Ratter Taxesand Falter BasesAn Evaluation of Current Proposals

Towar dbette rgovernment

Founde d193 7

A Tax Foundation Special Report

Board of Trustees

Officers ROBERT A.d&PALMA WILLIAM McCHESNEY MARTIN, JR .Senior Vice P resident 8 Chief Financial Officer Former Chairman

Honorary Chairman Rockwell International Corporation Federal Reserve BoardJOHN W . HANES

CHARLES T. FISHER . III PAUL W. McCRACKENChairman Chairman & President Edmund Ezra Day University Professo rW . BRUCE THOMAS National Band of Detroit of Business Administration

Chairman of the Executive Committee GWAIN H . GILLESPIEThe University of Michigan

THOMAS M . MACIOCE Senior Vice President & Chief Financial Officer PETER J . McLAUGHLIN

Vice Chairmen A.J. Reynolds Industries, Inc . Chairman & Chief Executive Officer

FRED L . HARTLEY RAY J. GROVES Union Camp Corporation

JOHN A. LOVE Chairman 8 Chief Executive WALTER F. O'CONNELL 'HANS W. WANDERS Ernst 8 Whinney Chairman of the Finance Committee

Treasurer PRENTIS C. HALE Olin Corporation

JOHN C . BURTON Chairman of the Executive Committee MONFORD A . ORLOFF

President and Secretary Carter Hawley Hale Stores, Inc . President

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JOHN C . BURTON Del Monte Corporationand The Wachovia Corporatio n

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Flatter Taxesand Fatter Bases

An Evaluation of Current Proposal s

A Talc Foundation Special Report

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FLATTER TAXES AND FATTER BASE S

An Evaluation of Current Proposals

I.

Summary and Outloo k

II.

The Proposal s

III.

Simplification and Certainty

IV.

Economic Impact

I . Summary and Outlook

Three leading reform plans for a modified flat income tax -- the Treasur yDepartment's November 1984 Report, the Bradley-Gephardt bill and the Kemp -Kasten bill -- are evaluated, with most attention to the more comprehensiv eTreasury report . The plans are evaluated principally for simplification objective sand economic impact. Simplification is considered in terms of both ease ofcompliance and for tax/investment planning .

A scorecard on eighteen major provisions of the Treasury cutting acros sthe economy reveals the following :

Twelve of the eighteen would be considered improvements for complianc epurposes but only seven improvements for tax/investment planning. Eight of theproposals are seen as further complications for planning purposes and the ne teffect of three is unknown . Simplification both for compliance and planning ismore evident for individuals under the Treasury program than for corporations .The most notable exception to the prospective general simplification forindividuals would be the plan to repeal numerous statutory fringe benefits whic hwould not only complicate tax compliance but have a major impact on employer -employee relations .

On the corporate side, of eight major proposed provisions mainly affectin gcorporations, compliance improvement is noted in half of them but improvemen tfor planning in only two .

In general, the Treasury plan would make some significant progresstoward simplification particularly in compliance. But the simplification objectiveis compromised by other tax reform considerations especially the proposed sprea dof indexing and new measurements of income in the business sector.

While no separate rating of the Bradley-Gephardt or Kemp-Kastenprovision has been made, it appears that they would offer somewhat less overal lsimplification for compliance purposes than the Treasury program but also involv eless planning complications than the Treasury program . Both congressiona lprograms are considerably more limited in the reach of their provisions .

There is much controversy over the economic impact of these tax refor mplans. All of them would curtail severely the capital recovery provisions of thepresent system . Any of them, if enacted, would mark a drastic reversal of the U .S.industrial tax policy put in place over the last thirty years . And the Treasury plan ,in particular, deliberately would shift a heavier tax burden to the corporate sector .

The cost of investment capital probably would increase under all theseplans. Because of the Treasury plan's fullscale extension of inflation indexing t odepreciation, capital gains, and debt, its potential impact on investment decision sand the economy would depend to a large extent on future inflation rates -- an dexpectations as to future inflation . For savings and investment incentives, lowe rmarginal rates would help offset the loss of the Accelerated Cost Recovery Systemand/or the investment credit . But no present econometric framework can captureall of the trade-offs and interactions of the proposed reforms. The net results foreconomic efficiency are unknown, and the attendant uncertainties about such adrastic change in industrial tax policy may lead to modification of the refor mplans.

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The Treasury plan above all emphasizes neutrality of tax treatmen tbetween income groups of individuals and among industries and investments . Thedrive for base-broadening neutrality appears to control the agenda of reformalthough it is not exclusive of political considerations, such as the proposeddoubling of the personal exemption and retaining the basic mortgage interestdeduction for individuals . In a number of cases the neutrality objective raises ne wquestions of equity as in the proposed elimination of deductions for state/loca ltaxes and in the interaction between proposed treatment of capital gains and stat eincome taxes.

What will happen to these ambitious tax reform plans in the 99th Congressis very much up for grabs . It will take a disciplined effort on the part of theAdministration, the congressional tax-writing committees, and Congress as a whol eto put through anything close to the Treasury reform plan or the Bradley-Gephard tor Kemp-Kasten programs . It's far from certain that any such effort will be mad eeven though there is a strong public interest in and desire for tax simplification an dreform .

It is unfortunate that the most extensive tax reform consideration in atleast thirty years is taking place in the context of the severest budget defici tproblem ever . Elegant plans of the reformers could be emasculated quickly in thecurrent environment . If the budget process turns to raising new taxes by combingthrough the agenda of reform, as has already been hinted by some, hope for a reallysimplified system could be dashed . Another round of TEFRA-type nickel and dimebase broadening with little or no rate reduction or other relief could be a fata lsetback to the cause of reform . It is no coincidence that those who are sincerelyinterested in improving the system strongly want to keep tax reform and thebudget deficit apart. They must succeed in this for any real reform to have achance.

II. The Proposals

Taxes are always good copy. Perhaps because of the pervasive reach ofthe tax system that touches so many people in different roles as consumers ,workers, investors, and producers, it is a truly universal topic -- grist for the medi amills, ammunition for the politicians and policy analysts, the source of millions o fanecdotal personal triumphs and tragedies . So it is that proposed changes in ourbasic tax structure draw lots of attention well beyond their likely actual impact ,and arouse such purple passions in the process .

The present round of Federal tax reform consideration is an excellen texample. Few believe that any of the leading reform proposals will be enacted i ntheir present form if at all . Many assume the budget deficit problem will shove taxreform aside. Yet the latter is the subject of intense scrutiny .

The most prominent tax reform proposals as of year-end 1984 all fitwithin the modified flat income tax concept . They all call for a greatl ycompressed rate structure and a widened taxable income base. Their objectivesare the same : simplification, greater equity in treatment of similarly situate dgroups of taxpayers, a more efficient system . All are designed to be basicall yrevenue neutral -- to bring in the same amount of revenue as the present system.

It is interesting to note that despite considerable academic and othe rinterest in moving to a consumption tax base -- through a value-added tax orconsumed income tax -- the current leading proposals all stick with the net incom ebase. Judgment has been made that the country is not prepared, at least not now,for a whole new tax system which would be very difficult to implement . We alsoshould note that the present Federal income tax structure has become, in somerespects, a de facto consumption tax and all leading reform proposals would retai nsome of the features of the present system that have steered toward consumptio ntaxation through partial exemption of savings . The new proposals, of course, wouldmake very significant changes in the taxation of capital and capital income .

The idea of moving to a flat tax structure has a long-term allure . That isreally where we started back before World War I (1913-1915) when the Federalincome tax rate was all of 1% on taxable income up to $20,000, which coveredalmost everyone who paid any tax, and ranged no higher than 7% on those wit hincomes over $500,000, who were very few . As late as 1954, the time of the lastcomplete Internal Revenue Code revision, about 90% of all taxpayers paid at th erate of 20-22% -- even though the marginal rate structure went as high as 91% atthat time . Nobody suggests we can go back to pre-World War I rates, but theappeal of a much lower, flatter, and uncomplicated rate structure is undeniabl yvery popular, attractive to all shades of political and economic opinion .

But something else was happening during our passage from a 1% basi cincome tax in the early 1900's . As government's spending demands rosedramatically during and after two world wars and marginal tax rates spiraled over90%, we learned to rely on all those special deductions, credits, and shelters to

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protect us from the worst bite of high marginal rates . As both business andindividual economic affairs became more complicated, we learned to live wit hthose special provisions which were enacted to deal with the great variety o feconomic circumstances that taxpayers faced . And, most important, as inflationaccelerated in the post World War II period we also learned about bracket creep --the interaction of inflation and graduated tax rates which moves people up the rat escale without necessarily the proportionate ability to pay . True, Congressattempted to reduce tax burdens periodically to counter bracket creep, but it di dso spasmodically and unevenly . Many came to believe that the deductions, credits ,and shelters were surer bets than congressional promises to keep the rate structurein line. There is still a lot of this feeling even after the landmark 1981 legislatio nwhich, starting in January 1985, indexed the rate brackets, zero bracket allowance ,and personal exemption to eliminate the unlegislated tax increase from inflation .

Thus, most of the flat tax proposals that found their way into actua llegislative form have avoided a complete frontal assault on deductions an dshelters, at least retaining the most popular of them, such as deductions fo rmortgage interest and charitable contributions, exclusions for retirement income ,etc. The new Treasury program (Tax Reform for Fairness, Simplicity, an dEconomic Growth, November 1984) makes a bow in this direction too, particularl ywith respect to home mortgages and retirement planning. But it then sweeps on toattack a very wide range of existing special provisions for individuals and busines sto broaden the base and reform the system in a much more far-reaching manne rthan most had anticipated . The Treasury proposal also differs from leadin gcongressional proposals in the extent to which it would spread the adjustment fo rinflation and the extent to which it asks the business sector to pick up the cost ofreform. In these respects, the Treasury proposal is clearly the most radical of th eleading plans, almost populist in its approach . This, coming from a department of aconservative Republican Administration, surprised many . It certainly caught thebusiness community off guard . It will continue to make waves even if th eAdministration backs off from the positions presented in November 1984 .

In any event, it's commonly acknowledged that the leading proposal sbesides the Treasury reform plan are already in legislative form : (1) The Fair TaxAct of 1983 (S. 1472 or H.R. 321 of the 98th Congress) introduced by Senator Bil lBradley (D-NJ) and Representative Richard A . Gephardt (D-MO) ; and (2) The Fairand Simple Tax Act (FAST) (S. 2948 or H.R. 6165 of the 98th Congress) introduce dby Senator Robert Kasten (R-WI) and Representative Jack Kemp (R-NY) . Asindicated, the Treasury plan is the broadest, most detailed of the three . BothBradley-Gephardt and Kemp-Kasten would retain more of the present system . Themost significant differences between the latter two, other than rate structure, ar ein the treatment of capital gains and capital recovery . Bradley-Gephardt woul deliminate the capital gains exclusion entirely while Kemp-Kasten would phase i tout but would index the basis of gains for inflation . Kemp-Kasten would retain theAccelerated Cost Recovery System (ACRS), while Bradley-Gephardt would replac eit with "economic depreciation." Neither would change the basic relationshi pbetween corporate and individual income taxes as would the Treasury proposal wit hits partial integration provision .

The three leading plans for tax reform already have been picked apart ,particularly by the groups most affected . For purposes of this evaluation we will

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use two principal criteria : simplification and economic impact . We also shall lookat some aspects of the proposals in terms of their suitability for a syste mattempting to treat millions of very different taxpayers in an equitable manner .Unfortunately, equity is often found in the eye of the beholder, one person's equit ybeing another's loophole. Thus the emphasis will be on criteria more easily an dobjectively measured .

Further, the focus will be on provisions of the reform proposals thataffect large groups of taxpayers or cut across most or all of the economy . Noattempt will be made to analyze provisions directed to special industry situation ssuch as energy and financial institutions . Further still, we shall analyze propose dprovisions as if they were fully in place and not in a phase-in process . Thisobviously would not be the case in fact . Very extensive transitional rules would b erequired to implement any of the three plans, which would involve considerableconfusion and complication. For ease of comparison in this analysis weconveniently shall ignore the need for transition rules.

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III . Simplification and Certainty

Tax simplification is a compelling goal in itself . Certainly the system isin trouble when 40% of all return filers and even a large number of those filing thesimplest forms -- 1040A or 1040FZ — seek the help of professional tax preparers .The forms are really not the problem . Most of these taxpayers could cope with theforms fairly easily . But they have the perception that the tax system is such amaze of special rules and penalties that if they do not consult tax professional sthey will miss out on a benefit or get hit by an unexpected assessment . There's nodenying some basis for these fears . The Internal Revenue Code, the regulations ,and the whole administrative process obviously present a large compliance burde nfor individuals and business . Cries for simplification reach sympathetic ears in thepress and Congress .

Tax simplification involves more than ease of compliance. It involvesdegrees of certainty -- certainty which is critical for tax planning, investmentplanning, and business planning . What may be fairly simple for complianc epurposes — say the indexing of interest payments — could be much mor ecomplicated for long-term planning. For planning purposes it is not so much th eexistence of special features in the Code as it is the frequency of changes in therules that makes the system complex .

It used to be understood that major Federal tax reform occurred only a tlong intervals -- the 1954 Code revision, some aspects of the 1962 legislation, the1969 Tax Reform Act, the 1976 Tax Reform Act . But starting in 1978, there has

been an extraordinary explosion of tax legislation with both substantial revenueimpact and all sorts of significant structural changes . Four major pieces of ta x

legislation occurred in a six-year span. No wonder we have a backlog of hundred sof regulations projects at IRS. Unfortunately, the present round of tax reform ,even in proposed form, will be destabilizing for planning and this already has bee nreflected in the financial markets.

Surely the authors of these plans intend them to represent the pinnacle ofreform that would endure for decades afterward . But of course future Congressesare not bound by such intentions . And the taxpayer not only does not know whatparts of the reform proposals will be enacted, but has no assurance that the systemwon't fall apart again . That's the lesson of the 1980's which puts an added burdenon the reformers. If they are going to turn the system upside down, they ha dbetter make sure the new foundations are sturdy . The advantages of any newprovisions should be so clear cut that they will make a lasting impression on th edecision makers of the future. Otherwise reform and simplification can turn sourquickly .

This paper takes a close look at provisions of the Treasury program, thebroadest of the reform plans, as they fit the objective of simplification both forcompliance and planning purposes (see table on pp 6-7) . In this exercise,compliance consequences are assessed both for taxpayers and the tax collecto r(IRS) but the taxpayer consequences are controlling . Coverage is limited to majorprovisions not including those directed to narrow tax shelter issues .

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Explanatory commentary follows the rating and includes comparisons withthe congressional proposals . A separate analysis is made of the overall economicimpact of these provisions on the corporate sector and capital formation .

Revenue estimates from the Treasury referred to in this analysis are al lon a static basis -- as if no economic behavior were changed by the change in ta xprovisions . This is unrealistic, of course, but the figures are used without furthercomment on this aspect to indicate relative magnitudes .

For Taxing Individuals

Simplification ScorecardMajor Provisions of U .S. Treasury Department Report on Tax Reform

Compliance Tax/Investment PlanningEstimatedRevenue Impact

Net EffectBy 1990($ bil)

Improvement Complication

Improvement Complication Unknown

X

X

(1) Compression and reductionof marginal tax rates

-132 .1(a)

X

(2) Increased zero bracket amount ,doubling of personal exemption ,single credit for elderly, blindand disabled, indexation ofearned income credit .

(a)

X

(3) Repeal of deduction fortwo-earner couples. (a)

X

X

(4) Replace child care credi twith deduction.

-0 .3

X

(5) Repeal or limitation ofnon-retirement fringebenefit exclusions .

+24 .1

X

(6) Repeal deduction ofstate/local taxes .

+38 .7

X

(7) Repeal above-line deductio nfor charitable contributions ,limit itemized deduction t oabove 2% of gross income, restric ttreatment of property contributions .

+6 .6

X

(8) Retirement savings; liberalize IRA's;eliminate 401k treatment ;other changes +1 .0

X

(9) Repeal minimum tax; % of incomethreshold for miscellaneous deductionsand employee business expenses ;other simplification provisions .

+2 .9

X

(10) Limit deductions for entertainment ,business meal and travel expenses .

+2 .3

X

X

X

X

X

X

X

X

Compliance

Tax/Investment Plannin gEstimatedRevenue ImpactBy 1990($ billion) Improvement

Complication

Improvement ComplicationNet Effec tUnknown

For Taxing Businessand Capital Incom e

(11) Uniform corporate rateof 33%.

(12) Repeal corporateminimum tax .

-50 . 5

(b)

X

X

X

X

(13) 50% dividends pai ddeduction . -38 .2(c) X X

(14) Repeal ACRS and investmentcredit; replace with indexedeconomic depreciation (RCRS) +99 .7(c) X X

(15) Treat capital gains asordinary income, index basis . -3 .7 X X

(16) Index interest and inventories .

(17) Uniform rules for capitalizingproduction costs and constructio nperiod interest .

-25 . 3

+13 .9(c)

X

X

X

X

(18) Require per county limitationon foreign tax credit . +3 .6(c) X X

TOTAL

NA

12

6

7

8

3

(a) Effect of increased personal exemption and ZBA and repeal of two-earner deduction combined with rate reduction .

(b) Not effective until other provisions go into full effect .

(c) Corporate effect only .

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Commentary

FOR TAXING INDIVIDUAL S

(1) Rates

The three-tier rate schedule under the Treasury proposal (15%, 25%, 35% )obviously would be a big plus both for compliance and planning . Almost everythin gis easier with lower rates . Reducing the top marginal rate to 35% probably woul dbe the single most useful step that could be taken to discourage resort t oeconomically unproductive tax shelters by high-income individuals. The Treasuryalso proposes to hit tax shelters with further specific reforms, such as limiting th einterest expense deduction, but such significant rate relief would be the mos teffective means, in the process easing the pressure on IRS audit resources .

The rate schedule for Bradley-Gephardt is very similar to Treasury .

However, Bradley-Gephardt would not continue income tax inflation indexing aswould the Treasury plan . Kemp-Kasten would set one flat rate of 25% with a 20%employment income exclusion, also indexed for inflation . Comparablesimplification results would be achieved with either although there is a notc hproblem with Kemp-Kasten as the earned income exclusion is phased out at ove r$100,000 .

(2) Allowances

The Treasury proposes several tax-reducing changes under the headin g"fairness for families," the most important of which is doubling of the persona lexemption for the taxpayer and each dependent . One objective is to eliminate ta xliability for most all below the official poverty level . Currently, the povertythreshold is said to range considerably above initial tax liability particularly fo rsingle people and couples with two or more dependents . While there has been somequestion about use of an arbitrary poverty statistic for such policy purposes ,inasmuch as it does not reflect in-kind welfare benefits or actual living conditions ,there's no question that raising the tax threshold can "simplify" the system merel yby removing a lot of low-income people from the rolls . This, of course, reduces thetax base and runs counter to the neutrality provisions of the reform program .

Presumably, the single credit for the elderly, blind and disabled would b eeasier to administer and comply with than the present system of exemptions an dretirement income credit .

Bradley-Gephardt and Kemp-Kasten also would expand tax free amount sof income by liberalizing allowances . Kemp-Kasten is by far the most generous i nthis respect, in large part to compensate for the effect of the 25% flat rate on lowincome groups .

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(3) Two-Earner Families

Treasury argues that the present two-earner deduction is a "poorl ydesigned" offset to the marriage penalty and that lower marginal rates are a bette rway to mitigate the penalty which still would persist to some extent under the ful lreform plan . Both Bradley-Gephardt and Kemp-Kasten also repeal the deduction .

(4) Child Care

As the current child and dependent care credit is clearly associated wit hproduction of income, it more properly should take the form of a limited deductio nas in the ordinary treatment of business expenses, according to the Treasur yreport . Bradley-Gephardt agrees with this but Kemp-Kasten would simply repea lthe credit.

( .5) Fringe Benefit s

The Treasury proposes far-reaching changes to increase tax liabilit yexposure of current statutory employee fringe benefit practices . By far the mostsignificant of these in dollar terms would be repeal of the exclusion of employer-provided health insurance premiums above a cap of $840 per year for individualsand $2,100 for families . (These limits would be indexed by the C.P.I. for yearsafter enactment.) Of the 14 specific recommendations in the fringe benefit area ,this alone would account for just about half of the overall revenue pickup, which i sestimated to grow from $9.3 billion in 1987 to $24 billion in 1990 . The proposal t olimit the health insurance exclusion has been made at least twice in recen tAdministration budget requests which Congress pointedly has ignored .

The Treasury's argument for inclusion of most statutory fringes in the ta xbase is basically neutrality of treatment. However, in recent years Treasury ha sexpressed much concern over the spread of fringe benefit practices, especially th epackaging of statutory exclusions with other benefits in cafeteria plans . Theseplans and greater emphasis on compensation in the form of fringe benefits are sai dto erode the tax base. In the case of employer-provided health insurance plans ,Treasury adds another complaint : that they have encouraged additional and in par tunnecessary demand for health services and thereby contributed to the inflation o fhealth costs .

Employers certainly are aware of the high costs of health insurance .Regardless of the tax exclusion, many employers recently have opted for policie swith larger deductibles and more co-insurance to reduce the volume of smallclaims and help control premium costs . Some employers argue that cafeteri aplans, subject of much Treasury and IRS opprobrium, are in fact one of the bestvehicles to control costs by giving employees incentives not to use healt hallowances in marginal cases .

Whatever its effect on incentives the proposal cap would have a dramaticimpact on employer-employee relations . When the Treasury says it would affect

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"only" 30% of civilian workers, that's 34 million people and their families! TheTreasury's proposal would attempt to ease the compliance burden of defining th ecost of employer-provided coverage with respect to individual employees by ag-gregating the annual cost for all employees with the same type of coverage (netpremiums charged or actual costs incurred including administrative costs reduce dby employee contributions if any) and dividing by the number of such employees .This, however, would raise another issue of discrimination, because in many healt hplans, particularly for small groups, actual premium charges vary greatly fro mindividual to individual depending on several factors beyond just single or familystatus. These factors include age, number of dependents, medical history ,occupation, etc . Consequently, under the Treasury approach, some employers 'attributed cost to the employee would be considerably below or above the •actua lpremium cost for that individual .

Theoretically the way to handle this and other implementation problem swould be for employers to provide benefits only up to the cap and for employees t ocontribute the rest on a payroll deduction basis . Employees, of course, still coul ddeduct their own contributions to the extent they exceeded 5% of A .G.I. if theyitemized deductions. But this wouldn't help much when the whole thrust of th eTreasury reform plan is to wean taxpayers away from itemized deductions .

Many formal labor contracts and long-standing industry practices call fo remployer-provided health benefits . It would be extraordinarily difficult to shif tsuch a significant part of the cost burden to employees without compensatingchanges elsewhere. If most employers continue to provide all or most all of thecoverage, there would be substantial withholding problems involved too . TheTreasury proposal would require cost of coverage to be determined or estimated inadvance of payroll periods and if such estimated costs were determined "not to b ereasonable," employers would be socked for the income tax liability at 35% plu sboth employer and employee shares of additional FICA taxes . A new tough ballgame that surely would make both compliance and planning more difficult .

The next biggest target on the Treasury hit list in this area is employer-provided group life insurance -- all of it whether above or below the current$50,000 policy exclusion . This is estimated to bring in an additional $1 .5 billion in1987, rising to $3 billion by 1990 . Again Treasury is aiming at a widely practicedfringe benefit involving half of all families and 40% of all life insurance in forceaccording to the Treasury report . The cost of this cannot simply be transferred t oemployees. Most employers undoubtedly would continue to provide the benefit .

Treasury offers no specifics on how the value of group life insurance t othe individual would be determined for tax purposes . But if it were calculated onthe same basis as the present "uniform" premiums established by Treasur yregulations, it hardly will be simplification . The Treasury cost tables have bee nthe subject of running dispute for years .

The reform plan goes on to suggest repeal of virtually all other specia lstatutory fringes on down to parsonage allowances. The most significant in dollarimpact would be to subject all unemployment and workers compensation (net o fmedical services) to tax liability . This is also the least likely for Congress to bu y-- almost a throwaway .

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In some cases it could be argued that doing away with special allowance swill simplify compliance and planning . For instance, the Treasury argues thatunder its general plan of disallowing most fringes there would be no need for th ecomplicated special rules on cafeteria plans . In the case of incentive stockoptions, the purpose of which Treasury seems to miss entirely, eliminating ta xdeferral and capital gains treatment would likely kill most all offerings and in tha tsense "simplify" tax treatment . In some other areas where the specific dollar valu eof benefits is difficult to measure or requires special documentation, sweepin gthem into the tax base would cause additional compliance and planning problems ,to the extent the benefits are still provided. This would certainly apply in the caseof employer-provided dependent care services, educational assistance, commutingservices, and employee awards .

Overall, while there are opportunities for simplification in the Treasur yproposals for much stiffer treatment of fringe benefits, the net result would be t ocomplicate tax administration and planning, again to the extent these benefitswere still provided. For the most important — health insurance and group lifeinsurance — employers probably would be required to continue such plans largely o na non-contributory basis regardless of any new tough tax treatment .

Neither of the leading congressional tax reform plans would go nearly asfar as the Treasury in broadening the tax base for non-retirement fringes . Bradley-Gephardt would limit the health insurance exclusion, repeal the exclusion for grou plife insurance, dependent care and special treatment of cafeteria plans and als owould tax all unemployment compensation . Kemp-Kasten would do nothing in thi sarea other than to tax unemployment compensation and restrict treatment fo rdeducting payments under workers compensation.

(6) State/Local Taxes

The Treasury reform plan takes its second biggest single step toward acomprehensive income tax base by repealing the itemized deduction for state/loca ltaxes (the biggest is repeal of ACRS -- at least through 1990) . Treasury present sthe usual rationale as to how the deduction benefits higher income groups mor ethan others, benefits taxpayers in high tax states more than others, and subsidizesstate/local services that might or might not be fully supported on their merits .Treasury again makes the argument that state/local taxes are really payments fo rconsumer "services" -- schooling, roads, fire and police protection, etc . -- ofbenefit to the taxpayer and akin to utility charges which are not deductible . Thisline of reasoning has never caught on in Congress, which has refused steadfastly toalter the basic state/local tax deductions in place since the origins of the Federalincome tax .

The case for deductibility of state/local taxes is made of course b yvirtually every state/local politician on the grounds that it encourages state/loca lresponsibility for public services and diversity of local effort . Treasury counter sthis claiming that with all the Federal base broadening in effect, the states woul dalmost automatically be taking in a lot more from their own income taxes anyway ,because of the extent of piggybacking on the Federal base .

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More telling perhaps is the question of basic fairness in subjecting citizen sof high tax states/localities to the full double tax bite when they do not hav eeffective control over their level of state/local tax liability, which in turn affectstheir ability to pay the Federal income tax -- the same rationale for retaining, a s

Treasury proposes to do, the itemized deduction for medical expenses in excess of5% of income. Treasury claims that taxpayers can control the rates of state/loca ltaxation through the electoral process or by voting "with their feet" and movin gelsewhere to a presumably more hospitable tax climate . This has some truth in th eaggregate but seems quite strained when applied to individual circumstances.Despite differences in average itemized deductions for state/local taxes rangin gfrom a high of $2,400 in New York to less than $500 in Wyoming, there are 26states where the average itemized deduction is well over $1,000 . And theaverages conceal tax burdens on many individuals of far higher amounts . Innumerous states $10,000 or more in state/local tax liability is not uncommon fo rupper-middle income taxpayers, who certainly are not starving but not necessaril yrich.

The impression here is that disallowing the state/local tax deduction has alot more to do with the perceived revenue equation then it does with any structura lflaws in the Federal system. Repeal would bring in an estimated $39 billion by1990. Without this big chunk of base broadening, the maneuvering room for rat ereduction and/or increasing tax free allowances would be significantly less .

Repeal of the itemized deduction for state/local taxes would lead tosome compliance improvement, particularly with regard to sales taxes whichpractically all itemizers just can't handle without resort to the admittedly ver yimperfect sales tax tables provided by IRS . Deductions for income and propert ytaxes are much more easily documented . It's hard to say that deductibility hererepresents any real compliance burden for either the taxpayer or, for that matter ,the IRS either in view of new reporting requirements and better coordination o frelevant information between state and Federal taxing authorities .

For planning purposes loss of state/local tax deductions would not appea rto offer any real net advantage . There would be some increased certainty as to th elevel of individual Federal tax liability, but this could be offset by the potentiall ygreater variation in total state/local tax burdens between locations .

Again, neither of the two leading congressional plans would go as far a sTreasury . Bradley-Gephardt would repeal the itemized deduction for personalproperty taxes but retain deductions for real property and income taxes limited,however, to deduction from income taxed at the first marginal rate of 14% -- anew complication. Kemp-Kasten, oddly, would repeal the deduction for stat eincome taxes but retain it for other state/local taxes . Treasury properly points ou tthat partial disallowance of state/local deductions which favors one method ofstate/local taxing over another is an intrusion on the ability of states/localities toset their own tax policy .

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(7) Charitable Contribution s

Treasury provisions to restrict the itemized deduction for charitabl econtributions are among the most controversial of the whole program . Treasuryclaims that by retaining the deduction for amounts above 2% of AGI significan tincentives for above average charitable giving will continue, although, of course ,the effect of all remaining deductions would be less under lower marginal rates .The 2% floor would knock out all charitable deductions of half of those taxpayer snow itemizing such deductions . The plan would also do away with the above-the-line charitable contribution deduction for non-itemizers and significantly restric tthe treatment of property contributions by limiting them to the lesser of fairmarket value or indexed basis of the property. The latter is of particular concer nto charitable organizations that depend on large gifts . Treasury says the presenttreatment is overly generous and is only a common vehicle for donors with income sover $200,000 .

It is conceded that the Treasury plan provisions in this area would be asignificant improvement for tax compliance both for the taxpayer and IRS .Substantial savings in record keeping and audit responsibilities could be realized ,particularly in eliminating the above-the-line deduction which allegedly is alread ysubject to considerable abuse . The tougher treatment overall also would permit arelaxing of the complicated percentage limitation rules according to the Treasur yplan.

For tax planning, however, the proposals offer much less advantage ;probably disadvantage overall . Planning would be somewhat easier for very largecontributors even if the economic impact on them is adverse . But the deductio nfor present itemizers, by Treasury's own admission, cluster around the 2% of AG Ilevel. Millions of taxpayers would have to deal with a new notch problem an duncertainty as to whether their contributions were deductible or not . This seemsto overwhelm the positive aspects for planning .

The Bradley-Gephardt proposal would limit the itemized deduction fo rcharitable contributions to income taxed at the first 14% rate . Otherwise, neitherit nor Kemp-Kasten would change the present system .

(8) Retirement Saving s

In the retirement savings area, Treasury proposes to increase the IRA ta xfree limits to $2,500 annually and raise the spousal IRA limit from $250 to $2,50 0for a total of $5,000 per couple . IRA's have proven extremely popular andadaptable savings vehicles of benefit to a wide segment of the population .Increasing the IRA limits would make for a more effective savings incentive . Thequid-pro-quo, however, in the Treasury view, would be repeal of the also ver ypopular 401k provisions which it claims discriminate against those without suc hplans and are unnecessary if IRA limits are raised .

Treasury also proposes a number of the changes in the retirement saving sarea designed to make tax treatment more consistent and simpler . How thesewould affect tax planning on a net basis is not known .

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Bradley-Gephardt and Kemp-Kasten do not propose any changes i ntreatment of retirement savings other than to repeal 10-year averaging for lum psum distributions from qualified pension plans .

(9) Other Simplificatio n

Treasury labels a catchall category "other simplification" for individuals .The most important provision for the tax system would be elimination of thealternative minimum tax on individuals. While less than 200,000 actually pay aminimum tax currently, it presents a royal pain to those and to millions more whomust compute it for potential liability -- to ensure that it turns out smaller tha nregular tax liability plus the exemption . Its rationale would disappear entirely i fenough of the Treasury base broadening objectives were met and no one woul dweep for it .

Another significant provision in this general area would consolidate th emiscellaneous itemized deductions and non-reimbursed employee expenses such a sunion and professional dues, agency fees, etc ., and move them above-the-line wit ha 1% of AGI threshold . This would simplify the system and also, because of the 1 %threshold, is estimated to pick up a fairly substantial amount of revenue. Otherprovisions would repeal the political contributions credit and presidential campaig ncheck-off and repeal the limited dividend exclusion . The latter would be redundantif the Treasury provision for a corporate deduction for half of dividends paid wer eadopted.

On the administrative level Treasury proposes a non-filing syste mwhereby a large number of low- and middle-income taxpayers would have the IR Scompute their liability -- to take effect only after base broadening and othe rreforms. For those income groups this would be real simplification .

On the congressional side Bradley-Gephardt also would repeal thealternative minimum tax . Both Bradley-Gephardt and Kemp-Kasten repeal thepolitical contributions credit and dividend exclusion .

(10) Entertainment, Business Meal, and Travel Expenses

There is a long history of resentment on the part of professional staff i nthe Treasury and elsewhere about private sector practices with regard t oentertainment and travel expenses . It's always couched in terms of the perceive dabuse of personal consumption going tax free while the working man's lunch i snondeductible . Periodically, public indignation is fanned by reference to the stil ldeductible three-martini lunch .

Congress has reacted to this with some tightening of treatment o fentertainment expense particularly with regard to entertainment facilities an drestrictive rules for attending foreign conventions . Congress has done nothing ,however, to disturb deductions for business meals or domestic travel as long a sbusiness purpose can be demonstrated.

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Treasury now proposes to crack down much harder : to limit business mea ldeductions to $10-$15-$25 per person for breakfast-lunch-dinner respectively (wit hno mention of indexing for future inflation) ; to eliminate completely all othe rentertainment deductions regardless of purpose ; to ban effectively any deductionsfor cruise ship travel ; and to limit business travel expenses to 200% of th emaximum Federal per diem for the particular location (150% after thirty day saway from home). Strangely, despite this full bore attack, there is no proposal onfirst class air travel .

Treasury claims these new restrictions are really quite "reasonable" citin gCensus statistics as to the small proportion of restaurant meals that would b eaffected and stating that the travel limits are sufficiently generous to allow all bu t"luxury" expense deductions . Therefore there should be little additiona lrecordkeeping or compliance burden and the economic impact would be modest .

Such assertions are certainly open to challenge -- and will be heatedl yopposed by the restaurant, hotel and convention industries . To those with personalexperience in business travel, 200% of Federal per diem -- which in the exampleprovided equates to $150 per day in Baltimore, MD -- for all meals, hotel, an dincidental travel expense -- may not seem very generous . Just how many taxpayer swould be involved or how many jobs impacted cannot be estimated with an yassurance. What is certain, however, is that a large number of meeting planners ,marketing executives, salesmen, business travelers and their accountingdepartments would have to contend with the restrictions whether or not the yactually lost any deductions. The shadow of the tax bureaucracy would be ove rthem every business trip or client lunch . And it is easy to envision the absurditie sthat such restrictions would engender : the salesman ducking home in the midst o fa long business trip to avoid dropping from 200% of Federal per diem to 150% ; theconvention planner desperately trying to figure how to apportion parts of a banque tto "program" costs rather than "meal" costs ; the executive scheduling meetings inthree different cities in the same day to maximize his per diem deduction ; and soon . Rules of this sort inevitably guarantee uneconomic behavior to get around o rminimize them, the total cost of which could be significant .

Treasury repeatedly has complained that the current system provides noobjective standard to determine whether travel and entertainment expenses ar edirectly related to business purpose or personal consumption . It ignores the rea ltest of business relationship — the willingness of the employer to pay the bill . Themarket will discipline loose expense practices which are not productive of sales o reconomic accomplishment. Who is in the best position to judge : the employer whopays the bill or a bureaucrat writing regulations for the Treasury?

It's no coincidence that the proposed tests for deductibility are relateddirectly to those covering Federal workers . Such rules may well be needed ingovernment lacking the market discipline . But to argue that they should apply t obusiness simply because of the lack of "objective" standards is a weak case indeed .In a report that prides itself, with considerable justification, for its marke torientation, the proposed rules on travel and entertainment expense stand out lik ea sore thumb.

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Significantly, none of the congressional plans for tax reform propose an ychange in the area of business travel and entertainment expense .

FOR TAXING BUSINESS AND CAPITAL INCOM E

(11) Uniform Corporate Rat e

Treasury proposes a single corporate income tax rate of 33%, cutting 1 3points off the current top rate of 46% and eliminating the graduated rates belo w$100,000 of taxable income. The basic rationale is the same as for reduction an dcompression of the individual rate structure : a more even-handed and efficien tsystem . Getting the top individual and corporate rates close together has lon gbeen a tax reform objective to minimize tax shelter mischief . Treasury also wantsto get rid of the lower corporate rates applying below $100,000 of income becaus eof alleged shelter opportunities for individuals . It claims that the subchapter Streatment is an ample break for small business and the lower rates ar eunnecessary.

The price of the uniform and lower rates is base broadening . And in thecorporate sector it is done with some vengeance through repeal of ACRS and th einvestment credit and other proposed reforms . Besides base broadening there is a tleast one other catch to the lower top rate . Treasury claims that a 33% rate woul dput the U.S. corporate income tax below most of our developed trading partner sabroad and lead to an unwanted buildup of excess foreign tax credits, which in tur nwould lead U .S. multinational firms to invest more in low-tax countries to avoi dsubjecting foreign income to U.S . tax. The Treasury solution : repeal the overal llimitation on the foreign tax credit and allow only a per country limitation . Inother words, flip-flop the decision in 1976 to ban the per country treatment an dallow only the overall .

For many multinationals this represents a two-edged sword . They couldbenefit directly from the lower U .S. rate, but if Congress buys the Treasur yargument, they could lose a lot of foreign tax credits (depending on thei rcircumstances, of course) . All this is quite apart from what they would lose i ncapital recovery or elsewhere .

In any event a uniform U .S . corporate income tax rate by itself wouldcertainly make domestic compliance and planning simpler . Under the Bradley-Gephardt program the corporate rate would be a uniform 30% . Kemp-Kastenwould set a two-level rate structure of 15% up to $50,000 of income and 30% abov ethat.

(12) Corporate Minimum Tax

The corporate minimum tax had a dubious beginning. It was added to th eTax Reform Act of 1969 almost as an afterthought without any real consideratio nas to whether or not any minimum tax concept should apply to the corporat esector. It has proven to be a significant burden not only for the approximately

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10,000 corporations that currently pay it but for virtually all large corporationsthat must compute it anyway to determine possible liability . -- the same overreac hproblem as with the individual alternative minimum tax . he corporate minimumtax obviously would be redundant, too, under Treasury base broadening plans, butTreasury would hold repeal of the minimum tax hostage until the base broadenin gmoves were fully in effect .

Bradley-Gephardt also would repeal the corporate minimum tax butKemp-Kasten would not .

(13)

Dividends Paid Deductio n

One of the critical reform features of the Treasury program which ha sreceived relatively little attention is its provision for partial relief of the doubletaxation of dividends . Under the proposal, 50% of dividends paid by domesti ccorporations to their shareholders would be eligible for deduction from corporatetax liability . Thus another round is fired in the long and so far almost completelyunsuccessful campaign to reduce the tax system's bias against corporate earning sdistributed as dividends. The objective is the same as before : to help reduce theimbalance of treatment between debt and equity financing, making firms lessreliant on debt financing and less vulnerable to economic swings, and encouragin gmore efficient investment patterns. According to Treasury calculations, partia ldividend relief combined with rate reduction and other changes would reduce th eoverall top individual and corporate tax rate on earnings distributed as dividend sfrom 73% to 45% and reduce the overall rate on corporate earnings paid as interes tfrom 50% to 35%. Thus the penalty spread against equity would be cut from 2 3percentage points to 10 with most of the relative improvement to equity due to th edividend relief provision.

Pending more detailed analysis, there are a few things that should be sai dabout the Treasury provision initially . First, its approach appears to be on th eright track. Dividend deduction at the corporate level is more practical and mor eeasily implemented than a shareholder credit, the vehicle of choice of most othe rproposals for partial integration in recent years . All of these proposals aborted .Treasury also appears not to have too much of a hang-up over distribution t oforeign shareholders or tax exempt organizations. However, it still insists that n odeduction should be allowed with respect to dividends paid from tax "preference "income. This was one of the stumbling blocks derailing consideration of dividen drelief in the late 1970's -- determining what income was too "tainted" to justify adeduction and how to cope with it in the calculation of an allowable deduction .This time Treasury appears to define tax preference income for purposes o fdividend eligibility as any allowable credits against tax liability including theforeign tax credit . Of course if the investment credit were repealed, this woul dremove one very large item of preference income as a limiting factor . Buttreating the foreign tax credit as tainted preference income would limit the abilit yof multinationals to take the dividend deduction .

There would be a number of compliance and other planning problems .Treasury has offered to extend dividend relief "unilaterally" for dividends paid toforeign shareholders in countries with appropriate bilateral income tax treaties .

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But it also proposes a new withholding tax on dividends paid to foreign shareholder soutside of treaty countries . There would be a whole new treatment o fintercorporate investment and special rules for dividend distributions i nredemptions and liquidations . Some complication, of course, is inevitable in thi stype of reform affecting the basic relationship between corporations andshareholders . By no means should this prejudice the case for dividend relief, whic hcould well be compelling enough to outweigh attendant complications . Once again ,reform and simplification are not necessarily synonymous .

Congress has been very reluctant to address the double taxation o fdividends issue at all . None of the present congressional reform plans touches it .Unfortunately, dividend relief might be one of the first proposals to be jettisone din a modification or retrenchment of the Treasury program .

(14)

Capital Recovery : ACRS and Investment Credit

Rumors were rife during the fall of 1984 that the Treasury report woulddo a hatchet job on the Accelerated Cost Recovery System (ACRS) . Still it was ashock to many that the report came out for complete repeal of both the investmen tcredit and the linchpin business tax program of the Economic Recovery Tax Ac t(ERTA) instituted only three years ago under the same Administration. Those whothought the basic capital recovery issue had finally been settled in 1981 -- an dmade plans accordingly -- were shaken by the legislative moves of 1982 and 198 4cutting back on ACRS; they were devastated at the prospect of such a drasti cturnabout as that contained in the Treasury plan . Obviously the reaction from thecapital-intensive industries has been swift, loud, and negative.

Treasury's complaint about ACRS now is the standard one heard eve nbefore its enactment : that the disparity in treatment of different asset classes andindustries and the front-end loading of deductions and credit distort investmen tdecisions and encourage "tax motivated" investment activity in nonproductiv eshelters . And distortions between industries have been accentuated by loss of th esafe harbor leasing program in 1982 . Treasury presents tables showing how, underACRS and the investment credit, effective tax rates on different investments wit hvarious inflation assumptions swing widely -- from close to the statutory rate o f46% on 18-year class assets with inflation at 10%, to -90% on 3-year class assets atzero inflation (assuming a 4% real rate of return in all cases) . Treasury apparentlyconsiders any effective tax rate on these hypothetical investments below thestatutory rate to be a sin and a negative effective rate to be a mortal sin. Thedifferences in effective tax rates between industries for both equipment an dstructures are said to vary widely, too .

Treasury would replace ACRS with "economic" depreciation indexed forinflation. This, dubbed Real Cost Recovery System (RCRS), is said to provide aneutral depreciation practice that when coupled with repeal of the investmen tcredit would synchronize effective tax rates with statutory rates across al linvestment. Assets would be reclassified in seven categories with constant rates o fdepreciation, ranging from 3% to 32%. These would be based on "empiricalstudies" of the Treasury as to economic useful lives . This, of course, is whatacademic tax professionals have wanted all along, although not necessarily with theinflation indexing .

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Treasury claims the new system could be just as "valuable" to business a sACRS. It presents tables showing that the present values of deductions underRCRS over the lifetime of assets are close to or even better than those unde rACRS (without the investment credit) for a variety of asset classes and unde rinflation assumptions between 5% and 10% annually .

One of the major difficulties in dealing with the capital recovery issu ehere is the tendency of Treasury to look at it only in hypothetical economic terms ,not in terms of facts and circumstances facing decisionmakers in business . So-called negative effective tax rates under the present system can appl ytheoretically to selective investments . Realistically, however, they are ver yunlikely to occur for a taxpayer firm as a whole because it must operate with a mi xof tangible and intangible assets that are essential to any given investmen tprogram . Rates of return are very important to the firm, however, and looking atthe permissible deductions under RCRS compared to ACRS with the investmentcredit, there would very likely be a lower rate of return on any given investmen tunder RCRS, unless, of course, a much higher rate of inflation is expected t ooccur . Currently, we have approximately 5% inflation, and according to economicassumptions underlying all Treasury's revenue estimates, this inflation rate willdiminish further through 1990. With the fast recovery features of ACRS andinvestment credit, it's very hard to see how business could be better off switchin gto RCRS in such a modest inflationary environment .

Treasury claims that compliance with RCRS would be no more comple xthan at present since there would be only a few more asset classifications tohandle. This is certainly debatable . Treasury admits that "ongoing studies" o feconomic depreciation would be necessary to refine the system, and this quit eeasily could mean much reclassification . Asset classification and writeoffs unde rACRS are entirely arbitrary . But the strong point of arbitrary ACRS has been it scertainty in terms of asset classification, doing away with any real tie to usefu llife or economic depreciation . In the past, despite volumes of empirical studies b ythe Office of Industrial Economics and predecessor bureaus, useful life was neve reasy to determine and, in many cases, the subject of long running controvers ybetween taxpayers and IRS . By definition, economic depreciation is always subjec tto differing interpretations and constant juggling of lives . The Treasury plan wouldallow a relatively simple close-out of depreciation when 15% of the inflation -adjusted original basis remains . And it would offer a compliance and planning plu sby doing away with recapture considerations. The price for the latter, however, i streatment of capital gains as ordinary income.

Repeal of the investment credit itself admittedly would achieve som esignificant compliance improvement . There would be no need to distinguis hqualified from non-qualified property, a task which has long been a problem in ta xadministration. A lot of special rules would be disposed of including determinatio nof basis adjustment from the investment credit, recapture, carryback an dcarryforward of unused credits, at-risk rules, distinguishing between new and use dproperty, and so on .

For tax/investment planning, on the other hand, RCRS represents one ofthe real dilemmas of tax reform. In its view, Treasury has proposed a mor erational new system which will correct many of the flaws of the present system

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and deal objectively with inflation in the economy -- insuring against its vagaries .But for the investment planner, indexed depreciation could represent not so muc hinsurance as new uncertainty even if the national trend of inflation as measured byCPI were to mirror the price trends of asset replacement in the pertinent specificindustry or investment program -- a large assumption in itself . The investmentplanner still must deal with the mostly unindexed world at large, and having part o ffuture cash flow indexed to an unknown rate of national inflation will no tnecessarily make the planning job easier . The investment planner may well preferto know specifically what future cash deductions will be thrown off by presentinvestments regardless of inflation . Even if inflation adjustment would appear torationalize the totality of capital investment decisions, it's a long leap to actua lpractice.

On the congressional side the Bradley-Gephardt program is similar to, andindeed certainly helped pave the way for, the Treasury proposal . The mostsignificant difference between the two plans is that Bradley-Gephardt would notadjust basis for inflation but would allow 250% declining balance depreciation o fassets under basically the old ADR classifications . Bradley-Gephardt would raisethe cost of capital compared to ACRS with the investment credit by slowingrecovery periods. Bradley-Gephardt would be more or less generous than theTreasury plan depending on the rate of inflation . Compliance aspects of theBradley-Gephardt plan are comparable to Treasury's, but the former might beconsidered easier to deal with for planning purposes .

Kemp-Kasten takes a decidedly different tack . It would retain thepresent ACRS system but repeal the investment credit and in so doing also slo wcapital recovery opportunities for the business sector .

(16)

Capital Gains

The Treasury report takes a long stride toward a "comprehensive" incom etax by treating capital gains as ordinary income . In a break from the traditionalHaig-Simons concept, however, Treasury would not attempt to tax accrued gains ,only realized gains as at present . In this the Treasury proposal gains a measure ofrespect for practicality as compared to, say, the more theoretically pure BluePrints for Tax Reform from the 1977 Treasury. The new plan also would index thebasis of capital assets for inflation -- an important factor for future economi cresults.

Treasury says the present 60% exclusion for long-term gains is a narbitrary and imprecise measure of compensating for inflation's component i ncapital appreciation . Hence the indexing proposal . But it wants to go further and,in the spirit of Haig-Simons, makes no basic distinction between income fromcapital and income from services -- "neutrality" as the most important standar dagain.

It's impossible to say just how the capital sector or even individua ltaxpayers would fare under the Treasury plan . In rough terms the higher the rateof appreciation and the longer the holding period the better off a taxpayer woul dbe under current rules . But the breakeven point would scamper all over thespectrum depending on inflation, growth of appreciation, marginal tax rate, andholding period . If inflation stays below 5%, most investment with reasonabl eappreciation expectation would probably be worse off under the Treasury plan .

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And it's generally agreed that venture capital investments requiring hig happreciation potential would definitely be worse off .

The situation gets even more complicated when the possible variations i ntotal tax burdens on capital under Federal and state income taxes are considered .If most states were to follow the Federal base and repeal the 60% exclusion - -which would be likely -- and even if most states adopt the indexing of basis --whic hwould be less likely -- the potential for greater disparity in dollar burden fro mstate to state increases, particularly if the Federal deduction for state incom etaxes is repealed .

For corporate taxpayers the picture need not be quite so complex simplybecause under the proposed structure the single corporate rate of 33% is only fivepercentage points higher than the existing special corporate rate on capital gain sat 28%. The benefits of indexation would seem to be potentially greater here thanwith individuals at the marginal rate of 35%, which is 15 percentage points ove rthe present maximum capital gains rate of 20% .

Treasury proposes to make compliance with the basis indexing reasonabl yeasy for the taxpayer by providing adjustment tables going back to 1965 -- thearbitrary start of basis adjustment . Any assets held longer than that would still b esubject to indexing as of 1965 . Treasury also makes much of the simplificationpotential in eliminating the shelter schemes and other motivation to conver tordinary income to capital gains. And, as indicated before, with no preferentia lcapital gains there would be no need for depreciation recapture . Still the need t omeasure net gains or losses would remain and there would be little if any recor dkeeping savings. Treasury would retain the present treatment of capital losses .Unlimited losses would not be allowed against ordinary income because of thei rshelter opportunities, according to Treasury . This might be a practical concern butdoes not square with the general concept of treating capital gains as ordinaryincome.

For most taxpayers anyway capital gains treatment may not enter intothe planning process with the same force and need for precision as woul ddepreciation allowances or debt service . But that doesn't mean that a reasonabl ecertainty of treatment is unimportant. There are just too many unknowns as t ohow the Treasury proposal would affect investment/tax planning to assign an yrating here .

Under the Bradley-Gephardt proposal capital gains also would beconsidered ordinary income but without any indexing of basis . This would deliver asignificantly harsher result for returns to capital than either the Treasury plan orcurrent law. Kemp-Kasten would follow the Treasury plan generally (with a longphase-out of the exclusion) except it would allow unlimited capital losses agains tother income (which would become a preference item under the minimum tax) andwould maintain a separate corporate capital gains rate of 20% .

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(16)

Interest and Inventorie s

Treasury would complete the cycle of full indexing of the tax system b yapplying it to net interest received or paid and also offering business taxpayers a noption to utilize an indexed FIFO system of inventory accounting for tax purposes .One of the stumbling blocks in past proposals to extend inflation adjustment ha sbeen the practical problem of applying it as an index factor to the principal of deb ton an annual basis . Treasury attempts to solve this by using a fractional exclusio nrate based on the inflation factor and applied to net interest received or paid ,reducing tax liability where net interest is received and reducing the deductio nwhen net interest is paid. The fractional exclusion rate serves as a reasonabl eproxy for general inflation indexing of principal . It would concern mainly busines staxpayers and individuals with net interest income . Individuals with net interes texpense would deduct mortgage interest (on principal residences) and a $5,00 0exemption before applying the exclusion rate .

This provision does follow logically from the Treasury overall polic ydecision. If you index brackets, allowances, capital gains, and depreciation, i tmakes economic sense to go whole hog and do debt instruments too . Under presentarrangements there is the same perceived mismeasurement of income and expens ebecause of inflation's impact on debt. In the case of inventories the LIFO metho ddoes adjust for inflation but it is not widely utilized, and Treasury wants to providea simplified indexed FIFO as an alternative and to repeal the uniformit yrequirement for book and tax accounting .

These provisions are pure "reform" in the sense of attempting to create abetter measure of income and reduce the distorting effect of inflation on debtor -creditor relationships particularly during periods of sharp increase or sudden dro pin the rate of inflation . The interest indexing provision would be a fairl ysignificant revenue loss in future years as long as the private sector as a wholeremains in a large net creditor position .

Simplification it is not . There would be both additional complianc eburdens and planning uncertainties . Actually the prospective compliance proble mprobably would not be too severe with the fractional rate method of interes tadjustment, which could be applied to returns by reference to IRS provided tableswithout undue complication . Some private accountants, however, have indicatedthat the proposed indexed FIFO method of inventory accounting would no tnecessarily be simple to apply and could raise some new problems .

The overall concern again is the implication of all this indexing fo rprivate sector planners, who still must deal with other unindexed financia lobligations including, of course, the debt service itself. A large net interest payer,perhaps one with relatively little choice as to method of financing, is obviousl ygoing to be quite concerned about cash flow projections with an uncertain futur einterest deduction . How all of this would be reflected in financial reports is left t oothers to unravel . While the Treasury proposal might well improve the efficienc yof an economy struggling with wild inflation swings, is it worth it for an econom yon a reasonably steady course of subdued inflation?

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Neither Bradley-Gephardt nor Kemp-Kasten attempt any inflatio nadjustments of debt or investors.

(17) Tax Accounting for Multiperiod Productio n

While it has not received the same publicity as other parts of the plan, th eTreasury proposal to revise tax accounting rules for multiperiod production woul dhave a major impact on several industries, especially extractive industries, firm swith long-term contracts, real estate and timber . Treasury proposes "uniform "rules for capitalizing production costs and construction-period interest that woul drequire much more extensive capitalization instead of current deduction . Therevenue impact would be quite significant for capital-intensive industries ,increasing liabilities by an estimated $14 billion by 1990 .

Treasury justifies these harsher rules as better measurement of incom eand elimination of the subsidy element of tax deferral . The proposed rule sobviously build on the time value of money changes under the 1984 tax legislatio nbut are much more sweeping . Such additional capitalization requirement sundoubtedly would mean additional record keeping and planning complications .

Both Bradley-Gephardt and Kemp-Kasten would require capitalization ofconstruction-period interest and taxes over a 10-year period but suggest no otherchanges in this area .

(18) Foreign Tax Credi t

As indicated earlier in the discussion of corporate rate cuts, the Treasur ymakes a corollary proposal to eliminate the overall limitation on the foreign ta xcredit and require a per country limitation instead. This is necessary according toTreasury, to prevent the buildup of excess foreign tax credits, and to discourag etax-motivated incentives for investing in low-tax countries instead of the Unite dStates. Treasury says that the overall limitation is bad tax policy, that it distort sinvestment decisions for "purely tax-motivated reasons ." One wonders if the percountry limitation, requiring the taxpayer to figure an allowable credit on the basisof separate results in each country where it has any investment, is so much better ,why it was abandoned in 1976 and only the overall limitation allowed .

Many multinational companies consider their foreign investments as apool of resources, not separate activities in separate countries. Investment,production, and marketing plans are drawn across national boundaries mainly fo reconomic reasons, not tax considerations, and in these cases the overall limitatio non the foreign tax credit, averaging results from operations abroad, would appea rto make more sense for planning purposes . Forcing everyone to abandon theoverall approach obviously would disrupt both tax administration and planning .

Neither Bradley-Gephardt nor Kemp-Kasten makes any comparabl eproposal .

However, Bradley-Gephardt would force current U .S . taxation of

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income from controlled foreign subsidiaries before that income is repatriated inthe form of dividends. This would raise a host of other questions and problems fo rmultinational firms .

In our simplification scorecard on eighteen major provisions of theTreasury program affecting both individuals and corporations, we find that twelv eof the eighteen would be considered improvements for compliance purposes bu tonly seven improvements for tax/investment planning. Eight of the proposals ar eseen as further complications for planning purposes, and the net effect of three i sunknown. Simplification both for compliance and planning is more evident fo rindividuals under the Treasury program than for corporations . The most notableexception to the prospective general simplification for individuals would be th eplan to repeal numerous statutory fringe benefits which would not only complicat etax compliance but have a major impact on employer-employee relations .

On the corporate side, of eight major proposed provisions mainly affectin gcorporations, compliance improvement is noted in half of them but improvemen tfor planning in only two.

In general, the Treasury plan would make some significant progres stoward simplification particularly in compliance . But the simplification objectiveis compromised by other tax reform considerations especially the proposed sprea dof indexing and new measurements of income in the business sector .

While no separate rating of the Bradley-Gephardt or Kemp-Kaste nprovisions has been made, it appears that they would offer somewhat less overal lsimplification for compliance purposes then the Treasury program but also involv eless planning complications then the Treasury program . Both congressiona lprograms are considerably more limited in the reach of their provisions .

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IV. Economic Impact

There had been much talk of revenue neutrality as a cardinal objective o fall serious income tax reform proposals . And there was the assumption that thismeant revenue neutrality between the individual and corporate sectors as well .This was the stated objective of the Bradley-Gephardt plan (although a preciserevenue estimating of the Bradley-Gephardt provisions probably would show a nincrease in corporate sector tax burden) . Thus it came as a distinct shock to th ebusiness community when the Treasury plan details were released portraying a ver ydecided shift in relative tax burdens toward the corporate sector and away fromindividuals, even though the overall revenue target was very close to balance wit hprojections under current laws. This result is shown in the summary table from th eTreasury report on page 26 .

How these results came about is the subject of some speculation .Treasury maintains that it is the natural consequence of a vigorous application o fthe neutrality standard for the distribution of tax burdens among individuals o fsimilar income groups and among industries and investments . Some less than pureneutrality motives may have crept into the calculations, however .

First, the ability of the plan designers to offer both a meaningful margina lrate reduction and a doubling of the personal exemption, while still retaining som ebasic itemized deductions, was quite circumscribed -- unless, of course, someadditional revenue could be found outside the individual sector . Raising thepersonal exemption to $2,000 would certainly be a popular attraction . It also has aweak link to neutrality of treatment and would be very expensive. Interestingly, ofthe myriads of revenue estimates provided by the Treasury for all kinds of change sfrom the breathtaking to the merely nit-picking, none is provided separately fo rthe cost of doubling the personal exemption and increasing the zero bracketamount --even though these are among the easiest to estimate . Instead, their costis lumped in with the effect of the marginal rate reductions totaling some $13 2billion by 1990, of which the increased allowances must account for a substantia lportion .

Secondly, Treasury may well have been influenced by the continuin gbarrage of comment and criticism as to the shrinking share of Federal receipts pai dby the corporate sector in income taxes . This is a long-term phenomenon ofcourse. Pre-World War II, the Federal corporate income tax generally provide dmore revenue than the individual income tax and even in the late 1950's accounte dfor about 30% of all receipts . Since then the corporate income tax share hasshrunk fairly steadily to a low of 6% in fiscal 1983 before rebounding to a nestimated 10%, with the recovery in corporate profits in fiscal 1985 . The long-term decline is associated with two trends having nothing to do with corporate ta xpolicy : a corresponding secular downtrend in gross corporate profit margin s(profits as a percent of national income) and the very sharp rise in Federal payrol ltaxes displacing the relative importance of all income taxes . Then too there havebeen more liberal capital recovery and other provisions which certainly hav ewhittled away at the corporate tax base especially in recent years . In absolutedollars Federal corporate tax receipts have risen substantially with only busines scycle interruption, to an estimated new peak of $74 billion in fiscal 1985 .

Estimated Revenue Impact of Treasury Tax Reform Program, 1986 - 199 0

Fiscal years

1986 1987 1988 1989

: 199 0

Current Service receipts : current law -- (Midsession Review of the

1985 budget)

($ Billions )

Individual 373 .0 407 .7 452 .4 493.1 537 . 4

Corporate 87.9 102 .7 111 .6 117 .0 122 . 6

Estate and gift 5 .4 5 .0 4.8 4 .8 5 . 1

Excise 36 .1 36 .8 35.4 34.7 34 . 0

Total

Current service receipts: proposed law

502 .5 552.2 604.2 649 .6 699 . 2

Individual 350.9 371.1 427 .2 467 .2 499 . 7

Corporate 110.1 133.3 141 .0 155.1 167 . 4

Estate and gift 5 .6 4 .9 4.7 4.7 5. 0

Excise 36 .3 37 .1 35.3 33.0 30 .9

Total 503 .0 546 .5 608 .1 659 .9 703 . 0

Net effect of the proposal - total receipts .5 -5 .8 3.9 10.3 3. 9

Total Change in Receipts : ($ Millions)

Individual -22,138 -36,613 -25,209 -25,908 -37,693

Corporate 22,164 30,582 29,341 38,062 44,72 0

Estate and gift 220 -94 -106 -109 -8 1

Excise 221 331 -123 -1,729 -3,08 1

Total 467 -5,794 3,903 10,316 3,865

Source : Office of the Secretary of the Treasury

Office of Tax Analysis, November 24, 1984

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None of this really should have much bearing on what the corporate ta xburden should be . As corporations themselves are incapable of bearing the rea lincidence of any tax, the decision to impose taxes on the corporate form shoul dstem from considerations of efficiency and limiting the shelter opportunities o findividuals . In the public perception, however, the corporate sector is getting awa ywith murder and this is reinforced by political statements and judgments reachin gwell into the Administration .

In any event the Treasury plan would impose a hefty new burden on th ecorporate side -- an estimated $44 .7 billion more by 1990 . This is a net figureincluding a much larger revenue pickup from eliminating ACRS and the investmen tcredit offset to an extent by cutting the corporate rate and dividend relief . Thebig change is in capital recovery, but it should be noted that the revenue estimate shere -- $68 billion by 1990 for knocking off ACRS -- exaggerate the likely rea limpact . Because what Treasury is proposing basically is to eliminate the front en dbenefits of the present system, the revenue effect would be bell shaped with th emaximum impact happening to occur about 1990, the last year covered by th erevenue estimates. Afterwards the revenue effect would diminish considerably - -still not much comfort to those now planning investment projects .

On the individual side the proposed distribution of tax burdens is ver yclose to the present for broad income groups, though the lowest income group swould gain some relative relief . This was a deliberate objective of the Treasuryprogram, with almost all of its reform effort going into attempts to improv e"horizontal" equity .

Within the corporate sector there would be a considerable redistributio nof tax burdens toward capital-intensive industries and away from the service -oriented industries . Treasury's single-minded devotion to neutrality amonginvestment media would result in including more capital income in the tax base ,particularly through the capital recovery provisions, but also due to the productio ncost rules and other reforms. This does not address directly what a number o fobservers feel is an inherent bias of income taxation against savings and capitalformation by subjecting overall savings and corporate earnings, unless specificallyexcepted, to double taxation. The Treasury plan for dividend relief would alleviat ethat double taxation in the corporate sector but conditional on tax penalties oncapital elsewhere . You can, of course, treat different investments more neutrall yand still end up handicapping the whole capital and savings sector relative toconsumption .

Some econometric studies of the Treasury reform plan and the leadin gcongressional plans already have been conducted . Mostly they show an adverseimpact on capital investment, output and employment from scrapping ACRS an dthe investment credit which would outweigh the positive effect of the lowe rcorporate rate . This might be expected from the probable increase in the cost o finvestment capital posed by the specific Treasury reforms and by the Bradley -Gephardt plan in particular . Two important points must be kept in mind here .

First, the inflation projection . Treasury's economic assumptions an dpresumably all of the relevant revenue estimates are based on the same projectio nof inflation as in mid-session review of the fiscal 1985 budget: 4.6% in 1985, 4.5%

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in 1986, 4.2% in 1987, 3 .9% in 1988, and 3 .6% in 1989 . In other words, a verystable pattern of slowly declining inflation. In such an environment the Treasury' smultiple indexing plans would be of less importance for tax/investment decisions .Conversely, the economic bang from ACRS and the investment credit, based onshort fixed write-offs from historical cost would remain large and certain to fa routweigh the erosion of the value of deductions from modest inflation . If,however, we were to reexperience double-digit inflation such as in the late 1970's ,the Treasury plan's inflation adjustments, particularly as applied to depreciatio nand capital gains, would become much more valuable both in tax savings and fo rmarket planning . The whole pattern of revenue impact would change too .

Secondly, Treasury quite properly points out that the quickie econometri cstudies of its reform plan do not take into account any improved overall efficienc yfrom lower marginal rates and better resource allocation to productive use.However, the Treasury itself has not provided such an analysis of overall efficienc yto date and there is a real question whether or not it can be measured --whether o rnot the sweep of proposed changes and extent of interaction between them can behandled by any econometric model . At this point Treasury is asking that its plan b etaken at face value in this respect on the strength of its presented logic as to broa deconomic consequences .

In so doing, Treasury, and to a somewhat lesser extent the Bradley-Gephardt and Kemp-Kasten plans too, are asking for a dramatic reversal of polic ywith regard to U.S. capital-intensive industries -- a reversal from the inception o fthe investment credit and guideline depreciation in the early 1960's and eve nfurther back from the introduction of accelerated methods of depreciation in the1954 Code revision . A basic tenet of this tax policy has been that specifi cencouragement must be given to domestic capital formation to: (1) counter theoverall bias of the income tax against capital formation ; and (2) to give U .S.capital-intensive industries a better lever to compete abroad . It has been assumedfurther that a very liberal capital recovery policy, whatever its theoretica lstructural flaws, would help lead the whole economy including the service sector t obetter performance -- creating more jobs and higher, living standards .

Proponents of this viewpoint cite fast expansion in capital spending forplant and equipment since the implementation of ERTA in 1981 as evidence tha tthe industrial based tax policy is working . Critics say this is only a cyclica lresponse to overall economic recovery and may not last . The critics also point tosome new directions in tax policy abroad, particularly in the U .K. where specia lincentives for manufacturing investment have been cut back in favor of corporaterate reduction .

U.S. tax policy has been oriented to provide relief to the capital-intensiv esector over a long period . The culmination of this policy came with ERTA in 1981 .The ACRS system and the liberalized investment credit rules then re