Tax Reform
The Treasury Views

In November 1984 the US Treasury submitted to President Reagan a set of reform proposals designed to reduce the distortionary effects of the tax system on private savings and investment. In his recent budgets the Chancellor has adopted the same goal of "fiscal neutrality'. At a February 25 lunchtime meeting, Emil Sunley and CEPR Research Fellow Mervyn King discussed the November Treasury proposals and their implications for tax policy in the UK. A modification of the November proposals was announced by the Treasury in May 1985; the speakers' remarks were applicable only to the original November proposals. Mr Sunley was Deputy Assistant Secretary for Tax Policy at the US Treasury from 1977 to 1981 and is now Director of Tax Analysis in the National Affairs Office of Deloitte, Haskins & Sells. Professor King is the author of the recent study "The Taxation of Income from Capital'.

Sunley noted that the Treasury proposals were designed to lower the individual and corporate tax rates and at the same time broaden the base of each tax by removing most exclusions and exemptions. The proposals would reduce individual income tax payments by 8% and increase corporate taxes by 24%, while leaving total tax revenues unchanged.

Corporate income tax was currently levied at a number of different rates, Sunley noted. The Treasury proposed to replace these rates with a single flat rate of 33%. The present system of investment tax credits and accelerated depreciation allowed firms to write off new machinery as soon as it entered service and led to effective tax rates of zero on new investment in machinery and equipment. This would be repealed under the Treasury proposals. Firms would be allowed to depreciate their equipment for tax purposes at the "economic' rate of depreciation, the actual rate of decline in the value of the machinery and equipment. If the rates of "economic' depreciation for different assets could be measured properly, then the Treasury proposal would mean that the effective tax rates facing business were the same as the normal tax rates.

Indexation was an important feature of the Treasury proposals and went well beyond earlier tax reform plans. The individual income tax would be indexed beginning in 1985, and the Treasury proposed to extend this indexation to depreciation, capital gains, inventories, interest income and debt. The indexation of interest payments on debt represented the most difficult problem. One possibility would be to index the principal outstanding on the debt. The Treasury had adopted instead a short-cut procedure by which a fraction of interest income would be excluded from the calculation of taxable income and a fraction of interest payments disallowed as a deduction from taxable income. The fraction excluded would vary with the rate of inflation. Sunley argued that this was an undesirable and unworkable approach, and the "Achilles heel' of the entire Treasury proposal.

The burden of taxation on individuals would be reduced under the Treasury proposals. The highest rates of taxation would be reduced and the current range of tax "bands' would be replaced by rates of 15, 25 and 35%. The income "base' on which the tax was assessed would be widened, and many exemptions, exclusions and deductions would be eliminated. The tax relief on mortgage interest would be restricted to principal residences, although the taxation of individual retirement accounts would remain unchanged.

At present 60% of capital gains are excluded from income. The Treasury proposed that these capital gains be taxed in full, after adjustment for inflation. This represented an important change, which could increase the maximum tax rate on real capital gains from 20% to 35%. It had aroused strong opposition, Sunley noted. Deductions for charitable contributions would be limited under the Treasury proposals. Sunley predicted that this limitation, and more importantly the reduction in top marginal tax rates would reduce the level of donations to charities.

Other aspects of the proposal had so far been less controversial. Individuals would no longer be allowed to deduct state and local taxes in calculating their taxable income. The deductibility of personal interest payments would be limited to $5000 each year. The Treasury proposed to index interest income and expenses for individuals in the same manner as for corporations. The net effect of these changes would be to increase the tax advantage of homeownership.

Was there any prospect that the Treasury proposals would be implemented? Many special interests would be affected by the reform proposals and will mount strong opposition in Congress. Nevertheless, the growing federal deficit will necessitate some action. Spending cuts are unlikely to be sufficient to eliminate the deficit, and the Treasury has already rejected a value-added tax or increases in income tax rates as means of generating further revenue. Sunley's own view was that Congress would eventually attempt to increase tax revenues by picking and choosing among those Treasury proposals intended to broaden the tax base. This might include a repeal of the investment tax credit or capital recovery rules.

The prospects for the Treasury proposals are uncertain, yet they may nevertheless contain useful lessons for UK tax policy. In his remarks Mervyn King noted that the Treasury proposals bore many similarities to Nigel Lawson's 1984 budget. Both adopted "fiscal neutrality' as a goal, and this necessitated important departures from previous tax policy. Existing tax structures produced effective rates of taxation on new investment which ranged from -100% to +100%, depending on the industry concerned, the method of financing chosen and the investor from whom the funds were obtained. The return on investment was dominated by the effects of the tax system, rather than by market forces. One way of achieving fiscal neutrality was the elimination of all special privileges for particular forms of savings and investment, as proposed by the US Treasury and the Chancellor. Fiscal neutrality can also be achieved by according the same privileges to all forms of savings - an expenditure tax. One could not adopt both approaches simultaneously, King noted. He argued that indexation was an essential feature of the US proposals. Without it, full taxation of capital gains as income would be inappropriate. The Chancellor's 1984 Budget, by contrast, removed stock relief, the only remaining element of indexation in the UK tax system. King argued that this was unwise and ignored the effects of even low inflation on effective tax rates. By 1986 effective tax rates in the UK will be even more sensitive to any increase in the rate of inflation than they were when stock relief was introduced in 1974.

King argued that the US Treasury had recognized the distortions arising from the different tax treatment of income and capital gains. They proposed to remove this distortion by taxing capital gains as income, after allowing full indexation and a reduction in income tax rates. The Chancellor could not hope to move towards a more neutral tax system while at the same time allowing the erosion of the capital gains tax. There was little evidence to date of a systematic approach to this problem. King recommended that capital gains be fully indexed and taxed as income. The top rate of income tax should be reduced below 50% at the same time, and capital allowances, stocks and interest income should be indexed along with capital gains.

The reforms of the 1984 budget needed to be carried further. They failed to treat indexation seriously and so remained vulnerable to an increase in inflation. The failure to index and tax capital gains as income impeded further progress toward fiscal neutrality. The November US Treasury proposals offered a way forward.