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

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

The Treatment of Payroll Taxes and Employer Paid Fringe Benefits: Payroll taxes are excluded as a deductible item in the VAT and in Armey's proposal. However, the Nunn-Domenici VAT provides for a tax credit for payroll taxes only. Other employer-paid fringe benefits are not deductible business expenses. Armey provides some relief, allowing the deductibility of employer-paid fringe benefits, if they are counted in compensation. In that case, employer-paid fringe benefits become taxable income to employees. In all cases, except for the Gephardt plan, there is a tax on employer-paid fringe benefits, and the question is whether the employee or the firm pays the tax. The treatment of fringe benefits is unclear under the Gephardt plan. They are taxable income at the personal level, and may also be nondeductible at the business level, if they become part of the unspecified $50 billion in "corporate welfare" that he seeks to eliminate.

If fringe benefits lose their deductibility for businesses, there would be major changes in the method of providing such benefits. A cash payment could replace the fringe benefits, in which case the individual would need to acquire such fringe benefits personally. In the case of pension contributions, this could radically alter the demand for investment products, as individuals rather than firms would undertake more of the acquisition of financial assets for retirement. In any event, providers of investment products must be alert to possible changes in investment avenues that may develop as a result of such changes in the treatment of employer provided fringes.

Unresolved Questions: Several major questions remain to be resolved. Two of the more salient ones are discussed below, by way of illustration:

1. Unused depreciation: The first is the treatment of unused depreciation under the Armey plan. Failure to provide some means of capturing unused depreciation will reduce the value of firms that have large unused depreciation charges.

2. Gross receipts tax and financial institutions: For financial institutions, borrowed funds are raw materials. For nonfinancial firms, raw materials are deductible costs in the VAT and the gross receipts tax. As currently proposed, by Nunn-Domenici and Armey, the inability to deduct interest on borrowed money creates a major disparity in the tax treatment of raw materials between financial institutions and other firms. Some arrangement must be made to allow financial institutions to count borrowed funds as raw materials. Otherwise, such institutions will face a confiscatory tax.

Personal Taxes and Effects on Financial

Products and Markets

Saving Preference: A straightforward national sales tax would, of course, exempt all personal saving from income taxation if combined with repeal of the current FIT. Nunn-Domenici also proposes that all personal net new saving be exempted from the personal income tax. However, it appears that the investment income on the net increase in qualified saving instruments would be subject to personal income tax, unless reinvested. The definition of income is broad under the Nunn-Domenici plan: wages, salaries, interest and dividend income, and capital gains. This plan provides a strong incentive for saving by exempting net saving in qualified instruments from the personal income tax. This, in turn should generate increases the saving pool and lead to a reduction in the general level of interest rates.