Tax Guide: The Current Scene (Chapter 1)

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Chapter 1
The Current Scene

ax planning in the wake of change is nothing new, of course, and the changes brought by the Taxpayer Relief Act of 1997 are no different. Since the Reagan tax cuts of 1981, Congress has passed four substantial tax increases, half a dozen minor tax bills, and one rewrite of the entire tax code. The difference this year is that for the first time since 1981 Congress has cut taxes. At the same time, spending cuts and very strong economic performance promise a balanced federal budget for the first time since 1969.

Important!

We've posted our updated tax planning guide. Click here for planning tips and strategies for 1999 and beyond.

For individuals, the measure of the 1997 tax cuts depends upon your personal situation. The new Act may provide substantial savings for you or have little effect on your personal return. Nearly all of the tax cuts target the individual income tax or the estate and gift tax. The vast majority of the Act's $152 billion in tax cuts is focused on

A $500-per-child tax credit for middle class families
Substantial new education incentives
Lower capital gains rates and exclusion of up to $500,000 of gain on the sale of a residence
New and enhanced Individual Retirement Accounts (IRAs)
Lower estate and gift taxes

As a result, the largest benefits of the new Act flow to three distinct groups:

Middle class families with children.
Middle class families able to save
All families or individuals with significant capital investments.

High-income taxpayers who do not have large taxable portfolios and single taxpayers and families with grown children may find the legislation offers them little direct benefit.

lthough these tax cuts are simple to name and describe in broad terms, you must exercise caution in planning. While the Act contains several sections of simplifications, on balance it presents enormous new complexity. For example, you now will confront possible capital gains tax rates of 8%, 10%, 18%, 20%, 25% and 28%. In planning your savings strategy, you now must analyze and make wise choices between traditional IRAs, new Roth IRA accounts, educational IRAs, and other options such as 401(k) plans and deferred annuity opportunities.

One further caution: The 1997 Act contains hundreds of miscellaneous tax cuts and simplifications together with a number of smaller tax increases. It forms the largest collection of miscellaneous tax cuts since the 1981 Act. These provisions reflect the fact that the 1986 struggle over tax reform and the ensuing efforts to curtail the deficit effectively blocked most miscellaneous tax legislation for the last decade. You cannot assume safely that any part of the tax law is unchanged.

As taxpayers come to understand how the Act affects them individually, they may ask: Where do we go next? The answer is, as it has been: Plan for change. The tax reform and tax cut debates are far from over.

roponents of a flat, national sales or value added tax argue that an income tax system improperly taxes income from savings, is unacceptably complex, and is too easily manipulated for political gain. When measured against the goals of fundamental reform, the 1997 Act receives mixed reviews. Cutting capital gains taxes, expanding IRAs, and increasing the estate tax exclusion all move in the direction of boosting savings as favored by consumption tax advocates. At the same time, the savings incentives, the child credit, and the education credits all add significant complexity for individuals. If this latest tax bill furthers the cause of tax reform, it will be by increasing discontent with the current system's complexity.

The conservative movement's greatest economic achievement may be enactment of the 1997 tax and budget legislation. Together, they promise a balanced budget by 2002, while cutting taxes. Although the 1997 tax cuts are relatively small, they are, as we've noted, the first since the Reagan era. Ironically, despite the political emphasis on slashing taxes, the budget now is projected to deliver less government, but not lower taxes. For the 1970s and 1980s, taxes averaged 18.2% of GDP. The new tax law will generate revenue in 2002 equal to 19.1% of GDP. Taxes will be higher in 2002 than when conservatives launched their effort to reduce the federal government. This fact will drive tax debates in the years ahead.

f economic projections prove correct, policymakers will face the new question of how to set budget priorities in an age of sustained surpluses. Conservatives already are promising further tax cuts and a friendlier tax-collection bureaucracy. Other see uses for the surpluses. Highway users, cities with aging water treatment systems, defense programs, and environmentalists already are laying claim to portions of any surplus. Surely some will argue that we must begin to pay down the $5.6 trillion in public debt accumulated over the past two decades.

In recent weeks, Congress has turned its attention to plans to reorganize the Internal Revenue Service (IRS), in part to deal with concerns about overaggressive enforcement of the tax laws. Although a broad consensus exists on the need for management reforms, it is difficult to watch the current activity without suspecting that some politicians see a potential political payoff in blaming the IRS for the complexities and absurdities of the tax system Congress created.

Each taxpayer has a vital stake in this debate. The IRS is not like a business. If we do not like the way the IRS runs the tax system or if its service is poor because of inadequate funding or leadership, we cannot choose to file our returns with another institution. If the IRS does a poor job of collecting taxes from our competitors, we cannot hire someone else to close the gap. As we enter a third decade of debates over how to structure our tax system, the planning process must continue on the basis of existing law. In the 1990-91 edition of this book, we confronted prospects for change and advised that

"the 1990s will belong, in the world of personal tax planning, to those who master the details of a complex law whose basic structure is likely to be relatively stable and whose details will change endlessly as Congress, the Treasury, and the courts struggle to understand this new creation."

We believe this advice is as valid for the immediate future as it has been for the last seven years.

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