How Would Tax Reform Affect Financial Markets?

Article excerpt

The U.S. Congress is evaluating several proposals to reform the federal income tax system. Proponents of tax reform want to simplify tax preparation and stimulate economic growth by increasing the incentives for taxpayers to work, save, and invest.

While the primary objective of tax reform is a more productive economy, changing the tax laws would also affect financial markets. Several of the proposals would change the way interest expenses are deducted and change the way income from interest, dividends, and capital gains is taxed. These changes would affect interest rates and the prices of stocks.

This article analyzes the effects of income tax reform on U.S. financial markets. The first section of the article describes the general goals and features of tax reform. The second section analyzes in broad terms how tax reforms would affect financial markets. The third section examines the specific proposals that Congress is evaluating and ranks them according to their effects on interest rates and stock prices.

The article reaches three conclusions. First, most proposals would reduce interest rates in credit markets where interest income is currently taxable, including bank loans, Treasury securities, and corporate securities. Second, all proposals would increase interest rates in municipal credit markets where interest income is not currently taxable. And third, most proposals would increase stock prices. All three of these effects could be substantial.

AN OVERVIEW OF TAX REFORM

Tax reformers typically agree that the broad goal of reform is to improve the well-being of U.S. taxpayers. One way to accomplish this goal is through tax simplification. Few taxpayers find pleasure in filling out their tax forms, and most would welcome a simpler, less costly way of performing this irritating annual ritual.

Another way to improve the well-being of taxpayers is to spur economic growth. Reformers would do so by minimizing the disincentives inherent in all tax systems. For example, economists have long recognized that taxing wages discourages work and taxing capital income discourages saving. Some tax systems distort economic decisions more than others. Proponents of reform want to minimize such distortions.

Tax reformers want to simplify the tax system to lower the costs of tax compliance. Although all of the costs of complying with the tax laws cannot be measured, estimates of these costs are substantial. Compliance costs include the time taxpayers spend preparing returns and the money they pay to tax preparers. Taxpayers must also keep records, and the IRS estimates that the record-keeping time exceeds the preparation time for some tax forms. In a study of 1985 tax returns commissioned by the IRS, Arthur D. Little, Inc. estimated that tax preparation and record-keeping costs were $50 billion for individuals and $100 billion for businesses. Since then, both the number of taxpayers and the reporting requirements have increased. Proponents of tax reform argue that a simpler tax system would eliminate most of the compliance costs.

In addition to reducing the explicit costs of tax compliance, proponents contend that a simpler tax system would reduce taxpayer frustration. The tax system currently contains approximately 480 IRS forms, 280 IRS information pamphlets, and thousands of pages of supplementary documentation. Money magazine highlighted this complexity when it asked 41 tax professionals to prepare the return of a fictional family who owed $35,000 in taxes (Tritch). Even though all 41 preparers knew their results would be published in the national magazine, only two preparers calculated the tax within $500 of the correct amount, and 14 missed by over $5,000. As further evidence of the system's complexity, up to a third of the callers to IRS taxpayer assistance lines receive incorrect answers (Simon).

More important than tax simplification, tax reformers also want to reduce the disincentives in the tax system. …