In terms of sheer volume of money, Ronald Reagan’s most important accomplishment so far is also his least well known. It is the passage of a new business accounting procedure called the Accelerated Cost Recovery System, which is the heart of the largest corporate tax cut in U.S. history. ACRS, a provision of last summer’s tax bill, will cost at least $143 billion in lost tax revenue by 1986, dwarfing Reagan’s budget cuts, of $35 billion. Personal income-tax reductions and defense-spending increases scheduled by the administration may eventually involve more money than ACRS, but these programs have yet to take full effect and aren’t certain to proceed as planned. ACRS is already in place.
When Reagan took office, he introduced a “clean” tax bill, with just two provisions—personal income-tax cuts and ACRS. Once it fell into the congressional whirlpool, however, the bill grew and grew until nearly every category of federal taxation was revised. (The finished bill had 121 sections; the bipartisan Joint Committee on Taxation’s “general explanation” of it runs 411 pages.) As often happens in Washington, the central element of the bill—ACRS—was nearly forgotten when attention shifted to the legislative struggle over its accessories, such as lowered windfall-profits taxes on oil. Since the bill’s passage, attention has shifted again, this time to its “tax leasing” section, which enables corporations to trade their tax benefits as if they were sacks of flour. The large sums involved in tax leasing are made possible by ACRS, which creates the surplus tax benefits being exchanged, according to Bernard Shapiro, director of tax policy for the accounting firm Price Waterhouse and former chief of staff of the Joint Committee on Taxation. “The real issue is ACRS; leasing just makes ACRS visible,” Mr. Shapiro says.
ACRS was not Reagan’s idea. The U.S. Chamber of Commerce, the Business Roundtable, the National Association of Manufacturers, and other business groups had been lobbying for it for years. But Reagan’s election gave ACRS the opening it needed to succeed on Capitol Hill. First, since it was designed to reward business investment in new equipment, it fit perfectly within the doctrines of supply-side economics. Supply-siders hold that business investment to create productive capacity, not buyer demand for goods and services, is what drives the economy. Second, given the times, no politician dared appear to be “against business.” ACRS would transfer a great deal of money to the business community, and whether or not the transaction would be good for the economy, it allowed congressmen who voted for it to describe themselves as “pro-business.”
ACRS—sometimes called “10-5-3”—did away with the old business depreciation tables, which based tax benefits on how long a piece of equipment actually lasts, and “accelerated” deductions into the present. Before ACRS, there were 130 depreciation cycles, some of which lasted as long as sixty years. If, for example, bulldozers normally had useful lives of ten years, they had to be depreciated over ten years. ACRS eliminated the notion that depreciation should correspond to actual use. It shrank the Internal Revenue Service codes to four cycles: a three-year period for light trucks, electronics, and other short-lived assets; a five-year period for heavy trucks, machinery, and factory equipment; a fifteen-year period for most buildings; and a ten-year period for just about everything else. Bulldozers, for instance, are now depreciated over five years. In five years, a community’s tax books will show a bulldozer bought in 1981 as fully depreciated and worth nothing, even though the machine will probably still be chugging around construction sites producing income.
ACRS also offers a feature that accelerates the acceleration—an accounting regimen called “150 percent declining balance.” Suppose the bulldozer cost $100,000. By itself, ACRS provides (in simplified terms) five yearly write-offs of $20,000 each. The declining-balance feature (again, a simplified description) increases the write-offs by 50 percent for the first two years, to $30,000; the write-off for the third year is $20,000, and for the fourth and fifth years $10,000.
Thus, under ACRS, the tax treatment of a $100,000 bulldozer works roughly like this: The company begins by claiming a $30,000 deduction for depreciation. This means that a $30,000 deduction will exempt (shelter) $30,000 of the company’s profits from tax; since the corporate tax rate is 46 percent, the deduction will save the company nearly $15,000. Next, the company claims a $10,000 investment-tax credit, which is subtracted directly from its tax bill. (The 10 percent investment-tax credit has existed in various forms since 1962.) Combined, the two tax breaks save the company $25,000. After the first year, the bulldozer produces no credits, since the investment-tax credit is a one-time benefit, but depreciation continues. Eventually this tax treatment will be even more generous. The declining balance will increase to 175 percent in 1985 and to 200 percent in 1986.
A few proponents of ACRS portrayed the system as an inflation fighter. “In recent years, the real value of depreciation allowances has been greatly eroded by inflation,” Donald Regan, the secretary of the Treasury, told the Congress in February of 1981. Any financial arrangement that takes years to play itself out can be upset by inflation; just as borrowers can benefit from an inflationary-period loan by paying it back with money worth steadily less, government can benefit from a long depreciation cycle by granting deductions of diminishing value. (If a $100,000 bulldozer had been purchased in 1970 and depreciated over ten years, the initial $10,000 write-off would have been worth a great deal more than the final $10,000 deduction in 1980.) This contention was true as far as it went, but it took into account only a small portion of the picture. Inflation was also driving up corporate revenues oat the same time that it diminished the value of depreciation allowances, and ACRS would be equally generous with or without inflation. The more important issue was whether ACRS would have the fundamental effect on business investment that supply-siders predicted. Murray Weidenbaum, chairman of the Council of Economic Advisers, told Congress that the economy was “drifting increasingly into stagnation, particularly with respect to productivity and net investment,” and that oppressive taxes were to blame. Only ACRS could reverse the slide.
Something was wrong with the economy, surely, but were taxes the villain? On paper, the 46 percent corporate tax rate is oppressive. But the paper rate bears little relation to what companies actually pay. Depreciation, investment credits, deductions for operating losses, and a wide variety of other tax benefits (pharmaceutical companies, for instance, receive exemptions for drugs manufactured in Puerto Rico) combine to cut the “effective” corporate tax rate to well below its official level. As new exemptions have increased relentlessly over recent years, so has the effective tax rate declined. Effective corporate tax rates were about 40 percent during the 1950s, 35 percent in the early 1960s, and 25 percent when Reagan took office, according to Dale Jorgenson, an economist at Harvard. Between tax benefits and lack of profits, even before ACRS, nearly half of the country’s corporations paid no taxes, corporate tax studies by the IRS show. Likewise, corporate contributions to federal government revenues had been falling regularly, on a percentage basis, as exemptions grew. In 1960, business supplied 24 percent of federal revenues. By 1980, the figure had fallen to 12 percent. So, during the 1960s, a period enshrined in economic nostalgia as a great time to be a businessman, corporate taxes were a far greater burden than when Reagan endorsed ACRS; and all through the 1970s, when, according to Reagan and the supply-side theorists, taxes were supposed to be strangling business, their impact was in fact steadily decreasing.
Other statistics suggested that corporate taxes might not be the problem. About a week after Weidenbaum’s dire statement concerning investment, the Commerce Department announced that for the first quarter of 1981, the onset of Reagan’s presidency, the gross national product showed an 8.6 percent “real” increase—the highest increase in three years. Oddly, Reagan said nothing about this good news; Weidenbaum sheepishly called it “a nice start.” Then came more Commerce Department figures, showing that industrial investment was at its highest since World War II. Investment in 1980 had been 11.3 percent of GNP, compared with 10.5 percent of GNP in 1970 and 9.6 percent in 1960. ACRS supporters were not fazed by this news. They admitted that overall investment was increasing, but maintained that a lot of the money was being sunk into pollution control and other federally mandated luxuries that satisfied bureaucrats but did nothing to increase production. Weidenbaum himself was a longtime champion of this argument, and it explained his use of the term “net investment.”
Was capital disappearing into an unproductive never-never land? A good place to check seemed to be the steel industry, since it is particularly hard hit by environmental standards and is often cited as a victim of regulation. Yet Bethlehem Steel’s capital expenses for pollution control were $59 million out of an investment budget of $418 million in 1979; $36 million out of $506 million in 1980; $45 million out of $455 million in 1981. So an average of 10 percent of Bethlehem’s capital resources has been diverted to nonproductive uses. Other steel companies have similar records. Assuming Bethlehem’s experience to be the national rule—a generous assumption, considering that steel has regulatory difficulties few industries face—then the 1980 investment rate of 11.3 percent minus the 10 percent of that sum spent to satisfy regulations leaves a “net” investment rate of 10.2 percent, higher than it was in 1960.
Still, many large companies were floundering, unemployment was rising, and profits were falling. Most congressmen, frustrated by their inability to find a formula that would counteract these problems, felt that ACRS was worth a try. Democrats as well as Republicans fell into line behind the ACRS proposal.
Reagan considered placing one other provision in his original “clean” tax bill—reduction of the maximum tax on stock dividends (the “top rate”) from 70 percent to 50 percent. (Gains from stock ownership are taxed two ways—as dividends when the company distributes earnings and as capital gains when the shareholder sells his stock at a profit. Dividend tax rates are much higher than capital-gains tax rates, and, like the corporate rate, seem confiscatory. Generally they are voided through tax shelters.) But since top-rate cuts would benefit upper-income taxpayers almost exclusively, Reagan’s advisers feared that they might be politically treacherous. Reagan agreed, and word was put out among Capitol Hill Republicans; no talk of top-rate cuts would be allowed.
Spring of 1981 came, and Reagan’s tax package began moving through Congress concurrent with his budget package, which was building irresistible momentum. Democrats began to sense that they couldn’t beat the President on the budget but might win on taxes. Since they, too, were on record as favoring large tax cuts, substituting their terms for Reagan’s would constitute winning. Democrats began to press for opening up the “clean” bill, and adding all the special-interest favors that, so far, the administration had valiantly resisted. Business lobbyists, of course, were delighted by this development. Major organizations such as the Business Roundtable and the National Association of Manufacturers were content with the clean bill and ACRS, but every minor pressure group in Washington wanted a rider to call its own. For a while, the administration held its ground. Then the Democrats—in the person of William Brodhead, a Michigan congressman, a member of the Ways and Means Committee, and chairman of the liberal Democratic Study Group—endorsed the top-rate cut Reagan was afraid to advance.
In short order, the clean-bill strategy collapsed. Lobbying for many special breaks—tax credits for research and development, elimination of estate taxes, lower oil-company taxes—began in earnest. Slowly, more exemptions began to burrow into the administration bill. The White House trembled slightly when Congressman Dan Rostenkowski, of Illinois, the chairman of Ways and Means, proposed “expensing,” a depreciation scheme permitting even faster write-offs than ACRS and, in some respects, more generous. A bidding war began, in which what was good for the country became secondary o what could be coaxed or rammed through Congress. It’s a familiar Washington story, but one that bears repeating; long-range problems of national policy take a back seat to momentary political irritation.
As the bidding war intensified, Treasury Department officials who “ran the numbers” on ACRS became increasingly concerned that the program would produce more tax benefits than most companies could use. For the half of U.S. companies that already paid no taxes, ACRS would be no incentive to invest. And ACRS would propel the many companies paying low taxes into the tax-free zone as well, leaving them with deductions to spare. Tax deductions, unlike operating losses, may not be carried forward or backward into other tax periods, nor, before Reagan, might they be transferred among companies, except by complicated, risky leases.
Years ago, a group of business lobbyists had predicted this side effect and had begun a quiet campaign for “refundability” of surplus tax credits. They were led by Charls Walker, a former deputy secretary of the Treasury department. Walker’s close ties to the Reagan camp have made him the most sought-after of Washington’s tax lobbyists. Walker’s idea was simple. If any company was not profitable enough to take advantage of the investment-tax credit, the Treasury would mail it a check for the unused portion.
At first, the idea—direct subsidies to mighty corporations, subsidies just for making routine business deals—embarrassed even its proponents. But that’s what tax credits and depreciation were, after all—subsidies. Taxes, it is useful to remember, were originally imposed for the single purpose of raising government revenues. There was no thought of rewarding or punishing any types of economic behavior. But along the way, that changed. Taxes came to be used to encourage individuals to buy homes, corporations to buy heavy machinery, and pharmaceutical firms to manufacture drugs in Puerto Rico. Tax preferences function as subsidies by forgiving debts rather than by issuing checks, but he bottom line is the same. If capital investment should be subsidized—if it creates some general social benefit that makes it inherently worthy—why shouldn’t all investment be subsidized, not just investment by profitable firms?
There was some irony in the tax-refundability campaign. Firms that paid no taxes (because they were unprofitable) were asking for relief from something that didn’t affect them. But ACRS, with its bonanza of deductions, promised to make the gap between thriving and struggling companies much greater, and so inspired considerable fear on the part of congressmen who had struggling firms in their districts. (It also promised to make many firms worth more dead than alive: those rich with unused tax deductions would become merger targets for companies more interested in acquiring their paperwork than their assets.) Administration officials came to feel that they should subsidize investment either for everyone or for no one, and they obviously weren’t going to do the latter.
But tax-refunding was out of the question politically. Reagan couldn’t’ send checks to the Fortune 500 while cutting off assistance to the poor, so Treasury Department officials, acting on White House orders, began searching for some other way to accomplish that end. They soon zeroed in on the equipment-leasing industry, which exists largely for the purpose of exchanging tax benefits. Airlines, which are often less profitable than other businesses, have been leasing their aircraft for many years. One company (typically an investment firm seeking deductions to offset its profits) would buy the aircraft from the manufacturer, and own it. This company would collect the tax advantages and lease the planes to an airline for a discounted price. But leases, according to IRS codes, required an “actual business purpose”: the lease had to have some substance beyond mere transfer of tax benefits; the lessor had truly to own the equipment and be at risk for its value. (If the airline went out of business in the midst of an “actual” lease, the lessor would be stuck with the airplanes.)
If the “actual business purpose” clause were eliminated, Treasury officials decided, companies could avoid the risk and complications of owning each other’s equipment, and enter into transactions that would be all but imaginary. Ford, for instance, could invest in $1 billion worth of equipment, “sell” it to IBM, and “lease” it back. The sale and lease prices would be symmetrical, canceling each other out; IBM would never control or perhaps even see its possession. As figurehead owner of the equipment, IBM would receive its ACRS and investment-tax-credit benefits. Ford would get an up-front cash payment from IBM for agreeing to the switch. The scheme came to be referred to as “tax leasing.” The eventual description of tax leasing in the Joint Committee on Taxation’s report would read, “The new provision [overrides] several fundamental principles of tax law. … When the substance of the transaction is examined, [it] may not bear any resemblance to a lease. … There has been no change of ownership and there is no business purpose for the transaction.” The net effect of tax leasing, Treasury officials knew, would be the same as issuing a check to Ford, because Washington would lose from IBM’s taxes what Ford would have been paid under tax refundability. Or so went the plan. At any rate, the political suicide pact of sending money to corporations could be avoided.
Tax leasing was not proposed until June. By then, White House officials felt, it was too late to gamble on an untested idea; leasing had not been debated in any congressional committee. Besides, the administration had other things to worry about. Rostenkowski was keeping the tax bill captive in his committee, just as another congressman, James Jones of Oklahoma, had tarried with the budget resolutions. Reagan decided to circumvent Rostenkowski with the same ploy he had used on Jones—a “bipartisan” bill backed by a Republican and a Democrat and taken straight to the House floor. When the Conable-Hance bill, named after Republican Barber Conable and Democrat Kent Hance, was unveiled by Reagan in a Rose Garden ceremony, tax leasing was absent. And, to the shock of the business community, the “declining balance” feature that was supposed to make ACRS so generous was cut back. (How could this have happened? To ensure Conable-Hance the triumphant victory Reagan coveted, the White House had included many of the Democrats’ sweeteners, such as $9 billion in extra breaks for oil producers. When the budget director, David Stockman, had seen the amounts involved, he had demanded some concession, and White House strategists, temporarily forgetting their many claims about the desperate need for accelerated depreciation, had cut ACRS.)
The reaction could not have been more extreme. Lobbyists and corporate executives descended on Washington en masse to plead their case, in what became known as the Lear Jet Weekend. “It was an absolute madhouse,” says Robert Lighthizer, staff director of the Senate Finance Committee. When Donald Regan tried to hold the party line, business threatened to bolt to the Democrats. After all, “expensing” was still on the table at Ways and Means, and suddenly it looked appealing. Other threats were made and, according to the undersecretary of the Treasury, Norman Ture, taken seriously. “Sometimes the threat was veiled,” Ture says, “and sometimes it was an open assertion that, look, this is a bidding war.”
In the swirl of the Lear Jet Weekend, administration officials were taking no chances. To them, winning was essential; the final budget votes were still a few weeks off, and any crack in the business alliance might end Reagan’s revolution before its first shots could be fired. “Declining balance” was restored to ACRS, although in modified form—150 percent immediately and escalations to the full 200 percent by 1986. Sensing its edge, business asked for more, and the administration gave again. Expediency had ousted economic necessity as the operating principle.
By the time “Conable-Hance II” emerged, it included a retroactive date of January, 1981, for ACRS; a 25 percent tax credit for research and development; virtual elimination of estate and gift taxes; a cut in the top rate from 70 percent to 50 percent; a capital-gains-tax reduction from 28 percent to 20 percent; an eased “marriage penalty”; extra charitable deductions for business and individuals; lower small-business tax rates; a liberalized inventory accounting procedure called “last in, first out”; halving of the windfall-profits tax on oil; extra tax deductions for state legislators (extra deductions for congressmen and senators would follow in a separate no-roll-call vote in December); the All Savers tax-shelter certificate; Individual Retirement Account tax shelters; breaks for independent oil producers; faster depreciation of real estate; fifteen-year “carryover” periods for operating losses, double the previous limit; a $95,000-per-year deduction for Americans working abroad; a “moratorium on fringe-benefit regulations”; waiver of unemployment-compensation taxes for fishing-boat crews; and breaks for investors in theme parks and racehorses. Of course it included tax leasing—not just for the investment0tax credit but for the entire ACRS package, something not even Walker had dared request.
From the clean bill to Conable-Hance II, only one provision had been shrunk rather than enriched: personal-tax reductions. Reagan originally proposed a 30 percent cut. He settled for 25 percent, with just five percent going into effect promptly and the rest promised for the future. Assuming that the scheduled personal-tax cuts do eventually take place,t hey will benefit mainly upper-income taxpayers. In general, anyone making $30,000 or less a year will find that Reagan’s personal-tax cut merely offsets the increase in Social Security taxes.
As a result of the Lear Jet Weekend, at least $41 billion in tax breaks (plus whatever leasing eventually costs) were added to the tax bill, more than wiping out the deficit-reducing effects of Reagan’s $35 billion spending cut. In mid-August, Reagan signed his bill into law, as the Economic Recovery Tax Act. ACRS proponents felt that the act of signing alone would send a message to the corporate community inspiring a surge of business confidence, a bull market, and immediate signs of renewed economic enthusiasm. The response instead was muted, almost eerie. The market continued to waver. Leading indicators such as housing starts and machine-tool orders did not soar. And in the same month that the bill was signed, Federal Reserve Board figures show that U.S. industrial production began to decline substantially for the first time in the Reagan presidency, signaling recession.
Both houses of Congress had voted overwhelmingly for Reagan’s tax bill. When it passed, there were whoops and shouts of celebration on the floor. But, like party-goers awakening from a night of revelry and wondering whatever possessed them to have that last drink, Congress soon began to worry about the wisdom of its acts. Economists were seeing not just a very low tax but a new phenomenon called a “negative rate.” It seemed that equipment bought under ACRS might produce more in the way of tax benefits than income.
A negative rate works (again in simplified form) like this: Recall the bulldozer whose ACRS deductions and investment-tax credit save the company $25,000 in the first year. Since the corporate tax rate is 46 percent, saving $25,000 on a company’s tax bill is the equivalent of having nearly $50,000 in profits sheltered from taxes. But no $100,000 bulldozer will earn $50,000 in profits in year; a 50 percent rate of return on any investment would be phenomenal. More realistically, a bulldozer might earn $10,000. So ACRS deductions would not only offset all profits from the new purchase but would also shelter $40,000 in profits from elsewhere in the company—in effect, a negative rate.
To speak of negative rates is not to say that a company is making money merely by buying equipment; that situation exists only in folklore, because any new equipment must produce something buyers want and must generate profits to be offset. But as long as profits are present, a Council of Economic Advisers study has found, negative tax rates under ACRS can be huge. With the passage of Reagan’s bill, all construction equipment, industrial machinery, and vehicles promised, on average, a negative rate of 18 percent; in other words, their purchase would shelter 18 percent more profit than the equipment would return. By the time ACRS takes full effect, in 1986, the negative tax rate on such equipment will average 82 percent.
Of course, a company bent on finding ways to shelter operating income usually can do it, but not without tying up funds in speculation or making other sacrifices. Negative rates on new capital investment offered, for the first time, a painless way to shelter operating income, since nearly every company buys equipment on a routine basis. Where it had been a trick to shelter general operating income before ACRS, now any company could do it. And that, economists began to realize, foretold the eventual repeal of corporate taxes. As years pass and equipment governed by old tax schedules wears out and is replaced by new equipment depreciated under ACRS, more and more of a company’s operations will return more money in tax benefits than in profit. At some point, even prosperous corporations will be entitled to more deductions than they can use, and then the “effective” corporate tax rate will fall to zero. Considering that the effective rate was only 25 percent before ACRS, Dale Jorgenson thinks a zero rate is not far off.
In fact, many prosperous corporations reached a zero tax rate the moment ACRS was passed. As soon as tax-leasing sales were permitted, benefits were sold not only by depressed firms such as Chrysler and Ford but by booming companies such as Occidental, LTV, and Burlington Northern. What had happened? Occidental, whose 1980 net income of $711 million was already completely sheltered by foreign tax credits, had $95 million in unneeded deductions, so it sold them to Marsh & McLennan. LTV, whose 1981 pre-tax profit was $504 million, sold $100 million worth of tax benefits; Burlington Northern, also profitable but tax-free, sold off $36 million in surplus benefits.
Other leasing surprises followed. In the dazed maneuvering just before Reagan’s bill passed, lobbyists for New York’s Metropolitan Transportation Authority managed to insert into the bill language allowing even rail and bus lines (“qualified mass commuting vehicles”) to sell tax benefits. MTA quickly sold $99 million worth of equipment to Metromedia, Inc., which operates seven television stations. This was an imaginary sale of imaginary credits, since public-transit authorities pay no taxes and have no write-offs to begin with. Transit authorities in Boston, Philadelphia, Cincinnati, Houston, and Baltimore followed suit, as did Amtrak. Marriott announced that it planned to sell tax exemptions to individuals in lots as low as $5,000.
Even the deals made by companies, such as Ford, that tax leasing was intended to help proved surprising. For selling its $1 billion in deductions to IBM, Ford received $153 million cash. IBM, on the other hand, stood to receive as much as $600 million in tax savings: approximately $500 million from ACRS deductions and $100 million from the investment-tax credit. Thus the prosperous firm had benefited far more than the troubled one. And to avoid the public-relations annoyance of writing a $153 million check to Ford, the Treasury had forsaken $600 million in revenues.
In December of 1981, the Treasury Department told Congress that leasing would involve no more than $15 billion a year by 1986. This March, Treasury released a study showing that in 1981 alone, when leasing transactions were allowed for a period of only three weeks, benefits were allowed for a period of only three weeks, benefits equal to approximately $11.4 billion in lost taxes had been sold. The Treasury estimates that $29 billion in revenues will be lost by 1986; a former IRS commissioner has said that the loss could be nearly twice that amount.
Trying to soften criticism, business executives stopped talking about “tax leasing” and spoke instead of “safe harbor leases,” as they still do. “Safe harbor” is a term from contract law that was mentioned in passing in Reagan’s bill to describe one technical aspect of tax leasing, but now it is being treated like the name of the program. It has a gentle ring, suggesting a placid haven for the troubled rather than a bustling marketplace.
As the true weight of numbers from ACRS, the negative rate, and tax leasing was felt, new budget-deficit figures began arriving. Reagan’s original “clean” bill had promised $60 billion in business cuts by 1986; the revised estimate is now $143 billion, not counting leasing. Deficit estimates are running between $96 billion and $158 billion for fiscal 1983, to $188 billion for 1984, and to $205 billion for 1985. Since Reagan had campaigned in 1980 with scathing condemnations of Jimmy Carter’s final, $58-billion deficit, the new figures hardly seemed real.
A selling point of the tax bill had been Reagan’s guarantee of long-term certainty, what the President called his “unshakable commitment” to stand by the cuts. Faced with new deficit projections, Reagan’s unshakable commitment lasted thirty days. By mid-September, White House officials were telling reporters about new revenue devices that Reagan might request—not tax increases but “tax enhancements.” By the end of September, Kent Hance, cosponsor of Conable-Hance, had recanted and was calling for postponement of personal-tax cut. Robert Dole, the chairman of the Senate Finance Committee, was talking of a “one-time” tax increase. Howard Baker, the Senate majority leader, suggested a 10 percent “surcharge” on personal taxes. Eventually, other prominent Republicans, such as Pete V. Domenici, chairman of the Senate Budget Committee, and Robert Michel, the House minority leader, were calling for the tax bill they had just finished backing to be rewritten. For his part, Reagan announced that balancing the budget wasn’t as important as he once said.
Economic-performance figures have continued along the bleak course that they began to follow in August of 1981. The GNP fell 4.5 percent in the three months after Reagan’s tax package was signed, and interest rates rose back into the high teens as lenders recoiled from the deficit projections. But there was one hope still—that ACRS would inspire an onrush of investment, the “expansion in capital outlays” that Secretary Regan had promised would lead to “increased productivity and economic growth.” Whatever else it is, ACRS is very kind to its investors. But investment is not expanding as predicted. Commerce Department surveys show that capital expenditures increased barely 0.3 percent in 1981, and are expected to fall another one percent this year. ACRS is not doing the one thing the administration felt there was no doubt it would do.
Can these surveys be wrong? I asked Norman Ture and John Chapoton, the assistant Treasury secretary for tax policy, if they had any evidence of increased investment caused by ACRS. Ture and Chapoton are the administration’s highest-ranking tax officials and were the principal architects of ACRS. Chapoton said, “A number of corporations have huge investment plans on the drawing boards. I hear that from company executives all the time over the phone, and people come up to me in the halls and tell me that whenever I’m at a business meeting.” Asked for specific examples of corporations or executives he had spoken to, Chapoton replied that he couldn’t “remember any of their names.” Chapoton later acknowledged that he could not cite a company that had increased investment because of tax cuts. Ture, asked the same question, gave virtually the same response “When I made a speech at the Tax Foundation in New York in December,” Ture said, “one person after another came up to tell me of enormous new capital plans.” But Ture also said he could not recall any names of people or companies.
Later, Ture proposed U.S. Steel as a success story of increased investment, and one of Secretary Regan’s press officers referred me to five companies that he said were expanding their capital outlays—J.C. Penney, Allegheny International, Pfizer, Prudential, and General Motors.
Unfortunately, U.S. Steel’s status is impossible to verify; a spokesman said the company would not reveal investment plans for 1982. He did say that U.S. Steel invested $843 million in new equipment in 1981. It is also investing $6.2 billion to acquire Marathon Oil, which means it is spending seven times as much to rearrange old assets as to create new ones.
J.C. Penney is on the plus side, having increased its capital-investment budget from $208 million in 1981 to $325 million in 1982. Pfizer, a pharmaceutical company, plans to invest $300 million this year—$13 million more than last. Allegheny International has also increased its investment budget, from $110 million to $150 million. But according to an investment banker familiar with the firm, most of Allegheny’s new capital will be spent not on expansion but on a real-estate venture soon to be announced. In other words, Allegheny will also devote new capital to rearranging old assets.
Prudential appears out of place on this list, not being a capital-intensive enterprise. It does lend money, however. Prudential’s capital-market loans were $1.5 billion in 1981 and will drop to $1.2 billion this year. Finally, General Motors, which invested $9.7 billion in 1981, plans to cut back to $8 billion this year.
By the logic of supply-side economics, the lack of new investment is baffling, because the new deductions unquestionably increase returns on investment. But while ACRS can make a successful investment more profitable, it cannot guarantee profits in the first place. If an investment does not produce profit, tax relief is no help; any businessman who fears that a new asset won’t make money is scarcely comforted by promises of breaks on a tax bill he won’t have. Even tax leasing offers no reassurance unless there are a number of highly profitable firms in the deduction-buying market.
David Hughes, a manager for 3M Corporation, explains how the investment sequence works at his company: “Our division is isolated from tax questions. Line management makes decisions based on products, technology, and what we think will sell in the market. Well-run companies take every advantage of taxes, but they don’t base investment decisions on taxes. They base them on what will sell.”
Thus, tax considerations follow, rather than lead, investment decisions; and whether there will be profit, not whether there will be bonus deductions, is the central concern. Yet every proposition about taxes I have heard from administration officials, every “widget” model suggested by economists, every example in the reports of congressional committees, proceeds from the assumption that investments, per se, are always profitable. Discussion then focuses on what level of profits, what style of taxation, will maximize outputs and federal revenues. The notion that profit is not automatic—that it’s hard to predict what will sell, and that when times are bad it’s even harder—has been absent from the ACRS debate.
The ACRS deduction strategy, and supply-side economics in general, presumes that investments to create new capacity will lead to prosperity regardless of other economic conditions. Any businessman contemplating new investment knows, however, that U.S. industry is operating at barely 70 percent of capacity, and knowing that nearly a third of the country’s productive capacity sits idle—unprofitable—hardly encourages the businessman to build more. While the present economy is said to be characterized by “too much money chasing too few goods,” in fact goods (or the capacity to manufacture them) exist in abundance. The real problem is too few customers, because so many are out of work, short of credit, or choosing rival, foreign products.
Not only are the hypothetical widget factories on which ACRS is based always assumed to be profitable but they are profitable at a precisely predictable rate. Businessmen are assumed somehow to know that a new furnace will return, say, exactly 8 percent, allowing them to calculate the exact bonus to be gained from ACRS deductions and be persuaded to launch investments poised on the margin. As a rule, however, only investments in existing products—mature markets where there are detailed sales histories and statistical records—can be predicted with pinpoint accuracy. It’s the mature industries (autos, steel, petrochemicals, housing) that now operate under capacity because of slack demand. Thus, in the one sector of the economy where improved returns from ACRS deductions might inspire a burst of investment, new capacity is not needed.
Of course, every industry, growing or mature, benefits from investments in new types of equipment that lower prices, improve quality, or produce innovative products. These, unfortunately, are the kinds of investments for which return is not wholly predictable, and which are avoided in uncertain times. “Today there’s a lot of risk,” says J. Robert Ferrari, chief economist for Prudential. His company is channeling its (reduced) investment capital into real estate and oil-and-gas partnerships. “You see some promising new investments, but today, if there’s risk, you turn to know quantities,” he says. Ethyl Corporation, a profitable chemicals company, recently put off a planned expansion in Richmond, Virginia, an expansion that would have been treated handsomely by ACRS. Soon after postponing the expansion, it pledged $270 million to acquire First Colony Life Insurance, a known quantity.
Ronald Reagan frequently says that his economic programs should not be held responsible for the current recession, because they are not yet in effect. In September of 1981, he said his programs would not start until October 1. This past February, he said that his programs “didn’t really start until 1982.” In April, Reagan declared that July (the due date for a personal-tax cut) would be “the real beginning of our program.” In fact, Reagan’s economic program began on January 1, 1981, the retroactive date when its main component, ACRS, took effect. As time passes, evidence mounts that lack of credit, lack of demand, and the poor quality of American products—not the tax burden on new investments—are what drag the economy down.
This situation might have been predicted. Healthy economies in other Western nations have sustained high corporate-tax rates, while extensive business tax benefits have failed to revive economies otherwise stagnant. According to an International Monetary Fund study, the free-market nations with the highest corporate taxes are Japan and West Germany. The one with the lowest corporate tax is Great Britain. Britain’s main corporate-tax break is accelerated depreciation.