TAX REFORM ACT HAS SOME FLAWS

The president and Congress missed three big opportunities for reform in the Tax Reform Act of 1986.

First, they wasted an ideal chance to enact automatic adjustments to prevent inflation from distorting the measurement of capital income. Congress retained indexation of exemptions, the standard deduction, and tax brackets, first enacted in 1981, but did not adopt the Treasury Department proposal to index depreciation, interest payments and income, capital gains, and inventory costs.The absence of an automatic adjustment mechanism during the inflation of the late 1970s and early 1980s led Congress in 1978 to increase the proportion of long-term capital gains excluded from tax and in 1981 to enact a number of ad hoc provisions - notably depreciation deductions more favorable to some assets than to others - that contributed to the wide variations in effective tax rates among different types of assets.

The Treasury Department's 1984 proposals would have removed the need for such adjustments during any future inflationary episode.

Unfortunately, the president rejected some of Treasury's recommendations, and Congress abandoned the rest. The fact that none was enacted demonstrates that indexation of the income tax base has little political sex appeal when inflation is low.

However, if inflation reemerges, Congress will be pressured once again to enact ad hoc adjustments, which will leave a residue of distortion. The lesson that inflation can undermine a tax system has not yet been learned.

The president and Congress also failed to make any progress in two other areas that would have advanced equitable and efficient income taxation: the taxation of fringe benefits and the integration of the personal and corporate income taxes.

The Tax Reform Act of 1986 does little to bring into the tax base fringe benefits that provide current consumption services to employees. Such fringes include employer-financed health insurance, up to $50,00 a year of term life insurance, group legal insurance, and assorted other items.

President Reagan in 1982 proposed limits on the exclusion from personal income tax of employer-purchased health insurance. He would have retained exclusion only up to a level sufficient to finance a fundamental health insurance plan; the cost of additional insurance was to be taxed as current income to employees.

The Treasury incorporated this recommendation, along with other limits on the exclusion of fringe benefits, in its 1984 proposal. Faced with the unbending opposition of Senator Bob Packwood, chairman of the Senate Finance Committee, the president backed down and replaced the Treasury initiative with a watered-down proposal that had no appeal.

The Committee on Ways and Means of the House of Representatives killed the president's proposal and rejected all alternative devices for including consumption-type fringe benefits in taxable income.

While little was done to limit exclusion of fringe benefits, Congress included a variety of amendments to tighten existing rules designed to prevent such fringes from primarily serving high-income employees. These ''nondiscrimination" rules typically require that no more than a stipulated fraction of a particular type of benefit can accrue to high-wage workers.

This outcome means that the tax system continues to favor certain kinds of consumption over others. Most notably, the tax system continues to encourage employees to seek and employers to provide health insurance plans that promote medical cost inflation by providing elaborate benefits that require patients to bear only a small portion of the costs.

It means that additional cuts in tax rates that would have been possible if fringe benefits had been included in the tax base had to be foregone. But it also means that such fringe benefits will be available more equally than in the past to low- and middle-wage workers.

The final missed opportunity was the failure to reduce the double taxation of dividend income. Under current law, dividend recipients are taxed twice - once indirectly by the corporate income tax, and once directly by the personal income tax. Most developed nations have instituted some relief for this double taxation.

The Treasury Department in 1984 proposed to permit corporations to deduct 50 percent of dividends paid. The White House scaled this decision back to 10 percent phased in over 10 years. The House dropped the deduction altogether, and the Senate did not revive it.

The dividend deduction would have encouraged corporate managers to pay out a larger proportion of earnings in dividends. This incentive may explain its demise. If dividend payments increased, corporate managers would retain a smaller pool of earnings for new investment projects. They would have to rely to a greater extent than they now do on new issues of debt and equity to raise

funds.

Open market competition for investment funds might increase the efficiency with which those funds are allocated, but it would assuredly complicate the fund-raising tasks of corporate managers.

The current tax policy of discouraging dividend payment lessens this particular managerial headache. The lack of enthusiasm among corporate managers for a dividend deduction, which made it easy for the White House and Congress to jettison the proposal, probably owes something to this fact of corporate financial life.

Although these missed opportunities should not be ignored - if possible they should be corrected in future legislation - they should not obscure the major achievements in the Tax Reform Act of 1986.

By removing millions of poor families from the tax rolls and reducing the burdens of millions of other low-income families, by slashing marginal tax rates and thereby reducing the importance of taxes in economic decisions, by ending the distinction between long-term and short-term capital gains, and reducing the incentives to engage in complex tax-avoidance maneuvers, by curbing tax shelters, and by equalizing effective tax rates on various kinds of investment, the tax bill represents a significant improvement in the structure of personal and corporate income taxes.

That a good bill contains flaws, some of them important, may make us yearn for what might have been, but it should not prevent us from celebrating a splendid political and economic achievement.

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