The loggers set their sights on a stand of hemlocks and white firs in the Olympic National Forest, a setting so undisturbed that they had to reach it by elk paths. They walked under a canopy of branches as old as the nation, amid scents of wood and foliage, in silence broken only by songbirds and their own footsteps.

It was the simplest of worlds, or so it seemed.

Then Ron Sackett, a second-generation lumberjack clad in the trademark flannel shirt, put his chainsaw to the bark of a towering hemlock, and it soon yielded, falling in slow motion with a whomp! on the forest floor.

The tree was dead in only one sense. Already, it had embarked on a new life in a strange and foreign jurisdiction: It was a creature of the federal tax code, a carrier of tax breaks.

Through tax breaks and budget subsidies to private businesses, the federal government has shaped the American economy in ways that are largely unseen. It props up houses, banks, oil wells, missile systems, movies, basketball teams, life insurance companies and yes, even trees. The system has grown so complex that even the experts despair of controlling its effect on society.

The forests are an apt starting point for exploring this system. Since the arrival of the first American settlers, trees have been among the nation's most valued natural resources. Testaments to their value echoed throughout the Capitol when Congress voted a major tax break for the timber industry in 1943.

Four decades later, an industry that boasted rugged independence from the government -- from flapjack-eating loggers to cigar-chomping timber barons -- is on the federal dole to the tune of several billion dollars a year in forgiven taxes, according to the Treasury Department.

Timber tax breaks drained enough money from the U.S. Treasury in 1984 to have financed the budget for managing the national forests. Their complexity has led the Internal Revenue Service, nominally a tax-collecting agency, to hire 22 full-time foresters to decipher the industry's tax returns.

They have helped make big timber companies bigger and medium-sized companies large. They have shaped investment decisions from whether to plant trees, to where to cut them, and when. They have become so entrenched that timber executives say they provide up to 25 percent of their profits after taxes, an unusually big chunk.

This year, more than ever before, leaders across the political and business spectrum are pressing to undo these federally subsidized support systems through drastic reforms in the way the government taxes and spends.

The Treasury Department, joined by liberal Democrats and conservative Republicans, has called for a sweeping purge of tax breaks for industries, including timber. Office of Management and Budget Director David A. Stockman is waging a similar campaign against many budget subsidies to private activities.

"The government, through the tax code, should not be deciding whether people grow trees," a senior Treasury economist said of the timber proposals. "People should make that decision on its merits. If we don't lure them into trees, maybe they'll put their money into something else, something that doesn't rely on a tax break for its attractiveness."

Industry spokesmen call the proposal "catastrophic." They say it would force them to grow fewer trees, build fewer factories and supply the nation with less home-grown wood. Stunned that a probusiness administration would seek such a thing, an industry newsletter asked: "Who won the election anyway?" Rewards for Time and Risk

In the world of the tax code, income from trees is called "capital gain," taxed at a much lower rate than regular income. Corporations pay 28 percent taxes on it, compared to the regular 46 percent; the top individual rate is 20 percent, compared to the regular 50 percent. The justification is that trees, unlike most products, require as long as 60 years and much risk to mature, and without a tax break, people might not plant them. At least, that was the theory in the 1920s, when the timber break started life in a corner of the tax code.

It since has spread even to loggers of trees in the national forests, which the federal government plants, and to growers of Christmas trees, which mature in as few as six years.

No less a president than Franklin D. Roosevelt tried to contain it. He vetoed a major expansion of the timber break in 1943 as "relief not for the needy, but for the greedy," only to be overridden by Congress in 1944. Presidents John F. Kennedy and Jimmy Carter also tried and failed, foiled by a little-known fact of Congress: For much of the last generation, the House and Senate tax committees have been headed by timber-state legislators.

The story of how the timber break came to be, and to spread, is in many ways the story of how the Internal Revenue Code became so complicated.

Initially, it applied only to those who held trees as an investment, selling them maybe once in a lifetime in a lump sum. It excluded those who used timber in businesses -- lumber or paper manufacturers.

Then came World War II and a soaring wartime demand for wood that drove prices skyward. Tax rates had risen as high as 90 percent to help finance the war, and timber-state congressmen warned that companies could not afford to cut trees with taxes so high -- a potential threat to the war effort because wood was a strategic resource. They also said companies would liquidate their timber assets, in a "cut-and-run" binge.

"They said we wouldn't have any trees left," recalled former House member Wilbur D. Mills (D-Ark.), who voted for the break as a young congressman. "I don't know how industries survive sometimes. They seem to have no brainpower. They won't do anything smart unless we give them a tax break."

Congress came through, declaring that timber companies could have the break, too, in the name of "equity" -- holders of the same asset should be taxed equally. Passing the equity around, Congress even awarded the break to firms that contract to cut timber owned by others, such as the U.S. Forest Service.

That is, the government pays twice: once, in the budget for growing trees in the national forests; later, in tax breaks to companies that cut them.


"There were political reasons," explained William K. Condrell, an attorney for the timber industry. "If you didn't give the benefit to them contract loggers , you'd be hurting the weakest segment of the industry. You'd drive them out of business because they depend on federal timber. You'd create an anticompetitive tax policy. We've said: Let's recognize that it was justified purely on equitable grounds and stop worrying about the economic grounds." Christmas Generosity

But there were other frontiers to conquer: Christmas trees, for example. When Congress overrode Roosevelt's 1943 veto, it excluded Christmas trees from the break, because, in the words of Senate Majority Leader Alben Barkley (D-Ky.), a leading timber statesman:

"To compare those little pine bushes with a sturdy oak, gum, poplar or spruce, which requires a generation of care and nurturing to produce and from which no annual income is derived until finally it is sold, is like comparing a cricket to a stallion."

But by 1954, an American Christmas tree industry was organized and had come to Congress under the time-tested banner of equity, arguing that although it may take less time to grow than spruce, fir and such, a Christmas tree requires significant risk and investment, too. And, said Don McNeil of the National Christmas Tree Association, "This is, after all, an American product, providing jobs for Americans, an inherent part of an American tradition, namely the celebration of Christmas."

Congress came around, and in the Revenue Act of 1954, extended the break to those "little pine bushes" as long as they require at least six years from planting to marketing.

Perhaps inevitably, the industry now has produced a fast-growing Christmas tree in New Mexico, Arizona and California, and a move is building on behalf of the newest "disadvantaged species" to advance the frontier of capital gains yet again.

Today the entire timber industry, from small-scale tree farmers in the Southeast to multinational corporations, is tailored to take advantage of the tax code. In capital gains breaks alone, Treasury officials say that this will cost the government $355 million in fiscal 1985.

At the same time, the nation's forest base has expanded dramatically. The increase since 1944 alone, according to government data, represents enough lumber to build houses for every person in the states of New York and California. Tampering with the code, industry lobbyists say, could threaten this valued resource.

But it is unclear how many of these trees owe their lives to the tax code, and whether the difference was worth the multibillion-dollar cost for 40 years. Forest Service economists said that much of the expanded acreage likely would have been planted anyway, because profits soared during World War II, and rose steadily until the early 1980s.

"Weyerhaeuser would have been in the timber business anyway, because of our enormous land ownership," said Neil Wissing, vice president and director of taxes for one of the nation's largest timber companies. " . . . We would have been a smaller company. We would have had less money to reinvest in forestry and in [philanthropy]. It's not a question of making a profit or not. But it obviously has improved the profit."

In addition, millions of dollars of tax breaks went to companies that never planted a tree. In the inflationary 1970s, major beneficiaries included firms that bought contracts to cut Forest Service timber, and held them until values rose, sometimes as much as 500 percent.

When those trees were cut, the companies paid capital gains rates on the profit -- saving about $200 in taxes on every $1,000 in profits. But none of that money went to replant the felled trees. The Forest Service paid for the reforestation with other tax dollars.

When the value of those contracts collapsed suddenly in the recession of theu early 1980s, Congress came to the rescue, allowing holders to bail out at reduced prices -- a direct subsidy approved by President Reagan that could cost the Treasury as much as $400 million, according to congressional calculations.

Is there a way out of this thicket? Or should there be?

The Treasury Department, in a sweeping "tax simplification" plan, proposes to eliminate most special breaks, including the lower rate for capital gains, and to use the savings to reduce corporate and individual tax rates across the board.

Treasury argues that if the government has social goals, like preserving the nation's forest base, it should advance them through the budget, in subsidy programs, rather than the tax code, whose purpose is to collect revenue.

But there is more to this forest than just the trees.

Large timber companies view tax breaks not just as a spur to reforest, but as money in the bank. No budget subsidy could come close to matching the sums that they reap in capital gains breaks.

Imagine, for example, a $57 million grant to Weyerhaeuser, $47 million to International Paper, $35 million to Georgia-Pacific -- the tax savings of those companies on capital gains alone in 1983, according to their annual reports.

Treasury economists acknowledge that the loss of these breaks will force companies out of business. They also predict that a "neutral" tax code will allow industries less dependent on tax favors to prosper.

But in the meantime, what becomes of millions of people and hundreds of towns that depend on timber, paper mills, sawmills, pulp mills and more? The economists' answer is that change should come gradually.

Robert Schuyler, Weyerhaeuser's senior vice president for financial planning, says otherwise.

"We're in international competition more than ever," Schuyler said, describing the capital gains break as a subsidy that enables American companies to compete with foreign firms, which also are subsidized. To "neutralize" the tax code in such a complex world market, he said, "is a nonsensical statement. Who knows if it's better for the economy? From whose point of view?"

"The Treasury plan is equivalent to saying: 'Follow the Yellow Brick Road.' But the bridge is out, that's the problem," said Wissing. "The agony you go through to get there is unbearable."

"We are losing forest lands already at the rate of 1 million acres a year," because of suburban sprawl, said Schuyler. "In the long run, there would be less and less timber available here or for export. Over a long period of time, prices would go up dramatically. Eventually we could reach a point where people would perceive we have a shortage of trees. But at that point it would take years to plant and grow what we need. You can't unring the bell." Caught in Economic Currents

The truth is that no one -- not the Treasury, not the industry -- knows what timber would look like in a tax-neutral world. Larger economic currents such as high interest rates and the power of the dollar already have done to timber what industry lobbyists warn would occur in an economy without tax breaks.

Demand for U.S. wood is depressed from the housing slump at home and the high value of the dollar abroad. An estimated 9 million acres of timberland is for sale in the United States, including holdings of International Paper, Crown-Zellerbach, ITT-Rayonier, Scott Paper and other longtime timber owners.

Timber company executives blame much of the problem on the large federal deficit, which some say has driven up the value of the dollar through high interest rates. Yet the industry's Washington lobbyists insist that eliminating the tax breaks, even to reduce the deficit, would hurt the industry more.

Out on the Olympic Peninsula, these currents have hit timber towns like a whack from a two-by-four. Unemployment here runs as high as 25 percent, and it is hard for most people to see how a change in tax policy could be as devastating as what has gone before. After all, taxes are paid on profits, and if the faltering companies of the peninsula could turn a profit, their officers say, taxes wouldn't seem like such bad medicine.

"It would hurt the big companies a lot more than it would hurt us, because they're the ones that made a bonanza on capital gains in the first place," Jim Middleton, president of Anderson & Middleton Lumber Co., an independent timber firm, said of the Treasury proposal. "The lobbying efforts of these large companies is awesome, as it should be. They've contributed a lot to the economy -- big payrolls to name one thing. They've earned their clout. They also employ people whose whole job it is to make these arguments."

He looked toward the forests of the peninsula, his back to the deserted harbor behind his office, and said what people have been saying in this region through good times and bad: "We've got the trees. Somebody's going to want them."