The tax revisions in the bill the Senate will begin to debate this week are so sweeping that the bill's economic impact is all but impossible to predict.
No one can be very sure how individuals and businesses will respond if the many changes in the bill become law.
Take cars, for instance. Will consumers buy fewer new cars if they are no longer allowed an itemized deduction for the interest paid when the car is financed, as proposed in the bill? Or would they buy more cars since, in the aggregate, they would get a tax cut and therefore have more money to spend? Meanwhile, what will happen to business purchases of cars if their cost has to be written off for tax purposes over five years instead of three?
Or might impact of the loss of the deduction for consumer interest payments, as well as the longer depreciation period, be offset directly by a significant drop in the level of interest rates that would flow from a combination of the bill's provisions?
After looking at all of the bill's major features, the auto industry decided it would back the measure.
Among the major uncertainties about the bill's impact is the effect on business spending for new plants and equipment, according to a number of analysts.
In general, the bill would raise corporate income taxes substantially, in part by repealing or reducing some major investment incentives, including the 6 percent to 10 percent investment tax credit (ITC). In exchange, the maximum corporate tax rate would be lowered from 46 percent to 33 percent.
As with consumers buying cars, there are a number of potentially offsetting effects, including the possibility of some gain in efficiency for the entire economy from having the flow of income from different types of capital investment taxed more equally than at present.
Several of these issues were addressed at a National Bureau of Economic Research conference held here last week. The NBER is a highly respected nonprofit research organization founded in 1920 which supports and publishes research largely by academic economists. (Among other activities, as an outgrowth of its long history of analyzing business cycles, an NBER group determines the "official" beginning and end of recessions in the United States.)
At the conference, Lawrence H. Summers of Harvard University suggested that repeal of the investment tax credit might have more of a depressing effect on investment in business equipment than expected because many corporate executives give heavy weight to tax benefits available soon after an asset is purchased. The ITC, which is the economic equivalent of a discount on the purchase price of equipment if a buyer has profits to be taxed, is available in its entirely when the purchase is made.
The Senate bill would repeal the ITC. Some of that loss would be offset by allowing businesses somewhat more generous depreciation allowances for equipment.
Since a business usually must pay for equipment when it is purchased, executives want to know the present value of the tax write-offs they will get this year and in the future. But because of inflation, a future benefit will be worth less in today's dollars when it is actually received. To adjust for that fact, many businesses "discount" those future benefits in deciding whether to make a particular investment.
"It is only because of discounting that depreciation schedules affect investment decisions, and their effects depend critically on the assumed discount rate," Summers said. The economists on the staff of the Joint Taxation Committee who are providing the background analysis for the Senate Finance Committee report on the tax revisions bill use a discount rate of 8 percent to 9 percent -- adding a 4 percent real rate of return to a 4 percent to 5 percent inflation rate -- in estimating the effects of changes, Summers said.
However, some large businesses use a much higher discount rate. Summers surveyed the chief financial officers of the top 200 corporations in the Fortune 500 asking whether they used this approach in making investment decisions, and if so, what discount rate they used.
There were 95 useable responses, Summers said, with virtually all of the large corporations saying that the procedure was of "considerable" or "overriding" importance in their investment decisions. The discount rates used ranged from 8 percent -- in line with the Joint Committee's assumption -- to 30 percent, with half of them higher than 15 percent.
The higher the discount rate, the lower the present value of depreciation received in future years. Thus, Summers concluded, the somewhat more generous depreciation schedule under the Senate Finance Committee bill than under current law would do little, in the minds of corporate decision makers, to offset the loss of the ITC, which does not have to be discounted.
A 16 percent discount rate, about in the middle of those reported in the survey, means that the present value of depreciation received six years from now would be worth only half what it would be if received this year.
"The fact that firms use very high discount rates in evaluating projects suggests that the investment tax credit is likely to be a very potent tax incentive per dollar of government revenue foregone," Summers said.
Nevertheless, if any tax revision bill passes, the ITC is likely to be gone. Its repeal was a feature of both the original proposal by President Reagan and the bill passed by the House last year and is in the bill before the Senate. Among other things, the revenue gain from its repeal is just about large enough to pay for the reduction in the top corporate tax rate from 46 percent to 33 percent.
Martin S. Feldstein, the Harvard economist who heads NBER and was chairman of the president's Council of Economic Advisers, told the conference that he estimates that the House tax revision bill would reduce net business investment by about 10 percent. "In other words, the reduction in investment will be as large as the revenue raised by the bill" from the corporate sector, he said.
The Senate version, with greater depreciation allowances, would hurt investment less. And if the lower tax rates that would be paid by individual investors on income from their investments is taken into account, the ultimate rate of return would be affected much less -- and so would be the level of investment, Feldstein said.
A recent analysis of the Senate bill by Data Resources Inc., an economic consulting firm, found that even with a more accommodative monetary policy from the Federal Reserve, business investment in both equipment and structures would likely fall significantly after its passage. By 1988, annual investment in both would be about 5 percent lower than if current law was not changed, according to DRI senior economist Robert A. Gough Jr.
By 1990, the lower rate of investment would reduce the nation's total stock of business capital by about 2.4 percent compared with what it otherwise would be. And the decline in capital would lead to a slower rate of increase in productivity of about 0.4 percentage points a year during the 1987-1991 period, Gough explained.
In the short run, the DRI analysis also shows that the quick repeal of the ITC -- the Senate bill would make it retroactive to last Jan. 1 -- and the delay in cutting personal income tax rates until the middle of next year combine to produce enough of a revenue bulge to slow economic growth. It would trim 0.7 percent off next year's growth rate, he said.
But Gough, like many other economists, still favors passage of the Senate bill as a "first step" toward tax reform. "I would vote for it and then try to fix it the amended tax code . This is by no means the end of the discussion," he said.
In short, Gough has little confidence in the ability of the DRI econometric model to predict what is going to happen when so many changes are made more or less simultaneously in the tax law. "I just don't think it will be negative in the long run," he declared.
At the NBER conference, Patric Hendershott of Ohio State University noted that while both the House and Senate versions of tax revision would make taxation of different types of corporate investment more equal -- in particular reducing the advantage of equipment over inventories and structures -- both would increase the bias in present law toward investment in owner-occupied housing. "As a result," he said, "saving would be allocated even less efficiently under these plans than under current law."
Hendershott declared that the tax revision bills are "generally anti-investment." To offset that change, he calculated, the level of interest rates would have to fall by about 1.5 percentage points to keep investment from falling.
Some analysts believe that the level of interest rates ought to decline if the Senate bill became law. The argument goes this way:
An investor really cares about his after-tax rate of return, not the pretax rate. Thus, if his tax rate is cut, as it would be for most individuals under the Senate and House bills, the investor ought to be willing to invest at a lower pretax interest rate.
At the same time, the demand for credit ought to be falling. Consumer borrowing would be discouraged for some because consumer interest would no longer be deductible. Businesses also would probably borrow less because with their tax rate lower, there would be less incentive to borrow so as to deduct the interest paid rather than issue more stock.
And with some specific investment incentives reduced or eliminated -- the ITC and the proposed strict limit on deduction of certain types of tax-shelter losses -- the demand for credit ought to fall compared with what it would otherwise be.
"Lower tax rates mean lower interest rates, and eventually lower equity yields," Feldstein said. "The Senate Finance bill could mean no drop in investment," as lower interest rates offset the bill's other negative effects.
DRI's Gough said that his firm's calculations about the bill's impact made no allowance for a drop in interest rates that might flow from the specific changes made by the bill.
In fact, to have done so would have been a matter of having a set of assumptions about behavior determine the outcome of the analysis.