The Treasury Department's tax reform proposal would result in slower economic growth, slightly lower interest rates and little change in inflation in the next few years, according to a study by a major economic forecasting firm.
The study, one of the first major reviews of the proposal's effects on the economy, concluded that, in the short run, the tax reform proposal would reduce growth by 0.25 percentage point a year for the first two years.
In the long run, its impact would be "relatively neutral, but somewhat negative," said David Wyss, senior vice president of Data Resources Inc. The worst that would happen would be that 0.5 percentage point would be shaved off growth in output, Wyss said.
DRI forecasts 3 percent real growth in 1986 and 4 percent growth in 1987.
One of the promises of the Treasury proposal is that it would foster economic growth because the restructured tax system would allow market forces to shift resources to areas where they will be more economically efficient, leading to greater output.
However, the study by Data Resources Inc. said that one of the reasons growth would be slower is that the Treasury plan would eliminate many of the incentives to buy capital. As a result, investment would decline and so would productivity, the study concluded.
Wyss said the Treasury plan would result in more efficient allocation of resources but that benefit would be offset by lower investment. On the other hand, individuals' incomes would increase, leading to higher consumption.
Wyss said DRI experts largely ignored the effect of indexing interest payments -- a key part of the Treasury plan -- because they believed it could not be implemented.
If interest indexing could be accomplished, the prime interest rate could decline as much as 1.5 percentage points, Wyss said.
Absent the indexing, interest rates would decline slightly under the Treasury proposal, Wyss said. The Treasury plan would eliminate the investment tax credit and the accelerated cost recovery depreciation system, which Wyss said would increase the cost of capital, reduce investment incentives and lower borrowing demand.
The reduction of corporate tax rates from 46 percent to 33 percent would not offset the loss to corporations resulting from special tax breaks, Wyss said.
Treasury Department officials had not yet seen the study and said they had no comment on it.
DRI said Treasury's proposal to index interest payments, if implemented, would increase the cost of borrowing because the taxpayer would no longer be able to deduct the inflation part of the interest expense.
At the same time, the lender would pay tax only on the smaller, inflation-adjusted interest payment. The result would be less borrowing and more incentive for lenders to lower interest rates.
Somewhat offsetting the effect of slower loan demand is a proposal in the Treasury plan to allow the deductibility of 50 percent of dividend payments. As a result, businesses will increase dividend payments but borrow to pay them, increasing credit demand, Wyss said.
Inflation would be little affected by the Treasury plan, Wyss said. In the short run, the proposal would have "a small negative impact" because of the somewhat weaker economy resulting from the plan, he said. "But it reverses very quickly."
Because of the fall in interest rates, the dollar would become less attractive and the value of the dollar would decline, according to DRI. However, he said it would have a negligible effect on inflation in the short run.
The Treasury plan would limit to $5,000 more than investment income the interest deduction for second homes and other interest expenses. Initial DRI estimates show a loss of 200,000 housing starts a year as people attempt to get rid of second homes. However, housing should rebound later, Wyss said.
In addition, initial estimates showed that the average home price may drop 12 percent as a result of Treasury proposals, assuming interest rates remain the same. The value of expensive homes will fall much more than that of cheaper houses and the prices of second homes will decline more than that of primary residences, Wyss said.