Even before the House Ways and Means Committee officially decided to repeal the investment tax credit and lengthen depreciation schedules for American business last weekend, the computers at the U.S. Chamber of Commerce were hard at work building a case against the changes.
The instant analysis produced by the chamber showed the proposed cutbacks raising the cost of investment. Subsequent forecasts said the committee's actions would curb investment, increase unemployment and slow overall economic growth.
The issues the chamber and others are debating constitute perhaps the most central question in federal taxation of business: how to account for the "loss" a business takes as its assets decline in value.
At some point, a truck or a tool or a factory has deteriorated so much that it is worth nothing to its owner and must be replaced. Because that deterioration occurs over a period of years, tax policy makers long have agreed that some part of it should be written off annually, just as a bad debt or an employe's salary should be deducted. But there has been disagreement for decades over how many years, and at what rate.
Congress has swung back and forth from generous tax incentives to tighter taxation of business, changing the law in this area 15 times in the last 30 years.
In 1981, Congress adopted President Reagan's proposal to make depreciation and the investment tax credit more beneficial to business; the battle ever since has been over how much those new breaks should be reversed.
The chamber is not alone in its opposition to the proposed investment tax changes. Other business groups also are arguing that loss of the investment tax credit, which subsidizes up to 10 percent of the cost of investment in equipment, and the slower depreciation schedules for writing off the cost of equipment and structures would harm the nation's ability to compete for foreign markets.
Alexander S. Trowbridge of the National Association of Manufacturers said the changes "pose extremely high risks for the economy." And even Commerce Secretary Malcolm Baldrige, whose administration has proposed repeal of the ITC, said last week that "incentives for capital investment" are needed to preserve international competitiveness.
Tax economists now studying the Ways and Means plan say, however, that the issues involved in revising tax provisions affecting investment are much more complicated than that.
Although they say there are some defects in the Ways and Means bill from a tax-policy standpoint, they disagree about what those defects are and caution that the business groups may be taking too narrow a view.
Some warn that quick econometric analysis is based on many assumptions about inflation, budget deficits and exchange rates that have at least as great an effect on business investment as tax changes. Forecasting too quickly -- many details about the bill remain unavailable -- could produce questionable results, some economists suggest.
"The clever econometric-model user can produce any kind of result his client wants by the judicious use of assumptions," said Henry Aaron of the Brookings Institution. "We know the chamber is quite anxious to retain every tax advantage that equipment now enjoys and the overly rapid depreciation schedules now in existence. I would view with skepticism the results of those kinds of projections, and I would want to see projections based on different kinds of assumptions."
The economist who produced the forecast for the chamber, Joel L. Prakken of Laurence Meyer & Associates in St. Louis, said his results could be reached so fast because the sophisticated model already contained much of the information and assumptions needed to test the Ways and Means bill before the legislation was complete. The assumptions are based on economic projections from leading forecasting firms, he said.
However, the forecast, of necessity, did not include alternative scenarios. For example, if the tax plan caused the economy to slow down, the Federal Reserve might increase the growth of money and credit and cause GNP to rise to where it would have been without the tax change. The only difference would be that the composition of the economy would shift away from investment and toward consumption, Prakken said. The forecast he released to the press assumes no action by the Fed.
Similarly, Prakken used a model that assumes investment levels are fairly sensitive to tax and other changes in the cost of capital. A model with more rigidity in investment decisions would show a less marked effect from repeal of the ITC and depreciation cutbacks. Lastly, the model assumes no "efficiency gains" -- it takes no account of the possibility that the gears of the economy will mesh more smoothly if assets are taxed more equally, with less loss from wasted effort and unproductive investment.
"What we're showing are the downside risks that would have to be offset by other goodies" stemming from the tax changes, Prakken said.
Policy makers have listened to these kinds of debates since World War II. Until 1981, depreciation was determined by grouping assets into different classes, each class with its own time period for writing off the original cost of the investment. The periods were supposed to approximate the actual time it took for an asset to wear out -- longer for real estate, shorter for equipment.
Although it permitted some "acceleration" of the write-offs so that deductions were larger in the early years of the period, the system generally failed to deal with assets that became obsolete before they wore out. Nor did it deal with the effect of high inflation, which made the cost of replacing an asset much higher than the deductions the company had taken.
Congress, pressured by the Reagan administration, responded by enacting the Accelerated Cost Recovery System in 1981, which dropped the linkage between an asset's useful life and its depreciation period. The idea was to use depreciation as a stimulus to investment at high inflation rates along with the investment tax credit, which had been enacted and repealed several times during the previous 20 years.
It set four classes, the longest being 15 years for real estate (it since has been lengthened to 19 years); the shortest, three years for vehicles. Acceleration also was increased.
"All the laws had paid lip service to the notion that write-off periods should conform to some version of taxpayer experience, and that was just thrown out the window in 1981," said Charles R. Hulten, economics professor at the University of Maryland. "I called it the arbitrary cost recovery system."
When the inflation rate fell rapidly, companies found themselves with generous deductions that, in some cases, lowered or wiped out their tax liability. Critics said then -- and are saying now -- that ACRS, in combination with the tax credit, was an outright subsidy to business, and that it resulted in widely differing tax rates on different kinds of investments.
The Treasury Department accepted many of these conclusions in its tax-revision proposal issued almost exactly a year ago. That plan called for longer depreciation periods, from five to 63 years, approximating more closely the useful life of an asset. But it coupled that change with the indexation of the depreciable value of the asset to the rate of inflation.
President Reagan's version of tax overhaul issued last May was intended to preserve "investment incentives," in the words of the plan. The write-off periods, still indexed to inflation, were shortened to a range of four to 28 years and the degree of the deduction that could be taken in early years was increased.
By the time Ways and Means had finished wrestling with depreciation, the committee had made sizable changes. The periods covered 10 new classes of assets ranging from three to 30 years, with most commercial real estate in the 30-year category. Inflation indexing was retained only partially: Companies could adjust the basis of their assets to half the amount that the inflation rate exceeded 5 percent. In other words, if prices rose 7 percent, companies could make a 1 percent adjustment.
The investment tax credit was gone, as it had been under all the administration proposals. In its place, however, the committee had increased the deductions available in the early years of an asset's life. Essentially, companies could write off 20 percent of the remaining value of the asset each year so that, for a $1,000 asset with a 10-year life, the deduction in the first year would be $200. In the second year, it would be 20 percent of $800, or $160, and so on.
Given all those complexities, economists were divided over what effect the proposal, which is scheduled for a vote in the House during the second week of December, would have on investment.
"I think it is a disaster," said Martin S. Feldstein, formerly chairman of the Council of Economic Advisers and now at Harvard. "Whatever may have been the value of the original bill, we now have something that is simply a major increase in the tax on business investment that would be used to finance increases in the personal exemption."
Taking issue with the contentions of some economists and other proponents that the legislation would make the tax rates on income from different kinds of investments more equal, Feldstein pointed out that real estate already enjoys other tax advantages because it is heavily financed by debt. As a result, the investment tax credit and accelerated depreciation for plant and equipment merely serve to offset that benefit, he said.
"If you raise the cost of capital for investment in plant and equipment, that money will go abroad, it will go into shopping centers, condominiums, second homes," Feldstein said. "I don't see it as a level playing field at all."
John Makin of the American Enterprise Institute worried that, without indexing to inflation, the legislation merely amounted to tax increases on business. If indexing had been fully retained and the corporate rate reduced to the 33 percent Reagan wanted rather than the 36 percent in the bill, the changes might make sense, Makin said.
"They have built in some problems they will have to come back to," he added.
Hulten agreed that the lack of full inflation indexing is a matter of concern, but pointed out that, at the low rates of price increase today, the effect of the plan would be similar to the effect of the original Treasury proposal. Assets that had been taxed heavily would do better, while those that had enjoyed low tax rates, such as equipment, might see less investment.
Emil Sunley of Deloitte Haskins & Sells, an accounting firm, said the generous tax treatment given to owner-occupied housing -- interest on mortgages for the first two residences would remain fully deductible -- means raising the tax rate on other kinds of investment could entice more of the supply of savings into housing. Nonetheless, Sunley expected that disparity to continue.
"My own quick reaction is that clearly the pendulum is going to swing back to less-generous capital recovery rules," he said. "Politically, there is some feeling that pendulum swung too far in 1981. The question is whether it will swing too far the other way."