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Tax Reform Falling Prey to Tax Cuts

By Steven Pearlstein and Clay Chandler
Washington Post Staff Writers
Sunday, December 18, 1994; Page A01

The election of 1994 has claimed another victim: tax simplification.

Back in 1986, Congress, with the strong support of President Ronald Reagan, decided that the tax code was so full of credits, deductions, carry-forwards and accelerated depreciations that it would be better to wipe out most of them and simply lower tax rates for everyone.

But now the consensus around tax reform is crumbling fast as a Democratic president and a Republican Congress rush to propose a raft of tax benefits designed to provide financial relief to some families and encourage certain kinds of economic behavior but not others.

The trio of middle class tax breaks proposed by President Clinton last week includes a tax credit for households with children ($10.6 billion loss to the Treasury in the year 2000), deductions for college tuitions and vocational training ($6.9 billion loss) and expanded eligibility for tax-deductible contributions to individual retirement accounts ($2 billion loss).

And this is small change compared with the almost $35 billion in annual tax breaks Republicans have proposed to put extra money in the pockets of businesses that invest in new equipment and investors who profit from the sale of stocks and bonds, in addition to even larger benefits to savers and parents.

"The problem with these kinds of proposals is that they open up the process to an endless stream of petitioners pleading for a special tax treatment for their worthy cause," said Henry Aaron, a Brookings Institution economist. "This is a slippery slide and we took a big jump onto it."

"What all these tax cuts are about is politics," said Herbert Stein, senior economist at the more conservatively oriented American Enterprise Institute. "There is very little economics involved here."

Stanley Collender, who follows the federal budget process for the accounting firm Price Waterhouse & Co., characterized the flurry of tax proposals as nothing more than backdoor spending programs that would be politically unacceptable if they were framed as the new entitlements that they really are.

It is a matter of almost doctrinal belief among economists that tax breaks of any kind make the economy less efficient because they distort the choices made by consumers, investors and business owners who otherwise would be guided solely by the forces of the free market.

But administration officials scrambled last week to defend the idea of adding new tax breaks for the middle class, arguing that as long as the tax code already provides deductions for home mortgages or oil drilling, it ought to at least provide equal treatment for savings, education and the costs of child rearing.

"You have to see this in the context of the entire tax code as it is today," one official said.

"This is not just a tax cut, this is an investment in the future prosperity of working Americans," declared Labor Secretary Robert B. Reich.

The irony is that while many saw in the November election results a desire by voters to get government out of their lives, the purpose of a tax deduction or credit is to use government financial incentives to get people to do things – save, invest, further their education – that they might not have done otherwise.

"The government is now firmly under the control of Democrats and Republicans who believe that the tax code is a instrument of social engineering and economic planning," said Robert S. McIntyre, executive director of Citizens for Tax Justice, a labor-funded research organization that has long advocated tax simplification. "This is nothing more than socialism dressed up in free-market rhetoric."

Other critics complain that the tax breaks won't change much behavior at all. Instead, they argue, they will simply wind up as windfalls for those who are already saving and investing and putting themselves or their children through school.

Economic literature, for example, remains sharply divided on whether IRAs really get people to save any more, although Cornell University's Richard Thaler has found that the withdrawal penalties of the IRA have had the effect of encouraging people to leave their savings untouched rather than splurging on boats or vacations.

And Republican proposals to allow businesses bigger or faster write-offs on their capital spending traditionally have been greeted skeptically by analysts at the Congressional Budget Office, which has found tax considerations to be much less important than business conditions and profit levels in deciding when to add plant and equipment.

As for education, few doubt its value: Recent studies show that every year of post-secondary education adds 6 percent to 12 percent to a person's earning power. But economists are skeptical that tuition tax deductions will lure many more people into classrooms.

The Treasury Department's internal estimates, for example, show that a $10,000 deduction for college and vocation school tuitions would add only 500,000 students into the education system, a gain of 3 percent. By that calculation, almost $6 billion of the $6.9 billion that the education tax break would cost the Treasury each year would go to those who would have been in class even without the incentive.

Aaron and other critics also warned that tuition tax breaks might simply have the effect of encouraging cash-strapped state universities and private colleges to raise their tuitions, which was what happened in earlier decades when the government increased its tuition assistance.

Administration officials responded by saying that an increasingly competitive education market should work to keep prices down. But the available evidence is not encouraging: Education costs have climbed at twice the inflation rate for more than a decade.

Despite these myriad reservations, however, the tax deduction seems to be alive and well again in Washington.

"The Tax Reform Act of 1986 was a great leap forward," said Robert D. Reischauer, the outgoing CBO director. "Now we're slowly undoing the good that we did then."

© Copyright 1994 The Washington Post Company

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