II. GENERAL REASONS FOR THE BILL

Current tax law reflects policy decisions made during the past 10 years as the Federal Government tried to help the economy adjust to worldwide events which significantly affected the United States. These events often produced contradictory economic conditions, such as simultaneous high unemployment and inflation, which severely limited the choice available to policymakers. Throughout the period, the economy also was responding to long-term demographic, geographic, and resource factors.

Continuation of some of the pressures from the recent past and the waning of others mandate periodic review and change in the Internal Revenue Code. Both inflation and real economic growth tend to increase the percentage of income paid in Federal taxes, and unless government spending also is rising as a percent of total income, periodic tax reductions are needed. Tax incentives must be reexamined to see if they are still appropriate in the light of changing conditions, and relative tax burdens of particular types of taxpayers must be reconsidered in terms of their ability to pay tax and what is a fair distribution among all taxpayers of the total tax burden. This bill is part of this periodic review.

Inflation and economic growth

Federal taxes generally have been reduced early in the recovery from a recession in order to stimulate a vigorous recovery. The reductions were intended to offset some of the decline in after-tax income caused by the recession. When Congress reduced taxes substantially in 1975, the reduction principally was made as a general, or per capita, tax credit that was enacted initially for a short period of time to stimulate the economy, hopefully to expire after the economic recovery was well under way.

The slow pace of the economic recovery, as reflected in the unemployment rate and the rate of capacity utilization, resulted in extensions of the general tax credit in 1976 and 1977. The additional tax burden resulting from the interaction of inflation and the progressive individual income tax structure and the increasing tax payments required to maintain the integrity of the social security system make it necessary this year to make permanent the amounts of the temporary tax cuts and to provide additional permanent income tax relief.

Currently, economic forecasts made by government and private economists generally are in agreement that the economic recovery cannot be sustained at its present rate without new tax cuts. All of the major sectors of the economy-consumption, business investment and government-continue to show regular increases in the real value of activity, i.e., adjusted for inflation, but the rates of increase are getting smaller. Gross national product increased at an annual rate of 7.4 percent in the second quarter of 1978, but when the first quarter decrease and the second quarter increase are averaged, the result is an increase (9)

in the first half of 1978 at an annual rate of 3.6 percent, compared to 5.7 percent in 1976 and 4.9 percent in 1977. The current growth rate is not sufficient to sustain the economic recovery while also leading to additional decreases in the rate of unemployment. Most of the economic forecasters who anticipated this trend believe that the rate of economic growth will continue to decline through 1979, unless a new tax cut is enacted.

The tax relief, however, must not be so large that it will overstimulate the economy and generate inflationary pressures. The need to avoid overstimulation is shown by some of the conflicting tendencies currently evident. The rate of unemployment has fallen to 6.2 percent, compared to almost 9 percent in 1975. The index of industrial production also shows continuing increases. In contrast, the productivity of the labor force, measured as output per manhour of employment, remained unchanged in the second quarter of this year. The index of capacity utilization is now 84 percent, only 4 points below its 1973 peak, and close to that critical level above which further increases in output will lead to the use of relatively inefficient facilities which can operate only at higher costs per unit of output.

As a result, the committee reported a bill which provides a general net reduction of tax liabilities of $16 billion in 1979. The bill will reduce tax liabilities of individuals by $10 billion, of business by $4 billion, and of capital gains for both individuals and business by $2 billion. In ;udgetary terms, receipts will be reduced by $9.3 billion in fiscal year 1979. The committee did not agree to larger tax reductions because it was aware that such action could overstimulate the economy and create additional inflationary pressures.

The committee acted to translate the temporary individual income tax credits into a permanent tax reduction in a form consistent with the permanent tax structure and to provide enough additional modifications of the structure to yield a general net income tax reduction for individuals of about $10 billion.

As with individual income taxes, corporate tax rates were reduced temporarily in 1975 as part of the anti-recession tax relief program. This tax cut consisted of an increase to $50,000 in the amount of corporate taxable income exempt from the corporate surtax rate and a reduction in the normal tax rate that applied to the income exempt from the surtax. When this was enacted, the committee believed that small corporations needed the greatest amount of relief because they were most vulnerable to financial stringency during a recession. Since 1975, continued inflation has reduced the value of the surtax exemptions, and the committee decided to make the cuts permanent. Furthermore, the increase from the tax rate (22 percent) in the second level of the normal tax brackets to the combined normal plus surtax corporate rate of 48 percent. The committee believes that this big jump in corporate rates is very detrimental to the incentives and growth prospects of small business corporations. It is more appropriate from an economic as well as a tax policy standpoint to provide more graduation in the corporate income tax rate structure for a smoother transition to the top rate. The committee believes that its corporate reductions, while providing a strong economic stimulus for the business sector in general. focuses more specifically on the needs of small

businesses to encourage their development and growth which is so vital to our private enterprise system.

A major concern of the committee is the inadequate level of investment. Personal consumption expenditures, even after adjustments for inflation, are substantially higher than the pre-recession levels. Spending for nonresidential fixed investment, that is, for plant and equipment, only recently has exceeded the pre-recession levels in real terms. This measure is another indicator of the insufficient growth in productive capacity during the recovery and the threat that the inadequate capacity could be a source of inflationary pressure in the future. For this reason, the committee agreed to a significant reduction in both the corporate income tax rates (about $5 billion) and the capital gains tax rates (about $2 billion).

In the Tax Reduction Act of 1975, the investment tax credit was increased to 10 percent in order to reduce the cost of new investment and to stimulate increased spending for new investment. The new equipment purchased as a result of the stimulus would speed the recovery, increase productive capacity, and improve the productivity of the economy as new, generally more efficient, equipment is put into production. These goals of increased capacity and productivity are even more significant at this time, and the bill makes permanent the temporary increase in the investment credit to 10 percent. In addition, the limited allowance for used equipment also is made permanent as an added incentive to small business. The bill also expands the investment credit in several other ways in order to increase investment.

Economic incentives

Several of the provisions of the bill are designed to improve the effect of the tax system on economic incentives. Changes in the investment credit are examples of attempts to affect incentives. The committee also believed that other changes in the way business income is taxed were desirable. The reduction in capital gains taxes will encourage investment and reduce the current tendency to defer realization of capital gains, which restricts reinvestment of part of the gains in new business activities. The targeted jobs credit will encourage hiring individuals who have difficulty in finding employment even when the economy is expanding.

Retained income after taxes is the source of investable funds which firms prefer. The investment credit, by reducing the cost of equipment, makes a major contribution to these funds. Under present law, however, in years when a firm has a large increase in its investment and consequently in its investment credit, or a large decline in its taxable income, or a combination of the two, it is unable to use all of its credits to offset tax liability. This situation deprives the firm of all the benefits it anticipates from the credit, and it may even incur some additional costs because it may have to borrow funds outside. The committee, as a result, has phased in over a 4-year period an increase in the limit on the amount of tax liability which may be offset by the credit.

The extension of the investment credit to expenditures for the rehabilitation of existing buildings will encourage business investment that also will be valuable in revitalizing existing industrial areas. Currently, about 5 percent of fixed investment includes equipment necessary to conform with air and water pollution control require

ments. Except for certain specific cases, the pollution control equipment eligible for rapid amortization does not directly improve productive efficiency or increase capacity to produce. As a result, an increase in the investment credit has been included for anti-pollution equipment when the credit is used in conjunction with the special 60-month amortization incentive for installation of pollution control equipment. The committee believes that this action will reduce the cost a company incurs when complying with the regulations and free some of its internally generated funds for investment in equipment which increases efficiency and capacity.

The committee decided that revisions are necessary in two other currently available incentives which also are directed at specific forms of activity and are provided in addition to more generalized forms of incentives. One of these two amendments modifies the present law general jobs credit to limit the direct tax incentive to hire additional employees to the employment of individuals from the groups in the labor force who are experiencing high rates of unemployment. The second of these modifications will assist the financing of investment in new plant and equipment of relatively modest size. The provision increases one of the limits on the issue of tax-exempt industrial development bonds by increasing the total amount of such obligations that may be issued and the total investment that may be made in a project during a 6-year period from $5 million to $10 million.

Tax incentives and equity

A perpetual dilemma facing tax policymakers is how to raise the funds needed to finance government expenditures in a fair and equitable manner while allowing those who demonstrate economic initiative to feel they have retained a proper share of the rewards after payment of taxes. For those who receive their rewards in earned income, primarily wages and salaries the 50-percent maximum tax on such earnings was enacted to ensure an adequate after-tax return. This concept of income essentially involves a straight forward calculation. More difficult conceptual problems are associated with the proper measurement of income from capital.

Two problems in measuring the income from capital are the misuse of accounting rules through tax shelter devices and the effect of inflation on the value of capital and therefore on capital gains.

It has been possible in the past to use offsets to income that arise from other provisions in the Internal Revenue Code to shelter current income from taxation and to convert the untaxed income into capital appreciation which ultimately is taxed after sale at the lower capital gains tax rate. The tax provisions relied on for the shelters usually had been enacted to achieve entirely different results. Beginning in 1969, Congress has attempted to deal with these tax shelters in several ways. One of them involves efforts to circumscribe the distortion of tax provisions, which may be legitimate incentives for certain activities, into tax shelter devices by limiting tax losses to the amount for which the taxpayer is at risk in the enterprise. The bill contains provisions to extend the at-risk rules to several types of tax shelters not yet covered and to make the rules more effective where they apply.

The bill also deals with the effects of inflation in distorting the measurement of capital gains. When an asset's price increases at

the same rate as the rate of inflation, there has been no increase in the asset's real value, but under present law the taxpayer is taxed on the nominal increase in value on disposition of the asset in a taxable transaction. The committee decided to exempt from the capital gains tax those gains which result from inflation occurring after 1979. In addition, the first $100,000 of capital gain on the sale of a principal residence also may be exempted from capital gains tax.

Two other modifications were made in taxes which relate to capital gains. The offset to the 50-percent maximum tax on earned income attributable to preference income will not apply to the excluded half of capital gains. In addition, the excluded half of capital gains no longer will be taxed under the present minimum tax on preference income. To assure that the present tax on the included half of capital gains cannot be avoided through tax shelters, resulting in no tax on capital gains, the committee provided an alternative minimum tax on the excluded half of capital gains income. Finally, to insure that the objective of increasing incentives to invest does not increase inequity relative to other income, the 25-percent limit on the taxation of the first $50,000 of capital gains income will be repealed.

Base broadening and efficiency adjustments

The committee reviewed several of the existing deductions or exclusions and concluded that they no longer were necessary or that they needed modification.

The policy of limiting the number of State and local government taxes which may be deducted, which began in 1964, was extended by repealing the itemized deduction for State and local gasoline and motor fuel taxes. These taxes are properly viewed as user charges which pay for the construction and maintenance of highways and streets. Allowing the deduction of these taxes also is contrary to present national energy policy. In addition, computation of the tax paid would be difficult if the deduction were limited to the amount actually paid, and the deductions presently taken are estimated from a table which at best provides an approximate measure of the State and local gasoline taxes paid.

The bill repeals the alternative of a deduction for political contributions because the committee believes that the goal of encouraging greater political participation can be served more simply and equitably with the existing tax credit for political contributions.

Unemployment compensation has not been included in taxable income because this assistance is needed to offset the sudden loss of income and help bridge the adjustment to lower income or the period while new employment is being located. With increased participation in the labor force resulting in families with two or more income earners becoming more typical, the committee believed that when family income from other sources rose above specified levels, unemployment compensation should be included in taxable income. Accordingly, the exemption for unemployment compensation will be phased out when adjusted gross income (including unemployment compensation and disability income) rises above $20,000 for a single taxpayer return and $25,000 for a joint return.

As circumstances change in the future, the committee intends to review the other deductions, exclusions and credits in present tax law to see which ones should be modified or eliminated.

III-Budget effects of the Bill (pages 15-26) omitted.