In its determination to use tax breaks as a tonic to revive a slumping American economy, the Bush administration has cast aside one of the main tenets of the landmark 1986 Tax Reform Act.
That act was designed to discard much of the tangle of special taxbreaks and loopholes accumulated over many years so that future investments would be based on economics, not political preferences.
Notwithstanding its oft-stated opposition to "industrial planning," the administration side in the current budget negotiations is proposing to again make the tax code an instrument of industrial policy and is trying to steer people's economic decisions in certain directions.
Tax breaks involving oil drilling, venture capital investments in growing companies and corporate research and development spending are among the ideas proposed by the White House to satisfy President Bush's insistence on new "growth" measures.
"There is no reward for consistency," said Frederick Khedouri, a senior managing director of Bear Stearns & Co. and a budget official in the Reagan administration. "This whole capital formation exercise is the undoing of one of the premises of the '86 act. Now we're saying we want to create preferences."
"One of the main themes of 1986 was to let the market allocate capital," conceded one Bush adviser. He said many of the administration proposals in the current budget talks would "start steering capital in the marketplace. In that sense, it is inconsistent." Another adviser said that the fight for a capital gains tax cut "explicitly overturns" the theory behind the 1986 tax reform.
"One of the major achievements of the 1986 act was to treat income from labor and capital the same," said Sen. Bill Bradley (D-N.J.), an early backer of tax reform. "Putting the capital gains break back in would be a big mistake and would lead to increased inefficiency in the economy."
Bradley said "the idea was to allow businesses in question to decide how to use their money as opposed to having Congress tell them what to do with profits and say that if you invest in a certain type of machine for a certain length of time you get a tax break."
Even if the administration fails to cut the capital gains tax rate, as now appears likely, it has opened debate on a wide array of new proposals designed to direct people's economic choices. "These have a tendency to embolden others to come ask for tax preferences," said James Wetzler, commissioner of taxation and finance for the state of New York.
The National Venture Capital Association is pushing a capital gains tax cut for "young growth companies," and some sources suggest the budget negotiators are looking at such a proposal. A bill backed by Sen. Dale Bumpers (D-Ark.) would benefit individuals and companies that invest in the stock of "small" businesses with $100 million or less in capital. Its backers say it would only cost the Treasury $218 million over five years. But one administration adviser, while enthusiastic in principle, said it was impossible to define a venture capital or growth company. "We tried desperately," he said.
In the wake of the Persian Gulf crisis, Bush has renewed his appeal for tax incentives to spur domestic oil drilling. The incentives would treat income from oil drilling more favorably than other income. "I'd rather see us make consumers bear the full cost of energy use, rather than bribing producers to drain America first," said Lawrence Summers, an economics professor at Harvard University.
The final budget package is likely to renew tax credits for research and development by corporations. Though left intact under the 1986 act, the deductions need to be renewed and have widespread support in Congress and the administration.
Though not high on the agenda in the talks, Treasury Secretary Nicholas F. Brady has often talked about giving capital gains tax incentives to individuals who hold onto investments for at least a couple of years as a way of reducing instability and churning in stock markets.
Meanwhile, the administration is declaring that the "indexation" of capital gains is its new bottom line. This approach, which would protect investors from paying taxes on gains due solely to inflation, is supposed to be a growth measure too, and administration advisers say the president is convinced it will keep the economy out of recession, even though many economists argue that it will reward old investments, not new ones.
Indexation wouldn't treat different income differently, but the complexity of calculating the inflation-adjusted purchase price of investments would contradict the idea of simplifying the tax code. It also would create incentives for changing income from earned to capital gains. For example, it would encourage executives to take stock options instead of big salaries.
For both sides, tax preferences have become particularly appealing again because of the intense pressure to cut spending. Tax preferences are "an indirect way of increasing spending while pretending you're decreasing taxes," said Wetzler.
But Wetzler said that "attempts to use the tax code often work less well than direct spending." The capital gains tax cut proposal, for example, while allegedly favored to bolster economic growth, would also benefit gains from real estate sales or for investments that have been held for years and that have nothing to do with future growth, Wetzler said. "It is a relatively inefficient way of promoting growth, apart from equity concerns," he said.