In 1981, the Reagan administration and Congress adopted tax breaks for real estate investment that unleashed a flood of speculative construction around the country. When Congress closed the tax loopholes five years later and the boom turned to bust, skylines were left dotted with empty "see-through" office buildings as monuments to a tax policy that backfired.
Now, in the name of economic growth, President Bush and congressional budget negotiators have proposed new tax breaks for investors -- this time aimed at helping small businesses.
The new provision, which the White House insisted on, offers a series of breaks for individuals who buy stock in companies with equity -- non-borrowed funding -- of $50 million or less, with some notible exceptions: investments in real estate, banking, thrifts and insurance companies would not qualify.
"It's a powerful tax incentive designed to direct investment to sectors of the economy with the greatest potential for growth," said Roger Bolton, chief spokesman for the Treasury Department.
But as lawmakers, lobbyists and investors begin to digest the budget compromise, some are questioning whether the small business tax break will cause similar damage -- a fallout of failed, "see-through" widget companies that provide lucrative tax breaks for wealthy investors but that couldn't survive on their own.
One major feature would allow investors to deduct up to $50,000 a year from their taxable income for investments in newly issued common stocks from qualifying small companies. For investors in the 28 percent tax bracket, that translates into tax savings of up to $14,000.
"Clearly, for companies like ours, it would be an incentive to invest in us," said Steven C. Mendell, chairman and chief executive of Xoma Corp., a biotech company in Berkeley, Calif., with $100 million in assets but less than $30 million in shareholder equity. "The tax benefits would mitigate some of the risk of investing in a development-stage company or companies that don't have an established track record."
But some accountants said the tax break also could lead to too much money chasing after too few good ideas and companies, especially in the field of high-technology. That was the case in the 1980s in several major sectors of the high-technology industry in California, where, for example, an over-investment in makers of computer disk drives and IBM clones resulted in an overcrowded market and then a slew of bankruptcies.
Even more troublesome, congressional aides and accountants say, is the possibility that restoring the kind of special tax breaks eliminated in 1986 would open the way for others, draining revenue from the Treasury and increasing pressures for tax increases.
"It smells like some of the old tax shelters that were used by higher-income taxpayers," said Carl Duyck, tax partner at Price Waterhouse, the New York accounting firm. "It's a crack in the wall.
"I understand what they're trying to do. They're trying to stimulate investment in newer businesses, but, the fact is, they are subsidizing that investment with tax dollars," he said. While there's nothing necessarily wrong with that, he said, it undermines the underlying compromise of the 1986 tax law, where most tax benefits were erased so that the overall tax rate could be lowered. The small business tax proposal could represent a small but significant first step toward the day when overall rates have to be raised again, he said.
The key to whether the proposal proves a boon to economic growth or a misguided tax break may well depend on the detailed language spelling out the provision.
Treasury official Bolton said that the Treasury is committed to minimizing the potential for abuse of the tax benefit. For example, he said, Treasury favors a rule that limits tax benefits under the proposal to investors who purchased stock with their own money or with borrowed money for which they were personally liable. Borrowed money that was collateralized with purchased stock rather than with the personal guarantee of the borrower would not be allowed, he said.
Companies also would not be allowed to spin off subsidiaries to qualify, nor could they carve themselves up into qualifying smaller businesses.
"It's a laudable goal," Duyck said, but even if it works as intended, it will be "but a drop in the bucket," toward the policies the country needs to spark growth and remain competitive.
"The 1986 tax law made debt much more attractive than stock ownership and helped contribute to a lot of the problems in leveraged buyouts and thrifts in the last decade," said C. Richard Kramlich, managing partner in the leading venture capital firm of New Enterprise Associates and a co-chairman of the taxes and incentives committee of the National Venture Capital Association. Reversing that trend will require much more than the small business incentives in the current plan, he said.
"What we're talking about here is competitiveness in the world economy, about job creation and about the replacement of equity for debt, and I'm disappointed that these issues were political casualties in the budget deficit talks," he said.
To the administration, however, the goal of funneling money to smaller companies, from gasoline stations, dry-cleaners and restaurants to medium-size manufacturing firms, has more advantages than potential pitfalls.