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The Battle Of The Potomac


Cover Story: Where To Invest '96: The Framework: Washington Outlook

THE BATTLE OF THE POTOMAC

For investors in 1996, the wheeling and dealing on Wall Street could well pale beside the action on Pennsylvania Avenue. Take a look: There will be a titanic struggle for budget supremacy between President Clinton and congressional Republicans, a heated debate over the future of the income tax, and new battles over federal spending. Add to that a further restructuring of the NASDAQ market, unfinished squabbles over the scope of federal regulation, and an interest-rate cut or two by a Federal Reserve that's getting more confident that it's winning the battle against inflation. And for an end-of-year finale, investors can look forward to the 1996 Presidential and congressional elections.

The betting is that 1995's fiscal wars will end with a deal to balance the budget by 2002. The bitter debate over fiscal policy, though, will eventually be overshadowed by the year's major issue--nothing less than the future shape of the federal government. That debate will not only dominate the 1996 election but also affect investors' portfolios.

RICH AND POOR. Republicans will press their case that prosperity depends on shrinking government and regulations while cutting taxes. The Democrats will insist that Washington should still play a key role in providing social services, aiding education, training workers, and protecting the environment. Clinton will claim credit for an economy that's growing moderately with low inflation and will urge a national effort to narrow the gap between rich and poor. The debate won't be just rhetoric--it will affect the legislative agenda. Even with a balanced-budget agreement, which would establish only a framework for eliminating red ink, Congress must still make the actual cuts in programs in '96 and each successive year to keep the deficit moving toward zero.

If a budget compromise is engineered by White House Chief of Staff Leon E. Panetta and the Republican Congress, it should produce immediate dividends in the form of lower short-term interest rates. True, the Fed resents the popular perception that it would cut rates as a quid pro quo for a balanced-budget plan. "I very much dislike that thinking," says Fed Governor Janet L. Yellen. Even so, Chairman Alan Greenspan has promised for years that he would ease monetary policy to offset the economic drag of slower federal spending. If Washington delivers on deficit reduction, Greenspan & Co. can be counted on to meet their end of the bargain.

THIRD TERM. Monetary mandarins at the Fed hardly need an excuse to cut rates. Although the central bank doesn't expect a recession, it sees an economy starting to sag under the weight of high consumer debt and big factory inventories. With growth expected to slow in '96, the Fed believes it can cut rates without losing ground in the hard-fought battle to keep inflation at less than 3%. "I'm prepared to predict inflation is not going higher," insists Fed Vice-Chairman Alan S. Blinder.

As a result, the Fed is expected to cut the 5.75% federal funds rate (the key rate it sets for overnight loans between banks) by half a percentage point before spring. By then, Clinton will likely have rewarded Greenspan's stewardship of the central bank by nominating him to a third term as chief--welcome news to the markets. After that, Greenspan will probably move the Fed to the sidelines to keep the central bank out of next fall's election-year crossfire.

If news on the interest-rate front is good for investors, prospects on taxes are decidedly mixed. In the short run, a capital-gains tax cut still looks like a good bet as part of any budget agreement. The same can't be said for many other goodies included in earlier versions of the GOP budget. An effort by House Ways & Means Committee Chairman Bill Archer (R-Tex.) to index capital gains to inflation has been put off until the year 2000 and could well be dropped. A broad expansion of individual retirement accounts will probably be scaled back, as will GOP efforts to raise gradually--from $600,000 to $750,000--the amount that estates can transfer to heirs free of federal tax.

Even the long-awaited cut in capital gains may disappoint some investors. The GOP plan, which would reduce the top rate from 28% to 19.8%, was supposed to apply to assets sold anytime in 1995. But the prospect of a retroactive date has been dimming. That means market players may be better off waiting until '96 to take profits--if they're willing to risk a market correction that could eat up some of their gains.

One group of investors should act now. The GOP plan would treat investment losses less generously than current law: It would require $2 of losses to offset $1 of ordinary income, twice the current ratio. "Go ahead and take those losses," says Tom Jackson, a tax partner at Deloitte & Touche.

These proposals are mere tinkering, compared with some radical reforms the GOP has in mind. Archer says 1996 will "mark the beginning of the end of the current income tax code." In January, a GOP-chartered commission headed by former Housing & Urban Development Secretary Jack F. Kemp is scheduled to release recommendations for a simpler system. Later in the year, the House Ways & Means and Senate Finance committees plan to hold hearings on overhauling the tax code. "The flat tax will cause a lot of excitement," says Thomas P. Ochsenschlager, tax partner at accountants Grant Thornton.

Among the plans on the table: versions of a national sales tax offered by Archer and Senator Richard Lugar (Ind.), who is a Republican long shot for the White House, and a flat-rate income tax proposed by House Majority Leader Richard Armey (Tex.) and GOP Presidential hopeful Steve Forbes. Clinton, who has yet to be heard from on the tax reform debate, is likely to counter with a plan to simplify the existing code. But he will resist calls for a complete rewrite of tax law.

FEE BASIS. How will the tax debate turn out? Don't be surprised to see a Tax Reform Act of 1998 that looks a lot like the landmark tax legislation of 1986, which kept the income-tax system but lowered rates and trimmed many deductions.

More big news for investors will come from the Securities & Exchange Commission. The agency will turn up the pressure on firms to overhaul the way they pay brokers--moving from a system driven by sales commissions to one incorporating advisory fees. The SEC will also raise the stakes in its current review of the NASDAQ stock market. NASDAQ's recent proposal to recruit more outsiders for its board of directors and create an independent regulatory arm won't be enough to satisfy SEC Chairman Arthur Levitt Jr. New SEC initiatives would likely narrow spreads in the over-the-counter market to make the differences between dealers' buying and selling prices comparable to those on other exchanges.

In one respect, '96 should be easier for investors than '95. Instead of waiting until the end of the year to figure out how Congress may affect their portfolios, market players will probably know earlier in 1996 what's in store for them. That's because legislative action starts to grind to a halt as the November election approaches. But the pause will be only temporary. The great ideological struggle that began with the GOP's taking control of Congress in 1995 will play itself out for years to come.

Capital Issues

SPENDING: Reaching an agreement to balance the budget is the easy part. In '96, the Democrats and Republicans will have to begin really slashing spending--to turn the promise of deficit-reduction into reality.

TAXES: Over the next few weeks, Congress and the President will reach a deal on a modest tax cut. In 1996, the focus will shift to a long-term overhaul of the federal tax code, as Republicans lay the groundwork for serious reforms in 1998, should they regain the White House.

FEDERAL RESERVE: With the economy sluggish, look for the central bank to cut interest rates, especially if Washington agrees on a balanced budget. Chairman Alan Greenspan will then move the Fed to the sidelines for the rest of '96--out of election-year political crossfire.

FINANCE: The SEC will continue to push for big changes in the NASDAQ market, in an effort to narrow the spreads for small investors in over-the-counter stocks. In addition, the Supreme Court will rule on the issue of whether states can keep banks out of the insurance business.

REGULATION: Despite all the GOP promises, very few regulatory reforms were enacted in '95. The Republicans will try again in '96, focusing their efforts on negotiating bipartisan changes in environmental laws and health- and-safety regulations.

DATA: BUSINESS WEEKBy Dean Foust and Howard Gleckman, with Amy Barrett, in Washington


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