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Budget and tax haggling will keep investors on the edge of their seats

Savvy investors should take a ringside seat for the fiscal brawl brewing in Washington. After a bitter campaign in which President Clinton accused Republicans of trying to trash health care for the elderly, while the GOP hammered Democrats for their alleged ''tax and spend'' habits, both sides now must try to work out a compromise budget. They may get there--but not before months of ugly squabbling and finger-pointing.

If an agreement is reached, which seems likely, it would produce a balanced budget by 2002--at least on paper. A fiscal deal would also include a package of modest tax cuts--including a reduction in capital-gains levies--as well as changes in Medicare. And an agreement could pave the way for new initiatives to slash federal red tape and rewrite some key environmental laws. At the same time, two vital long-term issues--overhauling Social Security and the federal income tax code--will be topics of growing debate.

LOTS OF NOISE. The broad framework for such a pact is already clear: a five-year freeze on most domestic spending, small increases in military outlays, $125 billion to $150 billion in budget savings from Medicare, and a tax cut of roughly $100 billion. At the GOP's insistence, the package will include a constitutional amendment that requires a balanced budget. Clinton and Congress know they have to move quickly before lawmakers focus on the 1998 elections. ''We have about 18 months,'' says one top Administration official. ''After that, we can forget it until after 2000.''

While there is sure to be painful negotiating, Clinton badly wants an agreement, both for the history books and to get the vexing issue behind him. So do most Hill Republicans, whose days as revolutionaries are over for now. Clinton and the GOP were a hairbreadth away from a deal last New Year's Eve. And though 1996 campaign politics blew it, the outlines that emerged from those talks will set the stage for 1997's efforts. ''We have a model,'' says Senate Majority Leader Trent Lott (R-Miss.). ''I feel we can get results.''

That is certainly true when it comes to taxes. Both Clinton and Capitol Hill Republicans favor a tax credit for families with children, broader use of individual retirement accounts, a bigger exemption for estate taxes, and their own versions of a capital-gains tax cut. The trick will be melding the proposals without breaking the fiscal bank. ''I think we are going to be able to find some common ground,'' predicts House Ways & Means Committee Chairman Bill Archer (R.-Tex.).

In the end, the two sides will probably build a $100 billion, five-year tax cut around the child credit. The credit will be small--perhaps $300 instead of the $500 that was promised during the campaign. And it will be limited to middle- and working-class families. The GOP will probably accept some version of Clinton's plan to give new tax breaks for college tuition. And the President may accept up to a 50% cut in capital-gains taxes, but he will fight to target it in some way--either to startup businesses or to middle-class investors.

Still, the total tax cut will be so small--no more than $25 billion next year--that its impact on the nation's $7.5 trillion economy will be hardly noticeable. Broad-based tax restructuring would affect the economy in a much bigger way. But the debate over shifting to a flat tax or a national sales tax will go nowhere next year. Congressional GOP leaders disagree among themselves over the shape of reform, and Treasury Secretary Robert E. Rubin is flatly opposed.

Even without a budget deal, the deficit--just $107 billion in 1996--should remain in check for the next few years, assuming there's no economic downturn or costly military crisis. That's because Budget Director Franklin D. Raines will keep a lid on most domestic spending whether an accord is struck or not, in part thanks to pressure from the Republican-controlled Congress. But as baby boomers age, entitlements such as Medicare and Social Security will continue to balloon, and that will cause renewed deficit problems after 2000.

As a result, the debate over Social Security will generate lots of noise in '97. Possible reforms range from gradually raising the retirement age to allowing some funds to be invested in equity markets to privatizing the entire system. The most radical reforms would give workers big tax breaks for savings but make them financially responsible for their own retirement. Social Security as it now exists would remain only as a safety net for the poorest workers. Even modest changes will be enormously controversial, though, and that means Social Security reform won't be nailed down for years.

A QUIET FED. Investors will see faster action on a broad range of proposals intended to trim government red tape for business. Federal regulators will give banks, insurers, and brokerages new opportunities to compete with one another; Congress may open the way for new competition among electric utilities; and some environmental laws may be rewritten to ease business compliance in meeting antipollution standards.

While most policymakers will be going full tilt in 1997, the Federal Reserve will likely remain on the sidelines--as long as the economy keeps chugging along and inflation remains in check. If labor markets tighten much more, if the financial markets become too volatile, or if economic growth spurts upward once again, the central bank could raise interest rates. But for now, ''we're assuming the Fed is on hold,'' says Joel Prakken, chairman of consultant Macroeconomic Advisers.

That won't be true for the rest of Washington. After the fiasco of 1995, no capital denizen is prepared to guarantee a deal on the budget and taxes. But if Clinton and the GOP can agree on a balanced budget and investment-oriented tax cuts, and make a start on reforming Medicare and Social Security, the pols will have done their bit to make the markets happy indeed.

By Howard Gleckman, with Dean Foust, in Washington


TABLE: What to Expect from Washington on Key Issues in 1997

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Updated June 13, 1997 by bwwebmaster
Copyright 1996, Bloomberg L.P.
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