restrictions on business "incentives,' more realistic depreciation rules, a tough individual minimum tax. But here it's the Senate's bill that goes to the heart of the problem. If we really want to kick the slats out of the tax shelter business, we should follow a few simple steps in the Senate's plan.

First, we should adopt the Senate's passive loss rule. Currently, investors can also apply the losses from "passive' investments, such as limited partnerships, to shelter profits from "active' sources, such as salary income and earnings from investments such as stocks and bonds, and reduce their overall taxable income. By prohibiting the subtraction of surplus tax losses from regular income, the Senate's passive loss rule will take away most of the incentives people now have for investing in tax shelters. To ice the cake, we should impose an at-risk rule, which states that an investor can't write off losses on money for which he is not personally liable, such as the non-recourse loans that multiply McGovern's deductions. At-risk rules apply to almost all other investments; they should apply to real estate as well.

Second, we should eliminate the special tax break for capital gains, as provided for in the Senate bill. This will do more than help wreck the tax shelter industry. It will also restore almost a quarter of the incomes of the wealthiest Americans to the tax rolls--the richest 2 percent of Americans now get more than 85 percent of the benefits of the capital gains exclusion. Ending the break will, like the other reforms described above, make the tax code more progressive.

Some people fear that ending the capital gains deduction will cause money for new, risky, jobsproducing enterprises to dry up. In fact, most of the money that has flowed into venture capital funds that invest in new businesses has come from pension funds and other tax-exempt sources that don't benefit from the capital gains break. What has attracted this money are not tax breaks, but average annual rates of return of 25 percent or better. Eliminating tax shelters by ending such breaks will almost certainly cause more money, not less, to flow into productive new businesses.

The only ones certain to lose if we end the capital gains exclusion are lawyers, accountants, and tax shelter promoters. Eliminating the break will also, without doubt, be the biggest simplification of the tax code ever. As much as one-third of the tax code represents rules that govern when capital gains treatment is and is not allowed.

The House bill cracks down on corporate tax shelters; the Senate plan cracks down on personal tax shelters. Both bring long-overdue tax relief to the poor. Combining the best aspects of both bills is the obvious final step. Doing so would create a fairer tax system--and lower rates--for the vast majority of us, who pay our share, year in and year out.
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Author:McIntyre, Robert S.
Publication:Washington Monthly
Date:Jul 1, 1986
Words:3098
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