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The Risk Clinton Faces


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THE RISK CLINTON FACES

He had to ditch his call for a middle-class tax cut and his campaign vow to fight higher gasoline taxes. His plan to supercharge the economy through public investment was drastically scaled back. And his dream of universal health-care coverage had to be deferred. But after a bruising six-month struggle with Congress, it looks as if Bill Clinton will emerge with a $496 billion deficit-cutting plan that he hopes will cement his claim to be "a different kind of Democrat."

Who would have guessed it would turn out this way? During his run for the White House, Clinton downplayed budget-cutting. Instead, he talked of an activist government that would spur economic growth. Listen to the deficit hawk now, in his Aug. 3 address to the nation: "Without deficit reduction, we cannot have sustained economic growth." And though he was twisting arms for support right up to a scheduled Aug. 6 Senate showdown to nail down wavering votes, as BUSINESS WEEK went to press the President appeared to have the votes to get his package passed.

Clinton, however, is running a major risk: As necessary as it may be, his deficit-cutting could become a major drag on the economy, perhaps as early as next year. The danger is that low interest rates won't be enough to offset the major economic drag from cutting the deficit through higher taxes and lower spending.

The Clintonites think they have that covered. They argue that a 1.2 percentage-point drop in long-term interest rates since the President started talking tough about the deficit has already helped spur the economy. And Clinton thinks that enactment of his plan could knock rates down a bit more (page 24). That means lower borrowing costs for business and cheaper capital for new investment. Treasury Secretary Lloyd Bentsen argues that each percentage-point drop in rates equals $100 billion in economic stimulus over three years.

Indeed, Clinton's accomplishment is real. The Administration estimates its plan would trim the deficit from around 5% of gross domestic product now to around 3%. "A lot of people have been disappointed by how small the basic package is, but when you look at the incredible difficulties and bickering Clinton faced in just passing this program, you begin to realize that anything more ambitious was probably impossible," says Brookings Institution economist Barry P. Bosworth.

Yet the Clinton program clearly has inadequacies. Even with its savings, divided roughly between tax increases and spending cuts, the annual red ink will add $1 trillion to the national debt over the next four years. For 1998, the federal deficit is projected at $170 billion, down from $300 billion without the package. After that, the Administration admits, the deficit begins to rise again as entitlement spending and debt-service costs outstrip revenues. Clinton is counting on savings generated by health-care reform (page 26) to be his next line of defense against a rising deficit at the end of the decade. But most economists--and even some stalwart Democrats such as New Jersey Senator Bill Bradley (page 25)--agree that it's only a matter of time before another major deficit-reduction effort will be needed.

Clinton had greater things in mind when he started out. In his proposal of last February, he countered the drag of budget cuts with a $30 billion stimulus program, including $16 billion in spending and a temporary investment tax credit. But the ITC found sparse support on Capitol Hill, and a GOP filibuster killed the new spending in the Senate.

Without that boost, the economy faces a rough road. Growth has been far below expectations, running at a 1.2% annual rate in the first half. The Administration is preparing to lower its overly optimistic estimates for growth to less than 2.5% for the year. That rate probably means job creation will fall short of the number of people entering the labor market. Add a five-year, $127 billion cut in the Pentagon's spending, throw in a tax increase, and the austerity plan may begin to bite. Long-term rates may even inch down further if the bill passes, easing the pain a bit. Still, "Clinton is raising the tax component of the cost of capital and putting the economy on a lower growth track," insists supply-side economist Stephen J. Entin of the Institute for Research on the Economics of Taxation.

The biggest economic risk comes from provisions that haven't changed since the initial draft: the hefty tax increases on high-income individuals. Clinton's budget cuts and the gasoline tax will kick in over coming months and years. But the increase in taxes on the richest Americans is retroactive to Jan. 1, 1993. Although the tax hike hits just 1.2% of individuals and 4.2% of small businesses, this sliver of the economic pie is responsible for much of the nation's savings, investment, and job creation. "A relatively few small businesses may be affected, but they tend to be the ones employing the most people and with the potential to hire more as they grow," says Gillian Spooner, a partner at KPMG Peat Marwick.

Recognizing this, the White House acted on Aug. 4 to soften the blow: Payments for the 1993 tax increase can be spread out over 24 months, with only the first third of the extra income taxes due next April. The next two installments would be due the two subsequent Aprils. For example, according to a Price Waterhouse study, a couple with a gross income of $300,000 would owe $6,424 more in taxes in 1993 as a result of the Clinton budget package, for a total federal tax liability of $79,784. But $4,283 of that tax could be deferred until the two following years without penalty.

Democrats, who've been waiting 12 years to roll back Reaganomics, obviously feel they've found the formula to do it. Individuals with taxable incomes over $115,000 and couples making over $140,000 will see their marginal tax rate jump from 31% to 36%. Taxpayers pulling down more than $250,000 a year will be hit with a 10% surtax. In addition, the $135,000 cap on the 2.9% Medicare payroll tax is eliminated. Combining all the new levies, the maximum federal marginal rate will rise to an effective 44% from around 33%.

Targeting the rich allowed the White House to declare that 80% of all new taxes would be shouldered by those making more than $200,000. And there's help for those at the bottom of the ladder--a $19.1 billion increase in the earned-income tax credit for the working poor. Meanwhile, the inadequacies. Even with its savings, divided roughly between tax increases and spending cuts, the annual red ink will add $1 trillion to the national debt over the next four years. For 1998, the federal deficit is projected at $170 billion, down from $300 billion without the package. After that, the Administration admits, the deficit begins to rise again as entitlement spending and debt-service costs outstrip revenues. Clinton is counting on savings generated by health-care reform (page 26) to be his next line of defense against a rising deficit at the end of the decade. But most economists--and even some stalwart Democrats such as New Jersey Senator Bill Bradley (page 25)--agree that it's only a matter of time before another major deficit-reduction effort will be needed.

Clinton had greater things in mind when he started out. In his proposal of last February, he countered the drag of budget cuts with a $30 billion stimulus program, including $16 billion in spending and a temporary investment tax credit. But the ITC found sparse support on Capitol Hill, and a GOP filibuster killed the new spending in the Senate.

Without that boost, the economy faces a rough road. Growth has been far below expectations, running at a 1.2% annual rate in the first half. The Administration is preparing to lower its overly optimistic estimates for growth to less than 2.5% for the year. That rate probably means job creation will fall short of the number of people entering the labor market. Add a five-year, $127 billion cut in the Pentagon's spending, throw in a tax increase, and the austerity plan may begin to bite. Long-term rates may even inch down further if the bill passes, easing the pain a bit. Still, "Clinton is raising the tax component of the cost of capital and putting the economy on a lower growth track," insists supply-side economist Stephen J. Entin of the Institute for Research on the Economics of Taxation.

The biggest economic risk comes from provisions that haven't changed since the initial draft: the hefty tax increases on high-income individuals. Clinton's budget cuts and the gasoline tax will kick in over coming months and years. But the increase in taxes on the richest Americans is retroactive to Jan. 1, 1993. Although the tax hike hits just 1.2% of individuals and 4.2% of small businesses, this sliver of the economic pie is responsible for much of the nation's savings, investment, and job creation. "A relatively few small businesses may be affected, but they tend to be the ones employing the most people and with the potential to hire more as they grow," says Gillian Spooner, a partner at KPMG Peat Marwick.

Recognizing this, the White House acted on Aug. 4 to soften the blow: Payments for the 1993 tax increase can be spread out over 24 months, with only the first third of the extra income taxes due next April. The next two installments would be due the two subsequent Aprils. For example, according to a Price Waterhouse study, a couple with a gross income of $300,000 would owe $6,424 more in taxes in 1993 as a result of the Clinton budget package, for a total federal tax liability of $79,784. But $4,283 of that tax could be deferred until the two following years without penalty.

Democrats, who've been waiting 12 years to roll back Reaganomics, obviously feel they've found the formula to do it. Individuals with taxable incomes over $115,000 and couples making over $140,000 will see their marginal tax rate jump from 31% to 36%. Taxpayers pulling down more than $250,000 a year will be hit with a 10% surtax. In addition, the $135,000 cap on the 2.9% Medicare payroll tax is eliminated. Combining all the new levies, the maximum federal marginal rate will rise to an effective 44% from around 33%.

Targeting the rich allowed the White House to declare that 80% of all new taxes would be shouldered by those making more than $200,000. And there's help for those at the bottom of the ladder--a $19.1 billion increase in the earned-income tax credit for the working poor. Meanwhile, the middle class largely escaped new taxes. Only a 4.3 -per-gallon rise in the gasoline tax and a hike in the tax rate on upper-income Social Security recipients will affect the middle class.

Of course, the news is not all grim for business or the wealthy. Under the compromise plan, corporations will see their tax rates rise by just one percentage point on earnings over $10 million, half the increase sought by the Administration. Congress eased proposed tax hikes on multinational corporations. Some real estate professionals will be able to write off "passive investment" losses against regular income, just as they could before the 1986 tax reform.

There's little unbridled enthusiasm for Clinton's plan. "It's not close to what we really need in terms of deficit reduction in the long run," allows John P. White, of Harvard's John F. Kennedy School of Government. And it may be a while before the economy starts percolating. Merely avoiding disaster wasn't what Clinton promised during his campaign or what he expected when he revealed his plan last winter. But now he and the nation at least have a start on that task.Paul Magnusson in Washington


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