One of President Reagan's proposals for reducing future budget deficits is a sizable tax increase for defense contractors.
Only guess who would end up paying the higher taxes?
In the view of both Treasury and Defense officials, a significant percentage would be paid one way or another by the Defense Department, and so ultimately by the taxpayers.
"There will be an associated cost increase," said Jack Kendig, director of cost pricing and finance at the Defense Department. "This has to result in an increase in the price of goods" to the Pentagon, said a Treasury analyst.
The tax increase would apply to multiyear contracts and would yield an estimated $4.4 billion in 1984 and $19 billion through 1987. About 35 percent of this would come from private construction companies and 15 percent from companies that make heavy equipment. All this would be a real gain for the government.
But the other 50 percent would come from defense contractors, and here the gain would be largely illusory. The Treasury's gain would be the Defense Department's loss, in that the affected contractors would be able to pass along their higher taxes just as they do other costs.
The proposal would let the administration count some dollars twice, as part of the president's vaunted defense buildup and at the same time as part of his effort to reduce the deficit.
The tax controversy centers on a set of regulations technically called the "completed contract method of accounting." These regulations permit a company to put off paying federal taxes on a multiyear contract to produce, say, an office building or tanks or jet fighters until the contract is completed, even though the company receives partial progress payments in the interim.
Letting a company defer its taxes is like giving it an interest-free loan of the money owed; and a Treasury study says that at today's high interest rates, five years of deferral is equivalent to a 15 percent increase in profit. To keep up their profits, companies that lose deferral will have to raise their prices.
John B. Chapoton, assistant treasury secretary for tax policy, acknowledged that, in the case of the defense contractors, a portion of the proposed tax increase would be passed on to the Defense Department. "But I don't buy the theory that 100 percent will be passed on," he said.
The administration's estimate of likely revenue gain from dropping deferral did not make allowance for any increased costs to be paid by the Pentagon.
One official argued that the administration's defense spending goals have been set from the top down, largely in terms of percentage increases fixed almost in the abstract, rather than built from the bottom up in a carefully defined weapons acquisition program, and consequently the elimination of "completed contract" accounting will result in the purchase of fewer weapons, not an increase in Pentagon spending.
The completed contract issue directly touches on a basic, underlying problem of all corporate tax policy: who pays? Kendig, of the Defense Department, said such factors as interest charges, taxes and required dividend payments are not included when the Pentagon negotiates the pre-profit "cost" of a weapon or other item to be purchased.
But, he added, "we know that that kind of stuff is covered in the profit" and consequently in the final purchase "price" of the weapon. Elimination of completed contract accounting will, in effect, force companies to borrow more to finance production, he said, and "we recognize that it has to be included" in a corporation's calculation of profits.