If the administration's tax proposal ever gets enacted, it would seriously undermine the equipment investments that raise productivity and economic growth. Even the administration now admits that its plan would increase the cost of funds for investment in business equipment by more than 40 percent. In contrast, it would reduce the cost of funds for investing in commercial and rental structures. The result would be more hotels and shopping centers and other rental property.
The administration describes this key element in its plan to change the corporate tax structure as creating a "level playing field" for all capital investments. This conjures up an image of fair play and so appears to fit in nicely with the overall theme of increased fairness in the tax system. Although the underlying principle is the good one that all capital investments should be treated equally in the tax system, the facts just don't fit the administration's theory.
The administration argues that the level playing field would promote growth by leading to better use of the available capital stock. It claims that, 10 years after an accident, the improved capital allocation could raise real GNP by up to 1.1 percent. We wonder how many members of Congress are prepared for a radical overhaul of business taxes in order to raise GNP in 1996 by what its supporters claim could be an extra 1.1 percent especially when the natural procal GNP by 30 to 40 percent between now and 1996 if the tax law is left unchanged.
But even the very small improvement claimed by the administration is far too optimistic. The president's package of tax changes would actually make investment flow into les productive uses than it does under current law.
The administration actually got the whole argument upside down. That is because they started from the incorrect presumption that the current tax law, through investment tax credits and depreciation rules, is far more favorable to investment in business equipment than to investments in real estate -- hotels, office buildings and shopping centers. Its tax proposal was therefore designed to raise the relative tax rate on equipment very substantially. Thus the claim to a more level playing field.
In fact, though, this would move tax rates in just the wrong direction. Today it is the debt-financed investments shopping centers, hotels and office buildings that enjoy the most favorable tax treatment because of the tax deductibility of interest payments. The Treasury failed to recognize this in its analysis because it incorrectly ignored the use of borrowed funds and assumed that all investments are financed by equity.
The playing field is already tilted in favor of debt-financed investments in rental property, and the administration's proposal would only tilt it further in the same direction. The higher proposed tax rate on investments in business equipment would mean that American manufacturing businesses would suffer reduced competitiveness in world markets.
But the tax shelter investments in real estate would continue to provide an escape hatch for high income individuals seeking to pay little or no tax.
If that weren't bad enough, the administration proposal would also reduce savings and shrink the size of the capital stock in the United States. By raising the tax rates on investments in plant and equipment in the United States, the proposed tax rules would induce American businesses to invest more abroad and would discourage foreign investors from sending capital here. Other elements of the administration plan -- eliminating the tax benefits of company saving plans and taxing the return to saving in life insurance -- would directly reduce the incentive to save. The $25 billion rise in corporate tax receipts would reduce the return to savers and therefore further discourage saving. Less saving and a smaller capital stock inevitably means lower productivity and a lower standard of living. Congress should abandon its current counterproductive and complex efforts at radical tax overhaul and focus instead on a simple two-part plan that would not sacrifice any of the current incentives to save and invest.
First, although the public has been quite indifferent to the tax proposals that are now floating about, there is strong public sentiment to change the tax rules so that individuals and corporations with high incomes are forced to pay at least some significant amount of tax each year. Further, the public will support changes in the standard deduction and tax rates so that the poor will no longer have to pay any tax at all. If Congress focuses specifically on these popular revisions, we could still have a worthwhile tax reform bill.