Tax reform is long overdue, and the new law taking effect next month is doubtless a positive development. It will simplify our Byzantine tax code, redeploying many bright minds currently busy finding new ways for us to dodge taxes into more productive areas, such as helping U.S. industry compete in world markets. More important, it will restore the tax system to its original purpose--raising revenue for the government, not furthering social and economic causes championed by Congress.
The existing tax system promotes low-income housing, consumer borrowing and office construction; a lower tax rate on capital gains induces investors to hold assets for six months or longer. By eliminating most tax shelters and ending preferential tax treatment of most investments, the law will let the free market direct spending and investment decisions. Since market forces allocate resources more efficiently than Washington, the U.S. economy as a whole will gain.
But these are long-run benefits, and even when they are realized, they may be difficult to measure. In the short term, tax reform will have a palpably negative impact on economic growth. In fact, its implementation early next year may well push the already-slackening economy into a recession.
In the past two years, since the current slow-growth period began in mid-1984, consumer spending contributed more than 100% of the increase in the nation's gross national product, as the rest of the economy shrank. In the process, consumers have run up tremendous debts, and their debt burden now equals almost 20% of disposable personal income. Sooner or later they will have to pause, and the new tax law, by eliminating interest payment deductibility on consumer loans, may provide an impetus to do so early next year.
Slowdown in Consumer Borrowing
True, consumers have not shown much sensitivity to interest rates. But they have been sharing the burden of very high interest rates with Uncle Sam, so that those in the 50% tax bracket paid only half the interest on their loans because interest payments were fully tax-deductible. Next year this no longer will be true--interest deductibility on personal loans will be phased out starting in 1987--and consumers may not only stop borrowing, but will probably start saving to pay down their credit card balances and other debts.
Another provision of the new bill ends sales tax deductibility. Manufacturers and retailers, including auto companies and dealers, have been alerting consumers to this in TV ads and urging them to load up on big-ticket items before year-end. This may trigger a shopping spree in December, but those sales will be borrowed from next year: no one would buy an extra car or refrigerator just to get a sales tax write-off. Consequently, we may see a sharp decline in spending on consumer durables in early 1987.
In the short run, then, the new tax law will probably hobble the consumer, the only driving force in the economy, but it won't encourage other sectors to pick up the slack. On the contrary: In the private sector, the uncertainty and confusion that a tax law change of such magnitude is likely to create will probably result in lower levels of spending and investment, at least initially. And when the smoke clears, we may find investment in plant and equipment drastically curtailed. The rapid growth in this area earlier in the expansion was spurred, in large measure, by generous depreciation allowances, investment tax credits and other tax incentives introduced in 1981. The bloom had been off this rose even before the new tax law abolished those incentives; now, capital spending will surely be driven into the mud.
Further, the real sleeper in the new law is the impetus it will give to firms' cost-control efforts. It will lower the top corporate tax rate from the current 46% to 34% in 1988--which means that after-tax costs of every tax-deductible business expenditure will rise 26% for a firm in the highest tax bracket. This coming on top of several existing reasons to control costs--including, among others, import competition, inability to raise prices in an era of low inflation, still-high inflation-adjusted interest rates and the lasting effects of the severe recession of the early 1980s--means that businesses will continue to be extremely tight-fisted not only in their investment outlays, but also in worker compensation and elsewhere.
Tax Law's Bad Timing
In the past, lower tax revenues and increased government spending during recessions provided fiscal stimulus that mitigated business weakness. That approach will not be available next year because of the unfortunate timing of the new tax law. To make the law revenue-neutral, Congress found it necessary to raise government receipts by $10 billion in fiscal 1987. This will be reversed in fiscal 1988, but in the meantime, additional taxation will depress the economy.