1985 Goals: Tax Reform and Expansion Jude Wanniski December 3, 1984

Executive Summary: Tax simplification would be a "crowning achievement" of the Reagan tenure, and the flexibility of the Treasury proposal has put it in the President's path. RR seeks a bipartisan plan, joining Bradley-Gephardt, Kemp-Kasten, to Secretary Regan's, in time for a State of the Union push. But Volcker has to be pushed harder or a 1985 recession will sour all reform plans. The Fed keeps a vise-like grip on bank reserves and waits to see if the weakening economy will correct itself at Christmas. Pres Martin waits a minute too and the President is bemused by a soaring M-1. The White House plans a "confrontation" strategy on the budget, "consultation" on taxes. Business squawks at the Treasury plan helps Kemp-Kasten, which helps "the little guy," and capital formation as well. The key: an inexpensive "earned-income credit" that deserves another look. Kemp's main priority is the 25 percent top marginal rate. It all seems suddenly, surprisingly doable.

1985 Goals: Tax Reform and Expansion

A year or two from now, when people look back on what the Reagan Administration accomplished on economic policy in 1985, it's not likely they'll recall the size and place of budget cuts. But two things will stand out: Did the President get his ambitious tax simplification bill through Congress? And did the economy continue to expand, avoiding a recession?

This was the observation passed on to individual members of the White House high command by Lewis Lehrman in the weeks following the November elections. Lehrman, director of the Reagan-inspired Citizens for America, urged the White House senior staff to focus their energies on achieving these goals. In terms of tax reform, this would mean committing White House resources and the President's personal energies to that end; the issue would have to be kept separate and apart from "budget reform" David Stockman's most recent campaign to cut spending and raise taxes. To keep the economy growing in 1985, Lehrman insisted, the Administration had to bring about a growth-oriented monetary policy at the Federal Reserve.

As it develops, tax reform and budget reform are competing for the limelight at center stage. The Treasury tax proposal, unveiled by Secretary Regan November 27, has been getting its lumps from the predictable critics. But there is so much flexibility in the Administration's selling approach that there is new a surprisingly good chance that a bipartisan tax bill will emerge. This could happen in time for a major Reagan push for the idea in his January State of the Union address.

The White House is in fact following a "two-track strategy" on taxes and spending. The early moves of the President's strategists have been so adroit in inviting compromise that it has become clear they are serious about achieving a comprehensive tax reform. As suspicions are removed that the White House would simply be going through the motions, chances of success improve. If in the next month the President can produce a bipartisan bill, which is what he is seeking, what seemed like a ridiculous long shot only several weeks ago will begin to look like a winner.

But what about the economy? If it goes sour in 1985, the President's political capital will crumble and tax reform goes out the window. Yet that's exactly what seems to be coming. It's finally becoming clear even to some of the Wall Street economists that Santa Claus is not going to pull the fourth quarter GNP up. Where Polyconomics was alone on October 1 in foreseeing no growth at all in the fourth quarter, as the result of the Fed's continuing squeeze, it's now possible we were optimistic. When all accounts are in, we may have to mark up the quarter in the red.

Meanwhile, the Fed maintains its vise-like grip on bank reserves. The Fed's governors may be the last kids on the block to see what they've done to the economy. The leading indicators are all screaming recession, yet Paul Volcker, Anthony Solomon and Henry Wallich are all chirping about the underlying strength of the economy, assuring audiences that a bounceback is just around the corner. Volcker told a New York group November 30 that "A sharp slowing in growth for a time during an expansion period is in fact historically common, typically related to temporary imbalances in inventories following a period of rapid accumulation and temporary fluctuations in consumption. Something of that sort seems to be at work this fall." This widespread line of reasoning suggests that inventories will run off this quarter as consumption picks up; in January, new orders will bring the snap-back in production. Pure wishful thinking.

Volcker did finally come through with a Thanksgiving-eve half-point cut in the discount rate, to 81/2 percent. But the move did absolutely nothing to relieve the deflation, the year-long decline in commodity prices that is at the heart of the economy's slowdown. It didn't move the dollar down on foreign-exchange markets and it didn't move the price of gold up. Only a generous addition of bank reserves will do that.

Even as a stingy, long-overdue signal of possible monetary ease, the discount-rate cut may have cost more than it was worth. Volcker seems to have used it to buy time. It was a small bone to the growing number of Fed critics, and it even froze his leading critic inside the Fed, Vice Chairman Preston Martin.

Randall Forsyth of Barron's has it exactly right November 26 when he noted that Martin seemed pacified by the cut in the discount rate. Martin had told a television interviewer November 23: "Let's see what the economy does, partly as a result of our discount-rate cut and partly as a result of our moving along with the market to bring rates down. Now, we ought to wait a minute to see how these positive moves work out."

Forsyth's comment was perceptive: "That's from the Reserve Board member who has been most vociferous in arguing for the need to ease policy to prevent the current expansion from petering out. Given his colleagues' reluctance to loosen credit, even as the economy was clearly slowing since midyear, that may mean the Fed's current round of easing may be nearing an end."

With these kind of wait-and-see signals coming from the Fed, commodities sagged further. The gold price lost $13 in two days, probably as expectations of a Fed easing dropped a few notches. Oil and spot commodity prices sagged too. Volcker surely knows he's courting a recession, but he seems to want to look it right in the eye before he relaxes his grip. With Preston Martin, he will now "wait a minute" and see if things will improve.

The upshot of all this waiting around is that we can expect a weak first quarter in 1985. We also have to start worrying about all of 1985, if Volcker & Co. insists on keeping the squeeze on as they hope for signs of a spontaneous rebound in the first quarter. The political consequences of an '85 recession would be most unpleasant. "If the economy collapses," Morton Kondracke wrote in The Washington Times Nov. 26, "Jack Kemp will be in deep political trouble. Whether supply-side economics is really to blame or not, he and it will take the rap along with President Reagan." The budget deficit, rising even now as a result of the Fed-engineered slowdown, would climb further. The President would be drained of political capital and it would be unlikely that reforms of any kind could be pursued in that kind of environment.

The White House senior staff is well aware of this scenario and is far more eager to see an easier Fed policy than they are telling the press. But they're also frustrated by Volcker's tactics of pretending to ease without easing (pointing to declining interest rates as a sign of easing when this is only evidence he's stopped tightening) and his discount-rate wait-a-minute moves.

Another frustrating problem is that both the President and Donald Regan remain mesmerized by the "money-supply" numbers. When "M-1" flirts with the lower end of its current target range, Reagan and Regan become more alert to arguments that Volcker's being stingy. But then comes a day like November 29, when the Fed reports M-1 up by $6.7 billion, jumping to the middle of the range again, and the President is as happy as a clam. Meanwhile the bond market skids and gold and commodities slide further on this M-1 news, knowing full well it takes further pressure off the Fed to ease. Somebody should tell the President the M-1 number is meaningless and irrelevant and the President, in turn, can tell his Treasury Secretary.

There are people at the White House, though, who know what's going on at the Fed and who believe a loosening should be at the top of the Administration's agenda. There are even advocates of open-warfare with Volcker, restrained by wishful thinkers who are sure of a loosening any minute.

Our remaining confidence for 1985 is hinged on the supposition that any minute will come sooner rather than later. All the economy needs is an injection of bank reserves sufficient to take it out of the deflation danger-zone. A gold price up $50 or $60 from the current $330 would bring considerable relief to the system, without alarming any of the markets about a reignition of inflationary pressures. The year-long interruption of the bull market in stocks would of course be ended in the process and we'd feel the economy expanding again. In late 1982, we forecast a 6.5 percent growth in GNP for 1983 and as it turned out hit the number precisely. A year ago we again forecast a 6.5 percent year for 1984, and if the fourth quarter comes in as expected with no growth, we'll have hit the number exactly the second year in a row. What the Fed does in the remaining weeks of 1984 will condition our forecast for 1985. The kind of modest easing we suggest would enable us to see a 5.5 percent year, even with a slow-growth or no-growth first quarter. This is precisely the kind of backdrop needed if the President is going to succeed with his tax and budget reforms.

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A senior Reagan aide (probably Richard Darman) told The Washington Post on November 29 that the White House will follow entirely different strategies in seeking tax reform and spending cuts. There will be a "confrontation" strategy on spending cuts and a "consultation" strategy on tax reform. This is because there are several tax-reform proposals already developed in Congress, he said, which means there are people with whom to negotiate or "consult." But there is nobody with whom to negotiate on spending.

As in 1981, the Administration will try to get a single vote on a package of spending cuts amounting to $45 billion in fiscal 1986. Although the cuts would be painful, there may be majorities in both Senate and House to approve them. But not if the economy is in recession. And it will be up to David Stockman to sell his bundle of cuts without any room to bargain with Democrats over tax increases. White House strategy at the moment favors going after the budget cuts first, which, if successful, relieves pressure on tax policy from those who would use the reform package to enhance revenues.

The thing that worried us most about the Treasury version of a modified flat tax was that it would be handed down by Donald Regan on stone tablets, holy writ. Instead, Regan announced that it had been written on a word processor, implying that every word of it was subject to change. President Reagan went even further, telling The Washington Times in an interview November 29 that he hoped Treasury would be able to work out a compromise version with the Democratic bill, Bradley-Gephardt, and the Republican bill in Congress, Kemp-Kasten.

As a result, anything is now possible. The fact that the business community went berserk over the Treasury proposal — because of its phasing out of accelerated depreciation and 75 percent hike in the capital-gains tax — seemed helpful in generating interest and enthusiasm for the bill outside the business community. Liberal Democrats, used to seeing Old Guard Republicans play the zero-sum game of heaping taxes on labor to relieve capital were astonished to observe Treasury go in the opposite direction, seeming to favor "the little guy."

Thus, when New York Gov. Mario Cuomo blasted the proposal because it would repeal deductibility of state and local taxes, Rep. Charles Rangel of Manhattan dismissed Cuomo's concerns as unimportant and said the Treasury plan was "the greatest thing to come along/' because of its benefits to lower income classes. Rangel, a black, is a member of the House Ways and Means Committee. What Rangel likes is the Administration's doubling of the personal exemption to $2,000 for all taxpayers and their dependents, and a generous increase in the zero-bracket amounts, thereby eliminating taxation of families with incomes below the poverty level. Kemp-Kasten has a similar feature; Bradley-Gephardt does not double the personal exemption for children.

This doesn't mean it would be wonderful if the Treasury proposal were adopted, as is, which it will not be. It does suggest the kind of powerful and disparate support that can be generated for tax simplification and reform once people see there is a real chance of getting it. It's not so much the lobbyists who killed all the tax-reform proposals floated in the last two decades as it is the people who insisted it couldn't be done because the lobbyists will kill it. People won't waste their time trying to achieve something they've been told can't be done.

Charlie Rangel doesn't really want businessmen to lose their accelerated depreciation and investors to pay higher capital-gains taxes. He just wants the tax relief to his constituents that other provisions of Treasury's bill holds out. If a way can be found to retain the business writeoffs as well, in the bipartisan compromise that emerges from Treasury's consultations, President Reagan would be able to roll the legislation through Congress with much less difficulty than is being imagined.

Such a plan should not be difficult to devise. The Kemp-Kasten plan indeed retains the Accelerated Cost Recovery System (ACRS) even as it parallels the Treasury plan on relief to the lower income classes. For this reason, the business community is already nudging Treasury in the direction of Kemp-Kasten. One of Kemp's aides observed that the Treasury plan had generated more support for their plan in the business community than they had managed themselves.

In looking at the three plans side by side, it's obvious that Kemp-Kasten is superior. It looks so much more generous to everyone than the other two bills that it must be a "revenue loser". Yet it isn't. The key is its pivotal feature, the earned-income credit. Where Treasury and Bradley retain three progressive tax brackets in order to keep tax liabilities from rising in the lower income classes, Kemp-Kasten employs the earned-income credit for the same purpose. Its secret is that it's much cheaper than tax progressivity, because it's entirely focused on the problem income classes — between $15,000 and $40,000. Kemp-Kasten also has the lowest marginal rate, at 25 percent, which is the only rate. Progressivity is a more expensive solution because the higher income classes also get the benefit of the lower-bracket rates for part of their income. Kemp-Kasten "saves" these amounts and uses them to retain the lower rates on capital.

The 25 percent rate, which is Kemp's key objective in the consultations, also takes care of the capital-gains problem and the problem raised by Mario Cuomo. Because the capital-gains rate is now 20 percent, it rises by 75 percent if Treasury's top rate of 35 percent on personal income applies. It only rises by 25 percent if the top rate is 25 percent, and Kemp-Kasten offsets the loss by indexing the value of capital gains and providing full writeoff for capital losses. Indeed, the indexing feature in the long run is probably more beneficial to capital than the 5 percent lower rate. State and local income taxes have much less value as deductions at 25 percent than at 35 percent.

The bureaucrats who designed the Treasury plan will take a look at the Kemp earned-income-credit alternative, which should lead them to the discovery that it's more efficient than their own and would reduce the flak from the special-interest lobbyists. Even if this alternative doesn't make it into the final plan, there's an argument to be made along these lines for a two-bracket approach, at 15 and 25 percent. Elimination of Treasury's 35 percent bracket costs only $15 billion in revenue and could easily be made up elsewhere, Kemp's people believe.

It's pointless now to get into a more detailed discussion of "the compromise" and how it might look when it emerges. (What happens to the Three-Martini lunch? Charitable deductions? Interest deductions on second homes?) The most important thing now is that the Administration and congressional Republicans and Democrats are exploring the possibility of a majority coalition behind the populist idea of lower marginal rates.

There's always been plenty of opposition to lower marginal rates, not from the egalitarian liberals, but from the elite special interests who believe they're better off with high rates and loopholes that benefit themselves. (Church and college fund-raising lobbies are afraid giving will dry up, for example, if the tax incentive to give is diluted.) It's hard for such groups to see the dynamics of a reform that increases the efficiency of the economy, its productivity and wealth. There would be less giving for tax reasons, but there would be much more to give.

There's also plenty of concern about how Senator Dole, the new GOP Majority Leader, will behave through all this. And it's clear that Senator Packwood, the new chairman of Senate Finance, has expressed great coolness to the whole idea of tax simplification. But if the President gets a bipartisan ill from Don Regan, Bill Bradley and Jack Kemp, he would be in a position to go over the heads of remaining opposition in Washington and appeal to the grass roots. The key, everyone acknowledges, a bill the President can fight for with enthusiasm. If he gets it, Mssrs. Dole and Packwood would tend to see it as an idea whose time has come.

"It would stand as a major achievement in the history of American taxation" writes Walter Heller in The Wall Street Journal. "It could be the crowning achievement of this Administration," says Leonard Silk in The New York Times. And the Financial Times of London editorialized that "Congress will never get a better plan, or the President a better chance to stake his place in economic history."

Tax simplification may not look red hot at the moment, the opponents dominating the scene. But there will be counteroffensives heating it up again. Don't bet against it.