Manufacturers’ gross profits share Essay

ECONOMIC activity and prices increased moderately in the fourth
quarter, according to the “flash” GNP estimates. A 3-percent
annual rate increase in real GNP, in combination with a 1-1/2-percent
increase in the third quarter, indicates a marked slowing in the second
half of 1984 from a much larger increase in the first half. The GNP
Fixed-weighted price index increased at an annual rate of 3-1/2 pecent
in the fourth quarter, continuing the gradual slowing of inflation
throughout 1984 (table 1).



The third- and fourth-quarter increases in real GNP were not
markedly different; table 1 shows that the fourth-quarter increase was
larger by only 1.2 percentage points, or about $5 billion. However, it
should be noted that large swings in two GNP components tended to offset
each other. Further, the two components–change in business inventories
and net exports–are particularly difficult to estimate for the flash
GNP estimate. Only 1 month of source data for these components is
available, and the data show substantial month-to-month volatility,
which masks any trend that would be a guide to projecting the missing
months of source data. The flash GNP estimate in the fourth quarter
includes a slowing in inventory investment that subtracted about as much
from the change in GNP as the $10-1/2 billion pickup had added in the
third quarter. The flash estimate also includes a substantial increase
in net exports after a $15-1/2 billion decline–from a negative $11-1/2
billion to a negative $27 billion–in the third quarter. Both the
fourth-quarter increase in net exports and the third-quarter decline
were largely accounted for by imports.

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Other components of GNP are, in general, less difficult to estimate
for the flash estimate: Even if only 1 month of source data is
available, the data show less volatility, and for some
components–notably personal consumption expenditures (PCE)–more than 1
month of data is available. The measure that is the sum of these
components–final sales to domestic purchasers–probably increased about
as much in the fourth quarter as the 3-percent increase in the third.
Earlier in 1984, this measure, which represents domestic demand, had
been much stronger, registering increases of 6-1/2 percent and 11
percent in the first and second quarters, respectively. Within this
measure, PCE increased somewhat more in the fourth quarter than in the
third, fixed investment increased less than in the third, and government
purchases increased about the same in both quarters.



Fourth-quarter developments in the components of real GNP, in GNP
prices, and in personal income are sketched below on te basis of data
available as of mid-December. * PCE increased moderately after a
pause–an increase of only 1/2 percent–in the third quarter. Most of
the pickup was in durable goods, where purchases of furniture and
equipment increased substantially more than in the third quarter. In
addition, purchases of motor vehicles declined less than in the third
quarter; autos declined, as they had in the third quarter, but trucks
strengthened. Purchases of nondurables declined again, about as much as
the 1-percent declined registered in the third quarter. Several
categories–food, in particular–declined and others changed little.
Services increased about as much as the 4-percent increase in the third
quarter.



* Nonresidential fixed investment continued to increase, but at
only about one-half the third-quarter increase of 13-1/2 percent. In
producers’ durable equipment (PDE), the slowing was in both motor
vehicles and other PDE. In the former, as in PCE on motor vehicles, the
weakness was in the auto component, which declined after a third-quarter
increase. In terms of unit auto sales to all final purchases, the drop
was to about 9.9 million (seasonally adjusted annual rate) from 10.3
million in the third quarter. In contrast, until sales of trucks
increased to about 4.4 million (seasonally adjusted annual rate) in the
fourth quarter from 4.1 million in the third, continuing a strong
rebound to record or near-record levels in several categories. In other
PDE, the slowing was in computers and communications equipment.
Structures strengthened after little change in the third quarter, when
the increase in commercial structures had slowed. As discussed in the
article that reports on BEA’s October-November plant and equipment
expenditure survey, which now includes plans for the full year ahead,
business plans to increase capital spending in 1985 roughly one-half as
much as in 1984. The smaller fourth-quarter increase in nonresidential
fixed investment included in the flash GNP estimate appears consistent
with these plans.


* Residential investment was down again, about as much as the 4-1/2
percent registered in the third quarter. Construction of single-family
structures declined in both the third and fourth quarters, reflecting a
one-third falloff in housing starts from their recent peak in February.
A decline in mortgage interest rates since July has yet to work its way
through to encourage construction. Construction of multifamily units
increased about as much as in the third quarter, and the
“other” component (largely additions and alterations, mobile
homes, and commissions on house sales) changed little.



* Business inventories accumulated at a substantial rate, but less
than the $30-1/2 billion accumulation in the third quarter. An increase
in motor vehicle inventories–the only part of inventories for which
more than 1 month of source data is available for the fourth
quarter–reflected automakers’ rebuilding of inventories after
extensive plant closings in the United States and strikes in both the
United States and Canada. Only fragmentary information is available
about farm inventories; it appears that accumulation was roughly the
same as the $4 billion in the third quarter. Nonfarm inventories other
than motor vehicles appear to have increased, but less than the $26
billion in the third quarter. Reflecting the substantial additions to
inventories in the earlier quarters of 1984 and the variability of the
increases in final sales, inventory-sales ratios had turned up in the
first quarter, dropped back in the second, and increased in the third.
In the fourth quarter, it appears that the ratios held at about the
third-quarter level.



* Net exports, as mentioned earlier, appear to have increased
substantially. The increase, the first in 3 years, reflected a decline
in imports after a huge–$18 billion–increase in the third quarter. In
merchandise imports, where the decline was concentrated, declines were
widely spread across end-use commodity categories, as the increase had
been in the third quarter. The average change for the third and fourth
quarters, appears to have been a substantial increase, indicating that
imports continue to reflect the effects of cumulative dollar
appreciation. Investment income payments also appear to have declined,
partly reflecting lower interest rates on portfolio investment. In
exports, both agricultural and nonagricultural merchandise exports
increased, but the increases were more than offset by a decline in
investment income receipts.



* Government purchases increased about as much as in the third
quarter, when the Federal and the State and local components had
contributed about equally to a 5-1/2-percent increase. In Federal
purchases, defense purchases increased after a slight decline. Commodity
Credit Corporation (CCC) activities continued to dominate quarterly
changes in nondefense purchases. A higher rate of increase in CCC
inventories added to purchases in the fourth quarter, but not as much as
the $2 billion addition in the third. In State and local purchases, a
smaller increase than in the third quarter was largely in structures.



* The GNP fixed-weighted price index increased 3-1/2 percent, down
from 4 percent in the third quarter. The fourth-quarter increase in PCE
prices as measured by the fixed-weighted price index was slightly larger
than the 4 percent registered in the third quarter; food prices
increased slightly more than in the third quarter, and energy prices
increased after a small decline. Prices of structures–both residential
and nonresidential–showed little change after third-quarter increases
in the range of 1-1/2-4 percent, and prices of PDE slowed from a
3-percent increase.



* Personal income increased about $50 billion, compared with
$62-1/2 billion in thie third quarter. Most of the slowing was in
personal interest income, which was up only about one-half as much as
the $23-1/2 billion increase in the third quarter. The smaller increase
largely reflected the widespread decline in interest rates. Other
components of personal income increased about as much as they had in the
third quarter: wage and salary disbursements and farm proprietors’
income slightly less, and nonfarm proprietors’ income slightly
more.



The smaller increase in personal income in the fourth quarter than
in the third was augmented in its effect on disposable personal income
by a slightly larger increase in personal taxes than in the third
quarter. Although prices of PCE as measured by the implicit price
deflator increased less than in the third quarter, the increase in real
disposable income slowed further–down about 2 percentage points from
the 4-percent increase in the third quarter. Earlier in 1984, the
increases in real disposable income had been substantially larger–8-1/2
percent and 6-1/2 percent in the first and second quarters,
respectively. The fourth-quarter increase in personal outlays–in which
PCE predominates–was about the same as that in disposable personal
income, so personal saving changed little. The saving rate held at
about the third quarter’s rate of 6.3 percent. Throughout 1984,
the saving rate varied only slightly around 6 percent, as the slowing in
disposable income was accompanied by a similar slowing in outlays.



Corporate Profits



Revised third-quarter estimates show that profits from current
production–profits with inventory valuation adjustment and capital
consumption adjustment–declined $8 billion, to $283 billion, following
a $13-1/2 billion increase in the second. The preliminary estimates,
presented in November, had shown a decline of $9-1/2 billion.



The revisions generally reinforce the picture of widespread
declines in domestic profits described in the November “Business
Situation.” The revisions show sharper declines in profits of
manufacturers and financial corporations, but show trade profits, which
had been down in the preliminary estimates, as unchaged. (A discussion
of manufacturers’ gross profits shares follows.)



The revised estimates show a picture for rest-of-the-world profits
sharply different from that presented in November. Revised profits from
the rest of the world increased $3 billion in the third quarter, to
$24-1/2 billion, following at $4-1/2 billion decline in the second.
(Preliminary estimates of rest-of-the-world profits had been down $1/2
billion.) Both receipts on U.S. assets abroad and payments on foreign
assets in the United States were up, but receipts were up more. (See
the article “U.S. International Transactions, Third Quarter
1984” in this issue and table 1 on page 11, which reconciles the
balance on goods and services in the balance of payment accounts with
next exports in the national income and product accounts.)



Manufacturers’ gross profits share



Manufacturers’ economic performance has been debated in recent
years, some alleging that performance has been deteriorating and others
disputing this allegation. The debate is important because proponents
of certain policy measures–for example, industrial development banks
and tax incentives for investment–cite the alleged deterioration to
support their recommendations. Others, who dispute the idea of general
deterioration, take the position that sustained economic growth will
automatically create jobs and investment in manufacturing. The
following discussion suggests gross profits as a share of gross product
as a rough measure of industry performance, and uses it to evaluate the
record in manufacturing since 1947.



Gross profits as a share of gross product.–Industry gross product
is defined as sales or receipts plus change in inventories less
inermediate goods and services purchased. (The last item is also called
current account purchases; in the context of industry measures, it is
the output other than plant and equipment purchased for its own use by
one industry from other industries.) Industry gross product is also
defined as the costs of production–that is, the compensation of
employees, net interest, depreciation and other capital consumption
allowances, and indirect business taxes–and business profits, of which
corporate profits are the largest category. The national income and
product account (NIPA) estimates of industry gross product are prepared
by implementing the second definition. It is in the framework of these
estimates that gross profits as a percentage of gross product–hereafter
called the gross profits share–is calculated.



Gross profits is defined for this discussion as corporate profits
with inventory valuation adjustment plus two components of the costs of
production–net interest and corporate capital consumption allowances.
It would be desirable to use a measure net of capital consumption
allowances with the capital consumption adjustment–that is, a measure
of capital consumption that has been adjusted to reflect uniform service
lives and depreciation formulas and valued at replacement cost; however,
such an adjusted measure of capital consumption allowances is not
available by industry. A measure gross of corporate capital consumption
allowances does maintain the desirable characteristic of being
unaffected by changes in tax law that affect depreciation; for example,
it is unaffected by the introduction in 1981 of the accelerated cost
recovery system. The inclusion of net interest in gross profits
provides a measure that reflects returns to both debt and equity
capital, and is thus unaffected by changes over time in their
proportion.



In one respect, the coverage of the gross profits share as
calculated for this discussion is not fully consistent. Net interest
covers both corporate and noncorporate establishments, but the other
components of gross profits cover only corporate establishments. Gross
product also covers both corporate and noncorporate establishments.
(Corporate gross product is available for some, but not all, of the
1947-83 period.) For a measure of the corporate gross profits share,
the lack of full consistency does not affect the results appreciably,
because the noncorporate shares of net interest and gross product are
very small.



Gross product and the components of gross profits, except net
interest, are on an establishment basis rather than a company basis. Net
interest is on a company basis because information for allocating it to
an estabishment basis is not available. Establishment-based measures are
appropriate indicators of industry performance because, unlike
company-based measures, they allocate to each industry only the results
of activities in that industry. The difference between the two bases
can be illustrated with reference to an integrated company that
maintains petroleum extraction operations, a pipeline, and a refinery.
In establishment-based estimates, the gross product and gross profits
from the three kinds of establishments would appear in mining, public
utilities, and manufacturing, respectively. In company-based estimates,
all the company’s operation would appear in the industry that
constitute the company’s primary activity.



The rough measure of industry performance that the gross profits
share provides does not indicate performance in the sense of ability to
maintain past levels of output or market share. For example, a
shrinking industry that maintains its gross profits by closing plants
could record a constant share. The gross profits share does, however,
indicate performance in the sense of ability of an industry to remain
profitable under changing circumstances.



Manufacturers’ performance, 1947-83.–The gross profits share
for all manufacturing, durable goods and nondurable goods manufacturing,
and selected manufacturing industries for 1947-83 are shown in charts 1
and 2. Although the shares show pronounced cyclical fluctuations, in
most cases some underlying trend is discernible. For all manufacturing,
the share appears to have been relatively stable, lending little support
to the hypothesis of declining performance in manufacturing.
Nondurables manufacturing shows a relatively stable share until 1973 and
a slight uptrend thereafter. Durables manufacturing, in contrast, shows
stability until 1965 and a slight downtrend thereafter.



The slight deterioration in the performance of durables
manufacturing since 1965 reflects, in part, substantial deterioration in
the gross profits share of manufacturers of primary metals. A downtrend
in the share of manufacturers of motor vehicles from 1965 to 1980 also
contributed. Since 1980, however, the share of this industry has
improved, strengthening the durables share.



The slight improvement in the performance of nondurables
manufacturing since 1973 reflects, in part, the improvement in the gross
profits shares of two large industries–food and kindred products and
petroleum and coal products. These industries began to record markedly
higher shares in the 1970’s, when world prices of their outputs
shifted upward.



Employment and Hours: Two Years of Postrecession Growth



LAbor input to production–as measured by employment and average
weekly hours–increased strongly over the 2 years following the
third-quarter 1982 trough in real GNP, but the growth was not among the
strongest in post-World War II recoveries. The following discussion
highlights the industries where the growth in employment and hours was
the strongest and weakest in the 2 years following the 1981-82
recession. It also compares growth during that period, 1982-84, with
growth in the 2 years, 1975-77, following the 1973-75 recession. The
period following the trough in real GNP in the first quarter of 1975 is
used for comparison because it followed a recession similar to the
1981-82 recession in depth and duration. In addition, quarterly
employment growth in 1975-77 was the median of the seven (post-World War
II) recoveries preceding that in 1982-84.



Employment by industry



Nonfarm employment as measured by the Bureau of Labor Statistics establishment survey increased 5.3 million, or 3 percent at an annual
rate, over the 2 years following the 1982-84 recession. The increase
was one-half percentage point larger than that over the 2 years
following the 1973-75 recession (chart 3). In both recovery periods
nonfarm employment regained prerecession peaks in most service-producing
industries, both public and private, but did not regain prerecession
peaks in most goods-producing industries (table 2).



Despite an initial decline, total nonfarm employment regained the
prerecession peak by the fourth quarter of 1983 and expanded in the
first three quarters of 1984. More than three-fourths of the 2-year
increase in employment occurred in the second year–a larger proportion
than in any other post-World War II recovery. In 1975-77, slightly more
than one-half of the increase had occurred in the second year.



The increase in nonfarm employment was broadly based; employment
increased in every major industry group–albeit slowly in some–except
mining (table 3).



Private service-producing industries. –A little over one-half of
nonfarm employment is in private service-producing industries, which
accounted for 3.5 million, or about two-thirds, of the total 2-year
increase. Relatively higher growth rates during the 1982-84
postrecession period–an annual rate of 3-1/2 percent–continued a
long-term shift towards these jobs. The 1982-84 growth rate matched
that in 1975-77 for these industries. Of the four private
service-producing industry groups, employment in two–transportation and
public utilities and wholesale and retail trade–more than regained
prerecession peaks over the 2-year period. Employment in finance,
insurance, and real estate and in services had increased over the
recession and increased more rapidly in the recovery.



Goods-producing industries. –A little over one-quarter of nonfarm
employment is in goods-producing industries, which increased 1.5 million
and accounted for about one-third of the overall increase.
Manufacturing employment grew at an annual rate of 3 percent, a slightly
higher rate than that following the 1973-75 recession. Durables
employment grew at twice the 1975-77 rate, and nondurables at about
two-thirds the 1975-77 rate. All of the growth in durables and most of
the growth in nondurables occurred in the second year.



Employment in both durable and nondurable manufacturing did not
regain prerecession peaks in 1982-84, just as it had not in 1975-77. In
durables, notable exceptions were electronics, motor vehicles, lumber and lumber products, and furniture; these industries regained
prerecession peaks in 1982-84, but had not in 1975-77. Growth in the
electronics industry–a “high technology” industry–reflected
strong sales of microcomputers and telecommunications equipment. A
rebound in sales of automobiles and trucks accounted for much of the
employment growth in motor vehicles, and a rebound in sales of new homes
accounted for much of the employment growth in lumber and lumber
products and in furniture. In nondurables, the printing and publishing
industry and the rubber and miscellaneous plastics products industry
both regained prerecession peaks in 1982-84; in 1975-77, the former had
regained the prerecession peak, the latter had not.



Construction employment grew sharply–0.5 million, or 6 percent at
an annual rate–in 1982-84 and exceeded the prerecession peak. In
contrast, construction employment had been unchanged in 1975-77. The
strong 1982-84 growth, which was centered in special trades (e.g.,
carpenters, masons, plumbers, and electricians) and in residential
construction, reflected the sharp recovery in new home building.



In mining, employment declined 0.1 million, or 3-1/2 percent at an
annual rate–in sharp contrast to the 4-1/2-percent rate of increase
following the 1973-75 recession. Mining employment had increased over
the 1973-75 recession and had continued to increase in 1975-77. Much of
the contrast in growth in the postrecession periods is tied to energy
markets–coal, natural gas, and crude oil.



Government.–Employment increases in government were sluggish in
comparison with both private service-producing and goods-producing
industries; it increased only 0.2 million, or 1/2 percent at an annual
rate, over the 2 years. Government accounted for about one-sixth of
total nonfarm employment, but only 4 percent of the 2-year
increae–reflecting efforts to hold down employment levels. Employment
did regain the prerecession peak as it had in 1975-77. In contrast to
that period, 1982-84 growth was slow in both the Federal and the State
and local components; in 1975-77, Federal Government employment had
declined, and State and local government employment had increased more
rapidly.



Average weekly hours by industry



Despite an initial decline in the fourth quarter of 1982, average
weekly hours for private nonfarm production and nonsupervisory workers
increased 0.5 hours in the 2 years following the third-quarter trough in
real GNP (chart 4). The increase was strong in comparison with the
0.1-hour increase in 1975-77. As with employment, private nonfarm hours
regained the prerecession peak–35.2 hours–in the fourth quarter of
1983; hours reached 0.1 hours above that level in the first three
quarters following the 1981-82 recession occurred in the first year;
increases in the first year following the 1973-75 recession had more
than accounted for the 1975-77 increase.



The increase in average weekly hours was broadly based; hours
increased over the postrecession period in all but one major industry
group; hours in services were unchanged. The lagest increases were in
goods-producing industries, which had suffered the largest drops in the
recession. In 1975-77, no industry group had regained its prerecession
peak; in 1982-84, however, most regained their prerecession peaks.



Private service-producing industries. –Average weekly hours
increased slightly, on average, in service-producing industries in
1982-84; hours had declined in 1982-84; hours had declined in 1975-77
(table 4). Hours regained prerecession peaks in transportation and
public utilities. Hours in finance, insurance, and real estate and in
services had increased over the recession. Hours in the former continued
to increase in 1982-84, while those in the latter were unchanged. Hours
did not regain prerecession peaks in wholesale and retail trade. None
of the groups had regained prerecession peaks in 1975-77; in fact, hours
declined in all but transportation and public utilities.



Goods-producing industries. –Average weekly hours increased even
more strongly in manufacturing, construction, and mining in 1982-84 than
they had in 1975-77. Prerecession peaks were regained in manufacturing
(including that for overtime) and in construction. In manufacturing,
almost all of the increase occurred in the first year, and probably
reflected employers’ use of increased hours rather than recalls or
new hires to boost production early in the recovery. The increase in
construction continued an increase over the preceding recession. In
mining, where the prerecession peak was not regained, most of the
increase in hours occurred in the second year. Hours had not regained
the prerecession peak in any goods-producing group in 1975-77.
Comparison of the overall (net) increase in construction hours in
1982-84 with that in 1975-77 conceals sharp fluctuations in hours within
each period; early in the 1975-77 period, hours had regained the
prerecession peak.



Summary



The recovery and expansion in employment and hours for the nonfarm
sector was strong in the 2 years following the 1982 trough in real GNP,
but not among the strongest of the post-World War II recoveries. The
1982-84 increase in total labor input to production was more
concentrated in the second year. Most of the increase in hours occurred
in the first year, but most of the increase in employment occurred in
the second. In 1975-77, the increase in total labor input had been more
concentrated in the first year due to a strong increase in hours.



The recovery and expansion in employment was about the same as that
following the 1973-75 recession, which was the median for the post-war
period. Employment levels that had existed prior to the 1981-82
recession were, in general, regained in service-producing industries but
not in goods-producing industries–about the same performance as in
1975-77. The strongest increases were registered in construction and
services; employment declined in mining and increased only slowly in
transportation and public utilities.



The recovery and expansion in average weekly hours was stronger
than that in 1975-77. Prerecession hours levels, which had not been
regained in the 1975-77 recovery, were regained in most industries in
1982-84. The strongest increases were registered in the three
goods-producing industries–manufacturing, construction, and mining.
Hours remained unchanged in services, after increasing over the
recession, and increased only slightly in wholesale and retail trade.



Federal Fiscal Developments: The Tax Reform Proposal



In late November, the Department of the Treasury released the
proposal for tax reform requested in the President’s State of the
Union message last January. The proposal is designed to make the tax
system more equitable, simpler, and more conducive to economic growth.
If enacted, it would be a significant revision of the tax system,
including a substantial modification of the progressivity of the rate
structure.



Before formulating the proposal, the Treasury completed a study of
four options: a pure flat tax, a modified flat tax, a tax on income
consumed, and a general sales tax, including a value-added tax and a
Federal retail sales tax. The study laid out the following major
objectives:



* Revenue neutrality. Reform would leave revenues essentially
unchanged from what they would be under current law.



* Economic neutrality. Reform would not unnecessarily distort
choices about how income is earned or how it is spent. It would not
unduly favor leisure over work, or consumption over saving and
investment.



* Equity. Reform would not place significantly different tax
burdens on taxpayers in similar economic circumstances.



* Lower tax rates. Reform would keep tax rates as low as possible,
given other objectives.



* An unchanged distribution of tax burdens across income classes.
Reform would not significantly change tax burdens across income classes,
but would alter the distribution of tax burdens within income classes.



* Fairness for families. Reform would assure that families with
incomes below the poverty level would pay little or no tax.



* An inflation-proof tax law. Reform would provide inflation
adjustments–indexation–in the measurement of taxable income.



The proposal–for which the modified flat tax is the basis–is
essentially revenue neutral (see table 5), it does provide lower tax
rates, and, according to the Treasury, it does not significantly change
tax burdens across income classes. However, in designing a tax system
that is simpler, the proposal may have been only partly successful.
Some aspects of the proposal–such as the reduction in the number of tax
rates and brackets and the repeal of many deductions–worked toward
simplification, but other aspects–such as the indexation of capital
gains, interest, inventories, and depreciation allowances–may have
worked toward complication.



According to the Treasury, the proposal is an integrated package;
changes are mutually dependent and must occur together to avoid
inequities, distortions, complex administrative rules, and increased
compliance costs. Any change in the package means that either the
proposed rate structure or another proposal must be redesigned in order
to meet the objectives mentioned above.



The proposal would reduce the average individual’s income
taxes by 8-1/2 percent while raising corporation income taxes by 37
percent. Under the proposal, 78 percent of individual taxpayers would
experience no tax change or a tax decrease, and 22 percent would
experience higher taxes. Of individuals with higher taxes, more than
one-half would have an increase of less than 1 percent of income. The
gainers under the Treasury proposal are likely to be low-income families
and middle-income individuals who have few deductions or credits.
Losers are those who have many deductions and credits, or who live in
States with high income taxes. Among corporations, gainers are likely
to be in service and high-technology industries, while those in
capital-intensive industries, petroleum companies, and banks would be
losers.



Effective dates and transition rules



The Treasury proposal recognizes the difficulties in implementing
such a sweeping revision to the tax system. The proposed effective
dates and transition rules assume that legislation is introduced in
early 1985, enactment is July 1, 1985, and the general effective date is
January 1, 1986. The proposed transition rules can be divided into four
general categories.



1. Immediate implementation. In many cases, the Treasury
recommends that the proposals be implemented immediately. Changes in
the zero bracket amount, personl exemptions, and a variety of credits
and deductions fall into this category; changes in individual and
corporate tax rates would be delayed 6 months to achieve the goal of
revenue neutrality in the initial year after enactment. The special
preferences for energy and natural resource industries would be repealed
immediately. To reduce the impact of immediate implementation, the
repeal of the windfall profit tax would be accelerated by 3 years, with
the scheduled three-quarter phaseout beginning on January 1, 1988
instead of January 1, 1991.



2. Immediate implementation with grandfathering. Grandfathering
provisions–that is, provisions that exempt commitments entered into
prior to the legislation–are recommended to avoid reform-induced
windfall gains and losses. Permanent grandfathering is recommended, for
example, for existing commitments to accelerated cost recovery and the
investment tax credit. Temporary grandfathering is recommended, for
example, for fringe benefits. For most, the new rules will apply as
contracts expire or, at the latest, January 1, 1989, but in the case of
the two largest fringe benefits–employer-provided health care and life
insurance–the new rules will be fully effective January 1, 1990. In
addition, for those cases where tax-sheltered income is brought into the
tax base, it is recommended that the increase in income tax be spread
evenly over a fixed number of years for tax purposes.



3. Phased-in implementation. The Treasury recommends phased-in
implementation for dividend relief, elimination of the deduction for
State and local taxes, the limit on charitable contributions,
elimination of the graduated corporate tax rates, the limit on interest
deductions, and elimination of the business deductions for entertainment
expenses and for meal and travel costs in excess of a limit.



4. Delayed implementation. For various reasons, the Treasury
recommends delayed implementation for many of the changes in the
taxation of estates, certain military cash compensation, and
unemployment and workers’ compensation (January 1, 1987); interest
indexing (January 1, 1988); indexing capital gains on nondepreciable
assets (January 1, 1989); and repeal of the individual and corporate
minimum taxes (January 1, 1990).



The remainder of this article will discuss the major features of
the Treasury proposals (see tables 6 and 7). The effect for the year
1990 is referred to in order to encompass the full implementation of the
proposals.



Individual income taxes



Individual income taxes are reduced $37.7 billion in 1990 by the
Treasury proposal, the net result of $161.7 billion in tax reductions
and $123.8 billion in tax increases. Changes in the tax rate structure
(including the effect of indexation of rates, exemptions, and the zero
bracket amount) account for the bulk of the proposed reductions. The
current set of 14 rate brackets, ranging from 11 percent to 50 percent,
is changed to a modified flat tax with 3 rate brackets (see table 3 for
proposed rates and brackets). The indexation of interest income and
expense, capital gains, and the earned income tax credit accounts for
$19.2 billion of the reductions. The proposal to index interest
introduces some complications into the tax code. Mortgage interest on
an individual’s primary residence is fully deductible. Other
interest expense is then netted against interest income to derive net
interest income (or expense). If the taxpayer has net interest income,
a portion–the fractional interest exclusion–of this net income would
be excluded in determining adjusted gross income (AGI); the remainder
would be included in AGI. If the taxpayer has net interest expense, the
first $5,000 would be deductible, and the excess of $5,000 would be
subject to the fractional exclusion rate in determining the amont that
would be deductible. Other provisions of the interest indexation
proposal place limits on the total amount of net interest expense that
can be deducted in 1 year. The fractional exclusion rate, announced
each year, is to be set to reflect the relationship between the current
rate of inflation–measured by the percentage increase in the Consumer
Price Index over the previous 12 months–and the longrun real interest
rate. The desired relationship is approximated by dividing the
inflation rate by the nominal interest rate. For example, assuming an
inflation rate of 4 percent and a nominal interest of 10 percent, the
exclusion rate would be 40 percent. Thus, 40 percent of nominal net
interest income will not be taxed.



The repeal and limiting of deductions account for the largest
share–$50.3 billion–of the proposed increases and include: (1) repeal
of the deduction for State and local government taxes, and (2) limiting
the deduction for charitable contributions to those above 2 percent of
AGI. The repeal and limiting of exclusions account for $20.2 billion of
the increases and include taxing: (1) employer-paid health insurance
premiums in excess of $70 per month for a single person and $175 per
month for a family, and (2) workers’ compensation, but with a
special credit for the elderly and disabled. The proposal to repeal the
accelerated cost recovery system (ACRS) for depreciation and replace it
with an indexed economic depreciation–the real cost recovery
system–increases taxes $12.9 billion.



The proposal to provide relief from double taxation of dividends by
allowing a 50-percent dividend-paid deduction to corporations increases
individual income taxes $7.4 billion (based on the assumption that more
dividends will be paid by corporations).



Corporation income taxes



Corporation income taxes are increased $44.7 billion in 1990 by the
Treasury proposal, the net result of $109.5 billion in tax reductions
and $154.4 billion in tax increases. Changing the rate structure from a
graduated tax rate, up to 46 percent, to a flat rate of 33 percent
accounts for the bulk of the reductions. The major increase occurs from
repeal of ACRS and replacing it with indexed economic depreciation.
Repeal of the investment tax credit and applying uniform rules for
multiperiod construction increase taxes $31.7 billion and $13.9 billion,
respectively.



Other taxes



Estate and gift taxes are reduced slightly by a proposal to unify the estate and gift tax structure by conforming the computation of the
gift tax base to that of the estate tax. Excise taxes are reduced $3.1
billion in 1990 by the proposal to accelerate the phase-out of the
windfall profit tax.



Third-quarter NIPA revisions



The 75-day revisions of the national income and product accounts
estimates for the third quarter of 1984 are shown in Table 8.

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