Manufacturers’ gross profits share Essay

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

The third- and fourth-quarter increases in real GNP were notmarkedly different; table 1 shows that the fourth-quarter increase waslarger by only 1.2 percentage points, or about $5 billion. However, itshould be noted that large swings in two GNP components tended to offseteach other.

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Further, the two components–change in business inventoriesand net exports–are particularly difficult to estimate for the flashGNP estimate. Only 1 month of source data for these components isavailable, and the data show substantial month-to-month volatility,which masks any trend that would be a guide to projecting the missingmonths of source data. The flash GNP estimate in the fourth quarterincludes a slowing in inventory investment that subtracted about as muchfrom the change in GNP as the $10-1/2 billion pickup had added in thethird quarter. The flash estimate also includes a substantial increasein net exports after a $15-1/2 billion decline–from a negative $11-1/2billion to a negative $27 billion–in the third quarter.

Both thefourth-quarter increase in net exports and the third-quarter declinewere largely accounted for by imports. Other components of GNP are, in general, less difficult to estimatefor the flash estimate: Even if only 1 month of source data isavailable, the data show less volatility, and for somecomponents–notably personal consumption expenditures (PCE)–more than 1month of data is available. The measure that is the sum of thesecomponents–final sales to domestic purchasers–probably increased aboutas much in the fourth quarter as the 3-percent increase in the third.Earlier in 1984, this measure, which represents domestic demand, hadbeen much stronger, registering increases of 6-1/2 percent and 11percent in the first and second quarters, respectively. Within thismeasure, PCE increased somewhat more in the fourth quarter than in thethird, fixed investment increased less than in the third, and governmentpurchases increased about the same in both quarters. Fourth-quarter developments in the components of real GNP, in GNPprices, and in personal income are sketched below on te basis of dataavailable as of mid-December. * PCE increased moderately after apause–an increase of only 1/2 percent–in the third quarter. Most ofthe pickup was in durable goods, where purchases of furniture andequipment increased substantially more than in the third quarter.

Inaddition, purchases of motor vehicles declined less than in the thirdquarter; autos declined, as they had in the third quarter, but trucksstrengthened. Purchases of nondurables declined again, about as much asthe 1-percent declined registered in the third quarter. Severalcategories–food, in particular–declined and others changed little.Services increased about as much as the 4-percent increase in the thirdquarter. * Nonresidential fixed investment continued to increase, but atonly about one-half the third-quarter increase of 13-1/2 percent. Inproducers’ durable equipment (PDE), the slowing was in both motorvehicles and other PDE. In the former, as in PCE on motor vehicles, theweakness was in the auto component, which declined after a third-quarterincrease.

In terms of unit auto sales to all final purchases, the dropwas to about 9.9 million (seasonally adjusted annual rate) from 10.3million in the third quarter.

In contrast, until sales of trucksincreased to about 4.4 million (seasonally adjusted annual rate) in thefourth quarter from 4.1 million in the third, continuing a strongrebound to record or near-record levels in several categories. In otherPDE, the slowing was in computers and communications equipment.Structures strengthened after little change in the third quarter, whenthe increase in commercial structures had slowed. As discussed in thearticle that reports on BEA’s October-November plant and equipmentexpenditure survey, which now includes plans for the full year ahead,business plans to increase capital spending in 1985 roughly one-half asmuch as in 1984.

The smaller fourth-quarter increase in nonresidentialfixed investment included in the flash GNP estimate appears consistentwith these plans. * Residential investment was down again, about as much as the 4-1/2percent registered in the third quarter. Construction of single-familystructures declined in both the third and fourth quarters, reflecting aone-third falloff in housing starts from their recent peak in February.A decline in mortgage interest rates since July has yet to work its waythrough to encourage construction. Construction of multifamily unitsincreased about as much as in the third quarter, and the”other” component (largely additions and alterations, mobilehomes, and commissions on house sales) changed little. * Business inventories accumulated at a substantial rate, but lessthan the $30-1/2 billion accumulation in the third quarter. An increasein motor vehicle inventories–the only part of inventories for whichmore than 1 month of source data is available for the fourthquarter–reflected automakers’ rebuilding of inventories afterextensive plant closings in the United States and strikes in both theUnited States and Canada. Only fragmentary information is availableabout farm inventories; it appears that accumulation was roughly thesame as the $4 billion in the third quarter.

Nonfarm inventories otherthan motor vehicles appear to have increased, but less than the $26billion in the third quarter. Reflecting the substantial additions toinventories in the earlier quarters of 1984 and the variability of theincreases in final sales, inventory-sales ratios had turned up in thefirst quarter, dropped back in the second, and increased in the third.In the fourth quarter, it appears that the ratios held at about thethird-quarter level. * Net exports, as mentioned earlier, appear to have increasedsubstantially. The increase, the first in 3 years, reflected a declinein imports after a huge–$18 billion–increase in the third quarter. Inmerchandise imports, where the decline was concentrated, declines werewidely spread across end-use commodity categories, as the increase hadbeen in the third quarter. The average change for the third and fourthquarters, appears to have been a substantial increase, indicating thatimports continue to reflect the effects of cumulative dollarappreciation.

Investment income payments also appear to have declined,partly reflecting lower interest rates on portfolio investment. Inexports, both agricultural and nonagricultural merchandise exportsincreased, but the increases were more than offset by a decline ininvestment income receipts. * Government purchases increased about as much as in the thirdquarter, when the Federal and the State and local components hadcontributed about equally to a 5-1/2-percent increase. In Federalpurchases, defense purchases increased after a slight decline. CommodityCredit Corporation (CCC) activities continued to dominate quarterlychanges in nondefense purchases. A higher rate of increase in CCCinventories added to purchases in the fourth quarter, but not as much asthe $2 billion addition in the third.

In State and local purchases, asmaller increase than in the third quarter was largely in structures. * The GNP fixed-weighted price index increased 3-1/2 percent, downfrom 4 percent in the third quarter. The fourth-quarter increase in PCEprices as measured by the fixed-weighted price index was slightly largerthan the 4 percent registered in the third quarter; food pricesincreased slightly more than in the third quarter, and energy pricesincreased after a small decline. Prices of structures–both residentialand nonresidential–showed little change after third-quarter increasesin the range of 1-1/2-4 percent, and prices of PDE slowed from a3-percent increase. * Personal income increased about $50 billion, compared with$62-1/2 billion in thie third quarter.

Most of the slowing was inpersonal interest income, which was up only about one-half as much asthe $23-1/2 billion increase in the third quarter. The smaller increaselargely reflected the widespread decline in interest rates. Othercomponents of personal income increased about as much as they had in thethird quarter: wage and salary disbursements and farm proprietors’income slightly less, and nonfarm proprietors’ income slightlymore. The smaller increase in personal income in the fourth quarter thanin the third was augmented in its effect on disposable personal incomeby a slightly larger increase in personal taxes than in the thirdquarter. Although prices of PCE as measured by the implicit pricedeflator increased less than in the third quarter, the increase in realdisposable income slowed further–down about 2 percentage points fromthe 4-percent increase in the third quarter. Earlier in 1984, theincreases in real disposable income had been substantially larger–8-1/2percent and 6-1/2 percent in the first and second quarters,respectively. The fourth-quarter increase in personal outlays–in whichPCE predominates–was about the same as that in disposable personalincome, so personal saving changed little. The saving rate held atabout the third quarter’s rate of 6.

3 percent. Throughout 1984,the saving rate varied only slightly around 6 percent, as the slowing indisposable income was accompanied by a similar slowing in outlays. Corporate Profits Revised third-quarter estimates show that profits from currentproduction–profits with inventory valuation adjustment and capitalconsumption adjustment–declined $8 billion, to $283 billion, followinga $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 widespreaddeclines in domestic profits described in the November “BusinessSituation.” The revisions show sharper declines in profits ofmanufacturers and financial corporations, but show trade profits, whichhad been down in the preliminary estimates, as unchaged. (A discussionof manufacturers’ gross profits shares follows.

) The revised estimates show a picture for rest-of-the-world profitssharply different from that presented in November. Revised profits fromthe 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 $1/2billion.) Both receipts on U.

S. assets abroad and payments on foreignassets in the United States were up, but receipts were up more. (Seethe article “U.

S. International Transactions, Third Quarter1984″ in this issue and table 1 on page 11, which reconciles thebalance on goods and services in the balance of payment accounts withnext exports in the national income and product accounts.) Manufacturers’ gross profits share Manufacturers’ economic performance has been debated in recentyears, some alleging that performance has been deteriorating and othersdisputing this allegation. The debate is important because proponentsof certain policy measures–for example, industrial development banksand tax incentives for investment–cite the alleged deterioration tosupport their recommendations. Others, who dispute the idea of generaldeterioration, take the position that sustained economic growth willautomatically create jobs and investment in manufacturing. Thefollowing discussion suggests gross profits as a share of gross productas a rough measure of industry performance, and uses it to evaluate therecord in manufacturing since 1947. Gross profits as a share of gross product.–Industry gross productis defined as sales or receipts plus change in inventories lessinermediate goods and services purchased.

(The last item is also calledcurrent account purchases; in the context of industry measures, it isthe output other than plant and equipment purchased for its own use byone industry from other industries.) Industry gross product is alsodefined as the costs of production–that is, the compensation ofemployees, net interest, depreciation and other capital consumptionallowances, and indirect business taxes–and business profits, of whichcorporate profits are the largest category. The national income andproduct account (NIPA) estimates of industry gross product are preparedby implementing the second definition. It is in the framework of theseestimates that gross profits as a percentage of gross product–hereaftercalled the gross profits share–is calculated.

Gross profits is defined for this discussion as corporate profitswith inventory valuation adjustment plus two components of the costs ofproduction–net interest and corporate capital consumption allowances.It would be desirable to use a measure net of capital consumptionallowances with the capital consumption adjustment–that is, a measureof capital consumption that has been adjusted to reflect uniform servicelives and depreciation formulas and valued at replacement cost; however,such an adjusted measure of capital consumption allowances is notavailable by industry. A measure gross of corporate capital consumptionallowances does maintain the desirable characteristic of beingunaffected by changes in tax law that affect depreciation; for example,it is unaffected by the introduction in 1981 of the accelerated costrecovery system. The inclusion of net interest in gross profitsprovides a measure that reflects returns to both debt and equitycapital, and is thus unaffected by changes over time in theirproportion. In one respect, the coverage of the gross profits share ascalculated for this discussion is not fully consistent. Net interestcovers both corporate and noncorporate establishments, but the othercomponents of gross profits cover only corporate establishments. Grossproduct also covers both corporate and noncorporate establishments.

(Corporate gross product is available for some, but not all, of the1947-83 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 arevery small. Gross product and the components of gross profits, except netinterest, are on an establishment basis rather than a company basis. Netinterest is on a company basis because information for allocating it toan estabishment basis is not available.

Establishment-based measures areappropriate indicators of industry performance because, unlikecompany-based measures, they allocate to each industry only the resultsof activities in that industry. The difference between the two basescan be illustrated with reference to an integrated company thatmaintains petroleum extraction operations, a pipeline, and a refinery.In establishment-based estimates, the gross product and gross profitsfrom the three kinds of establishments would appear in mining, publicutilities, and manufacturing, respectively. In company-based estimates,all the company’s operation would appear in the industry thatconstitute the company’s primary activity. The rough measure of industry performance that the gross profitsshare provides does not indicate performance in the sense of ability tomaintain past levels of output or market share.

For example, ashrinking industry that maintains its gross profits by closing plantscould record a constant share. The gross profits share does, however,indicate performance in the sense of ability of an industry to remainprofitable under changing circumstances. Manufacturers’ performance, 1947-83.

–The gross profits sharefor all manufacturing, durable goods and nondurable goods manufacturing,and selected manufacturing industries for 1947-83 are shown in charts 1and 2. Although the shares show pronounced cyclical fluctuations, inmost cases some underlying trend is discernible. For all manufacturing,the share appears to have been relatively stable, lending little supportto the hypothesis of declining performance in manufacturing.Nondurables manufacturing shows a relatively stable share until 1973 anda slight uptrend thereafter. Durables manufacturing, in contrast, showsstability until 1965 and a slight downtrend thereafter. The slight deterioration in the performance of durablesmanufacturing since 1965 reflects, in part, substantial deterioration inthe gross profits share of manufacturers of primary metals. A downtrendin the share of manufacturers of motor vehicles from 1965 to 1980 alsocontributed. Since 1980, however, the share of this industry hasimproved, strengthening the durables share.

The slight improvement in the performance of nondurablesmanufacturing since 1973 reflects, in part, the improvement in the grossprofits shares of two large industries–food and kindred products andpetroleum and coal products. These industries began to record markedlyhigher shares in the 1970’s, when world prices of their outputsshifted upward. Employment and Hours: Two Years of Postrecession Growth LAbor input to production–as measured by employment and averageweekly hours–increased strongly over the 2 years following thethird-quarter 1982 trough in real GNP, but the growth was not among thestrongest in post-World War II recoveries. The following discussionhighlights the industries where the growth in employment and hours wasthe strongest and weakest in the 2 years following the 1981-82recession. It also compares growth during that period, 1982-84, withgrowth in the 2 years, 1975-77, following the 1973-75 recession. Theperiod following the trough in real GNP in the first quarter of 1975 isused for comparison because it followed a recession similar to the1981-82 recession in depth and duration. In addition, quarterlyemployment growth in 1975-77 was the median of the seven (post-World WarII) 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 annualrate, over the 2 years following the 1982-84 recession. The increasewas one-half percentage point larger than that over the 2 yearsfollowing the 1973-75 recession (chart 3). In both recovery periodsnonfarm employment regained prerecession peaks in most service-producingindustries, both public and private, but did not regain prerecessionpeaks in most goods-producing industries (table 2). Despite an initial decline, total nonfarm employment regained theprerecession peak by the fourth quarter of 1983 and expanded in thefirst three quarters of 1984. More than three-fourths of the 2-yearincrease in employment occurred in the second year–a larger proportionthan in any other post-World War II recovery. In 1975-77, slightly morethan one-half of the increase had occurred in the second year.

The increase in nonfarm employment was broadly based; employmentincreased in every major industry group–albeit slowly in some–exceptmining (table 3). Private service-producing industries. –A little over one-half ofnonfarm employment is in private service-producing industries, whichaccounted for 3.5 million, or about two-thirds, of the total 2-yearincrease. Relatively higher growth rates during the 1982-84postrecession period–an annual rate of 3-1/2 percent–continued along-term shift towards these jobs. The 1982-84 growth rate matchedthat in 1975-77 for these industries. Of the four privateservice-producing industry groups, employment in two–transportation andpublic utilities and wholesale and retail trade–more than regainedprerecession peaks over the 2-year period.

Employment in finance,insurance, and real estate and in services had increased over therecession and increased more rapidly in the recovery. Goods-producing industries. –A little over one-quarter of nonfarmemployment is in goods-producing industries, which increased 1.

5 millionand accounted for about one-third of the overall increase.Manufacturing employment grew at an annual rate of 3 percent, a slightlyhigher rate than that following the 1973-75 recession. Durablesemployment grew at twice the 1975-77 rate, and nondurables at abouttwo-thirds the 1975-77 rate. All of the growth in durables and most ofthe growth in nondurables occurred in the second year.

Employment in both durable and nondurable manufacturing did notregain prerecession peaks in 1982-84, just as it had not in 1975-77. Indurables, notable exceptions were electronics, motor vehicles, lumber and lumber products, and furniture; these industries regainedprerecession peaks in 1982-84, but had not in 1975-77. Growth in theelectronics industry–a “high technology” industry–reflectedstrong sales of microcomputers and telecommunications equipment. Arebound in sales of automobiles and trucks accounted for much of theemployment growth in motor vehicles, and a rebound in sales of new homesaccounted for much of the employment growth in lumber and lumberproducts and in furniture. In nondurables, the printing and publishingindustry and the rubber and miscellaneous plastics products industryboth regained prerecession peaks in 1982-84; in 1975-77, the former hadregained the prerecession peak, the latter had not. Construction employment grew sharply–0.5 million, or 6 percent atan annual rate–in 1982-84 and exceeded the prerecession peak.

Incontrast, construction employment had been unchanged in 1975-77. Thestrong 1982-84 growth, which was centered in special trades (e.g.

,carpenters, masons, plumbers, and electricians) and in residentialconstruction, reflected the sharp recovery in new home building. In mining, employment declined 0.1 million, or 3-1/2 percent at anannual rate–in sharp contrast to the 4-1/2-percent rate of increasefollowing the 1973-75 recession. Mining employment had increased overthe 1973-75 recession and had continued to increase in 1975-77. Much ofthe contrast in growth in the postrecession periods is tied to energymarkets–coal, natural gas, and crude oil. Government.

–Employment increases in government were sluggish incomparison with both private service-producing and goods-producingindustries; it increased only 0.2 million, or 1/2 percent at an annualrate, over the 2 years. Government accounted for about one-sixth oftotal nonfarm employment, but only 4 percent of the 2-yearincreae–reflecting efforts to hold down employment levels. Employmentdid regain the prerecession peak as it had in 1975-77. In contrast tothat period, 1982-84 growth was slow in both the Federal and the Stateand local components; in 1975-77, Federal Government employment haddeclined, and State and local government employment had increased morerapidly. Average weekly hours by industry Despite an initial decline in the fourth quarter of 1982, averageweekly hours for private nonfarm production and nonsupervisory workersincreased 0.5 hours in the 2 years following the third-quarter trough inreal GNP (chart 4).

The increase was strong in comparison with the0.1-hour increase in 1975-77. As with employment, private nonfarm hoursregained the prerecession peak–35.2 hours–in the fourth quarter of1983; hours reached 0.1 hours above that level in the first threequarters following the 1981-82 recession occurred in the first year;increases in the first year following the 1973-75 recession had morethan accounted for the 1975-77 increase. The increase in average weekly hours was broadly based; hoursincreased over the postrecession period in all but one major industrygroup; hours in services were unchanged.

The lagest increases were ingoods-producing industries, which had suffered the largest drops in therecession. In 1975-77, no industry group had regained its prerecessionpeak; in 1982-84, however, most regained their prerecession peaks. Private service-producing industries. –Average weekly hoursincreased slightly, on average, in service-producing industries in1982-84; hours had declined in 1982-84; hours had declined in 1975-77(table 4). Hours regained prerecession peaks in transportation andpublic utilities. Hours in finance, insurance, and real estate and inservices had increased over the recession.

Hours in the former continuedto increase in 1982-84, while those in the latter were unchanged. Hoursdid not regain prerecession peaks in wholesale and retail trade. Noneof the groups had regained prerecession peaks in 1975-77; in fact, hoursdeclined in all but transportation and public utilities. Goods-producing industries. –Average weekly hours increased evenmore strongly in manufacturing, construction, and mining in 1982-84 thanthey 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 probablyreflected employers’ use of increased hours rather than recalls ornew hires to boost production early in the recovery. The increase inconstruction continued an increase over the preceding recession.

Inmining, where the prerecession peak was not regained, most of theincrease in hours occurred in the second year. Hours had not regainedthe prerecession peak in any goods-producing group in 1975-77.Comparison of the overall (net) increase in construction hours in1982-84 with that in 1975-77 conceals sharp fluctuations in hours withineach period; early in the 1975-77 period, hours had regained theprerecession peak. Summary The recovery and expansion in employment and hours for the nonfarmsector 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. The1982-84 increase in total labor input to production was moreconcentrated in the second year. Most of the increase in hours occurredin the first year, but most of the increase in employment occurred inthe second.

In 1975-77, the increase in total labor input had been moreconcentrated in the first year due to a strong increase in hours. The recovery and expansion in employment was about the same as thatfollowing the 1973-75 recession, which was the median for the post-warperiod. Employment levels that had existed prior to the 1981-82recession were, in general, regained in service-producing industries butnot in goods-producing industries–about the same performance as in1975-77. The strongest increases were registered in construction andservices; employment declined in mining and increased only slowly intransportation and public utilities.

The recovery and expansion in average weekly hours was strongerthan that in 1975-77. Prerecession hours levels, which had not beenregained in the 1975-77 recovery, were regained in most industries in1982-84. The strongest increases were registered in the threegoods-producing industries–manufacturing, construction, and mining.Hours remained unchanged in services, after increasing over therecession, 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 theproposal for tax reform requested in the President’s State of theUnion message last January. The proposal is designed to make the taxsystem 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 ratestructure.

Before formulating the proposal, the Treasury completed a study offour options: a pure flat tax, a modified flat tax, a tax on incomeconsumed, and a general sales tax, including a value-added tax and aFederal retail sales tax. The study laid out the following majorobjectives: * Revenue neutrality. Reform would leave revenues essentiallyunchanged from what they would be under current law. * Economic neutrality. Reform would not unnecessarily distortchoices about how income is earned or how it is spent. It would notunduly favor leisure over work, or consumption over saving andinvestment. * Equity. Reform would not place significantly different taxburdens 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 withincomes below the poverty level would pay little or no tax. * An inflation-proof tax law. Reform would provide inflationadjustments–indexation–in the measurement of taxable income. The proposal–for which the modified flat tax is the basis–isessentially revenue neutral (see table 5), it does provide lower taxrates, and, according to the Treasury, it does not significantly changetax burdens across income classes. However, in designing a tax systemthat is simpler, the proposal may have been only partly successful.Some aspects of the proposal–such as the reduction in the number of taxrates and brackets and the repeal of many deductions–worked towardsimplification, but other aspects–such as the indexation of capitalgains, interest, inventories, and depreciation allowances–may haveworked toward complication.

According to the Treasury, the proposal is an integrated package;changes are mutually dependent and must occur together to avoidinequities, distortions, complex administrative rules, and increasedcompliance costs. Any change in the package means that either theproposed rate structure or another proposal must be redesigned in orderto meet the objectives mentioned above. The proposal would reduce the average individual’s incometaxes by 8-1/2 percent while raising corporation income taxes by 37percent. Under the proposal, 78 percent of individual taxpayers wouldexperience no tax change or a tax decrease, and 22 percent wouldexperience higher taxes. Of individuals with higher taxes, more thanone-half would have an increase of less than 1 percent of income.

Thegainers under the Treasury proposal are likely to be low-income familiesand middle-income individuals who have few deductions or credits.Losers are those who have many deductions and credits, or who live inStates with high income taxes. Among corporations, gainers are likelyto be in service and high-technology industries, while those incapital-intensive industries, petroleum companies, and banks would belosers.

Effective dates and transition rules The Treasury proposal recognizes the difficulties in implementingsuch a sweeping revision to the tax system. The proposed effectivedates and transition rules assume that legislation is introduced inearly 1985, enactment is July 1, 1985, and the general effective date isJanuary 1, 1986. The proposed transition rules can be divided into fourgeneral categories. 1.

Immediate implementation. In many cases, the Treasuryrecommends that the proposals be implemented immediately. Changes inthe zero bracket amount, personl exemptions, and a variety of creditsand deductions fall into this category; changes in individual andcorporate tax rates would be delayed 6 months to achieve the goal ofrevenue neutrality in the initial year after enactment. The specialpreferences for energy and natural resource industries would be repealedimmediately. To reduce the impact of immediate implementation, therepeal of the windfall profit tax would be accelerated by 3 years, withthe scheduled three-quarter phaseout beginning on January 1, 1988instead of January 1, 1991. 2. Immediate implementation with grandfathering. Grandfatheringprovisions–that is, provisions that exempt commitments entered intoprior to the legislation–are recommended to avoid reform-inducedwindfall gains and losses.

Permanent grandfathering is recommended, forexample, for existing commitments to accelerated cost recovery and theinvestment tax credit. Temporary grandfathering is recommended, forexample, for fringe benefits. For most, the new rules will apply ascontracts expire or, at the latest, January 1, 1989, but in the case ofthe two largest fringe benefits–employer-provided health care and lifeinsurance–the new rules will be fully effective January 1, 1990. Inaddition, for those cases where tax-sheltered income is brought into thetax base, it is recommended that the increase in income tax be spreadevenly over a fixed number of years for tax purposes. 3. Phased-in implementation. The Treasury recommends phased-inimplementation for dividend relief, elimination of the deduction forState and local taxes, the limit on charitable contributions,elimination of the graduated corporate tax rates, the limit on interestdeductions, and elimination of the business deductions for entertainmentexpenses and for meal and travel costs in excess of a limit.

4. Delayed implementation. For various reasons, the Treasuryrecommends delayed implementation for many of the changes in thetaxation of estates, certain military cash compensation, andunemployment and workers’ compensation (January 1, 1987); interestindexing (January 1, 1988); indexing capital gains on nondepreciableassets (January 1, 1989); and repeal of the individual and corporateminimum taxes (January 1, 1990).

The remainder of this article will discuss the major features ofthe Treasury proposals (see tables 6 and 7). The effect for the year1990 is referred to in order to encompass the full implementation of theproposals. Individual income taxes Individual income taxes are reduced $37.7 billion in 1990 by theTreasury proposal, the net result of $161.7 billion in tax reductionsand $123.8 billion in tax increases. Changes in the tax rate structure(including the effect of indexation of rates, exemptions, and the zerobracket amount) account for the bulk of the proposed reductions. Thecurrent 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 forproposed rates and brackets).

The indexation of interest income andexpense, capital gains, and the earned income tax credit accounts for$19.2 billion of the reductions. The proposal to index interestintroduces some complications into the tax code. Mortgage interest onan individual’s primary residence is fully deductible. Otherinterest expense is then netted against interest income to derive netinterest income (or expense). If the taxpayer has net interest income,a portion–the fractional interest exclusion–of this net income wouldbe excluded in determining adjusted gross income (AGI); the remainderwould be included in AGI. If the taxpayer has net interest expense, thefirst $5,000 would be deductible, and the excess of $5,000 would besubject to the fractional exclusion rate in determining the amont thatwould be deductible. Other provisions of the interest indexationproposal place limits on the total amount of net interest expense thatcan be deducted in 1 year.

The fractional exclusion rate, announcedeach year, is to be set to reflect the relationship between the currentrate of inflation–measured by the percentage increase in the ConsumerPrice Index over the previous 12 months–and the longrun real interestrate. The desired relationship is approximated by dividing theinflation rate by the nominal interest rate. For example, assuming aninflation rate of 4 percent and a nominal interest of 10 percent, theexclusion rate would be 40 percent. Thus, 40 percent of nominal netinterest income will not be taxed.

The repeal and limiting of deductions account for the largestshare–$50.3 billion–of the proposed increases and include: (1) repealof the deduction for State and local government taxes, and (2) limitingthe deduction for charitable contributions to those above 2 percent ofAGI. The repeal and limiting of exclusions account for $20.2 billion ofthe increases and include taxing: (1) employer-paid health insurancepremiums in excess of $70 per month for a single person and $175 permonth for a family, and (2) workers’ compensation, but with aspecial credit for the elderly and disabled. The proposal to repeal theaccelerated cost recovery system (ACRS) for depreciation and replace itwith an indexed economic depreciation–the real cost recoverysystem–increases taxes $12.9 billion. The proposal to provide relief from double taxation of dividends byallowing a 50-percent dividend-paid deduction to corporations increasesindividual income taxes $7.4 billion (based on the assumption that moredividends will be paid by corporations).

Corporation income taxes Corporation income taxes are increased $44.7 billion in 1990 by theTreasury proposal, the net result of $109.5 billion in tax reductionsand $154.4 billion in tax increases. Changing the rate structure from agraduated tax rate, up to 46 percent, to a flat rate of 33 percentaccounts for the bulk of the reductions. The major increase occurs fromrepeal of ACRS and replacing it with indexed economic depreciation.

Repeal of the investment tax credit and applying uniform rules formultiperiod 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 thegift tax base to that of the estate tax. Excise taxes are reduced $3.

1billion in 1990 by the proposal to accelerate the phase-out of thewindfall profit tax. Third-quarter NIPA revisions The 75-day revisions of the national income and product accountsestimates for the third quarter of 1984 are shown in Table 8.


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