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Tax Reform Sneaks Up on Budget Deficit

October 11, 1987|JAMES FLANIGAN

With all the hysteria over rising interest rates and falling stocks, has anybody noticed that tax revenues have been rolling into Washington? Thanks to the Tax Reform Act of 1986, the government took in money hand over fist in fiscal 1987--the 12-month period ended Sept. 30--and was able to cut the federal deficit impressively.

The government hasn't said much about its tax windfall, explains one Washington consultant, because the Treasury sticks to the position that the tax bill is "revenue neutral"--meaning it neither raises nor lowers taxes. Nonetheless, tax reform may have added as much as $60 billion to government revenues in fiscal '87.

Some increases were anticipated. Corporations no longer got tax credits for investing in machinery or hiring the underprivileged, and thus paid more to Internal Revenue. But some tax payments resulted fortuitously from accounting changes and corporate prepayments, says Delos Smith, who analyzes the federal budget for the Conference Board, a business research organization.

And individuals may have done more to swell government coffers. Higher capital gains tax payments brought an additional $20 billion into the Treasury, because people rushed to sell long-term investments last December when the capital gains rate was still 20% rather than the current 28%. And income tax withholding has been coming in at higher rates than before, which is no surprise to anyone who has filled out the new W-4 forms with their threats of penalties for under-withholding.

Deficit Going Down

Basically, the government is behaving like the owner of a troubled business, trying to stay afloat by getting customers to pay their accounts early. And succeeding.

Tax reform has lowered the top rate--from 50% to 38.5% this year and 28% next year for individuals, 46% to 34% for corporations--and compensated by eliminating deductions and insisting on prompt payments. It's not surprising that the government has collected more money--the average individual paid at a less-than-25% rate before reform, and many corporations paid little or nothing at all.

OK, so the government is doing no favors. What's new? What's new is that the federal deficit, which has been blamed for high interest rates, is declining--to roughly $155 billion in fiscal 1987 from $212 billion.

To be sure, many call that a one-shot reduction because the tax speed-ups that produced it can't be repeated. But tax reform may be more than one-shot, says Stephen Kunkel of the accounting firm Pannell Kerr Forster. The business tax base has been broadened tremendously, he points out, and that could mean a permanent expansion of government revenues.

Faster tax payments may not erase the deficit--which is projected to fall to $137 billion in this fiscal year--but they do make its downward trend more credible.

Then why are interest rates rising? Because the economy is expanding, says economist Neal Soss of First Boston Corp., and "when the economy is strong, interest rates go up--irrespective of the deficit."

But to some extent also, rates are rising because of fear, which makes lenders and investors demand interest protection. There are fears that Japanese investors will stop financing the deficit by buying U.S. Treasury bonds, and fears that the dollar will collapse, unleashing serious inflation.

The antidote to fear is reason. Japanese investors have been pulling out of U.S. Treasuries all year, reports Pierre Rinfret of the currency investment firm Rinfret Associates. The effect of their shift--to U.S. common stocks and Japanese long-term bonds--has long since been reflected, meaning interest rates have risen, but are not about to rise further.

As for the dollar, it's unlikely to decline, much less collapse, now that the major nations have agreed to stabilize currency values--while crediting "substantial reduction in the U.S. budget deficit" for making stability possible.

The upshot: Interest rates are not going back to the 15%-plus stratosphere they reached in 1981. The economy is improving. And the deficit is declining--thanks to tax reform, which has raised a lot of money while pretending not to.

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