The impact of proposed federal tax reforms on U.S. financial markets

Business Economics, Jan, 1996 by Albert E. DePrince, Jr., William F. Ford

During the past year, a number of proposals for fundamental reform of the U.S. federal income tax (FIT) program have moved from the realm of academic discussion into the political arena. It is likely that one or more bills proposing to replace or to change drastically the current FIT will be considered by the U.S. Congress. This paper reviews the major tax proposals advanced to date in the current session of Congress, and then analyzes the impact that those plans would have on the financial sector of the U.S. economy.

Thus far, much of the public discussion of FIT reform has focused on its impact on individual taxpayers. Democrats, led by President Clinton and House minority leader Gephardt, have argued for retaining a steeply progressive set of income-tax brackets, featuring tax breaks for the working poor and middle class while taxing upper income individuals heavily. They also advocate increasing taxes on private companies by reducing various corporate tax incentives they have characterized as "Corporate Welfare." Leaders of the recently elected Republican majority in the Congress, on the other hand, are advocating the adoption of various kinds of "flat tax" proposals that would exempt low income families from income taxation and tax all others at a low flat rate. Congressman Armey's "flat tax" proposal has received the most attention in that connection. Other Republicans, e.g., Congressman Archer, along with Ross Perot, would go further by repealing the FIT and replacing it entirely with a consumption tax. Finally, Senators Nunn and Domenici have produced a very detailed proposal, their so-called "USA Tax" plan, which involves a valued-added tax (VAT) on corporations and progressive income taxation of individual incomes less virtually unlimited tax exemptions for personal savings.

All of the major parties to the national debate on tax reform agree that any new system of federal taxation must generate sufficient revenue to eliminate federal deficit spending within seven to ten years. In that connection, Republicans favor the shorter time frame and much deeper cuts in spending than envisioned by the president. This, they assume, would enable them to provide greater tax rate relief that, in turn, would generate faster economic growth and enhanced total tax collections, in spite of lower tax rates.

The attached matrix, Table 1, presents a simplified overview of the major types of tax reform programs now being considered, with the business impact shown at the top of the table and the personal impact at the bottom. The left side of the table arrays the various reform programs, from top to bottom, in rough order of the radical nature of their departure from the current FIT. Thus, proposals for a flat rate national sales tax (per Congressman Archer and Ross Perot) appear at the top of the table, while modified versions of the current FIT, as proposed by Congressman Gephardt, appear at the bottom. Hybrid plans, such as the Nunn-Domenici "USA Tax" and the Armey "Flat Tax" appear in between the other proposals.

[TABULAR DATA OMITTED]

The horizontal vector of the matrix shows how the reform programs propose to treat various kinds of business income and expenses, as well as the treatment of personal sources of income, savings etc.

FINANCIAL MARKET EFFECTS

Most of the public debate about proposed reforms of the FIT, to date, have been centered on the class warfare aspects of such proposals. U.S. Labor Secretary Robert Reich's widely publicized comments on the need for "corporate welfare" reform have also drawn a lot of media attention, and have been echoed by President Clinton and Congressional Democratic leaders. Although not clearly defined, at this point the "corporate welfare" reform ideas imply that there would be significant increases in total corporate income tax collections.

However, relatively little attention has been focused on the very profound impacts that virtually all of the proposals would have on various segments of the financial sector of our economy. If and as any such reform proposals move toward fruition, one of two things must happen. Either the proposals will be refined significantly prior to their enactment to take account of their impacts on the financial sector, or major technical modifications of any such bills that are enacted will have to be made to correct such oversights in drafting new tax legislation.

Distinguishing Features Versus Earlier Efforts

The current set of proposals are not designed to cut taxes, overall, but rather to raise the same amount of revenue before and after the change. This sets the current reform efforts apart from the Kemp-Roth-Hollings reforms of the early 1980s and the 1986 tax changes. In both of those cases, there were substantial cuts in personal tax rates and taxes collected. In short, current proposals address the question of how revenue will be generated rather than how much revenue is to be raised.

As a result, there should be no change in the projected budget deficits over the foreseeable future. Because of that, the general level of interest rates will not be influenced by changes in the federal government's borrowing needs, though the general level of interest rates may be affected by other features of any new tax code.