1998 Tax Outlook
Tax Cuts on Congress' Mind,
Caution on President's in 1998

Wednesday, Jan. 7, 1998

OnLine

ow to cut taxes in the way best suited to gain maximum leverage for the November congressional election is foremost on the minds of the Republican-controlled Congress as it returns to work Jan. 27.

In addition Congress must complete work on various items left over from 1997, including restructuring the Internal Revenue Service and technical corrections.

Because of the mid-term election, the upcoming congressional session will be more volatile than the one just finished. Members of the House and about one-third of the Senate will cast votes knowing that constituents will decide their political fortunes in the November election. Observers will have to determine which bills are introduced with the intent of being enacted, and which mainly are intended to enhance a member or a political party in the eyes of the electorate.

The date of adjournment for the year also will be affected by the jockeying among Democrats and Republicans concerning the election. If congressional leaders decide GOP candidates will gain an advantage by a late adjournment, Congress will stay in Washington longer. On the other hand, leaders will not want members lingering in the Capitol if they have dispensed with their agenda for 1998, and GOP incumbents need more time to campaign.

GOP leaders are developing an agenda that includes passage of the IRS restructuring bill early in the year, followed by a tax cut, with lots of talk about tax reform thrown in for good measure, congressional aides said.

President Clinton probably will take a more cautious approach by claiming as much credit as possible for the IRS reform, by calling for caution on the tax-cut front, and by pointing out the unfairness of the GOP tax reform proposals.

The following analysis outlines the items on Congress’ agenda for 1998, based on interviews with the professional staffs of the tax-writing committees and with aides to members of the committees.

1. What To Do With A Budget Surplus?

The debate about cutting taxes is sparked by the prediction that the government will collect much more in tax revenue in fiscal 1998 than projected last year by government budget experts, enough so there may even be a budget surplus. Many GOP legislators favor using this bonus to enact moderate-sized tax cuts, such as eliminating the so-called marriage penalty, while the President supports a more cautious approach.

Democrats and Republicans must decide whether they want to enact a tax cut. Clinton could gain by passing a cut that would make his constituents happy, or by opposing one, thus positioning himself as a deficit hawk. Considering his Jan. 5 promise to propose a balanced budget for fiscal 1999, he seems to want to employ the latter strategy. This is a zero-mile marker strategy that will evolve as Congress and the President close in on the end of the year.

The GOP Congress also could gain by passing a cut -- a core issue for them -- that will be signed into law, or by passing a cut that is unacceptable to the President, thus positioning themselves as the party that helps American families and positioning Clinton as a tax-and-spend Democrat.

Marriage Penalty: The tax-cut idea that has generated the greatest amount of interest is the proposal to eliminate the so-called marriage penalty, which forces some dual-income married couples to pay higher taxes than if they paid taxes individually. Eliminating the marriage penalty plays well among suburban voters and appeals to conservative groups, such as the Christian Coalition.

House Ways and Means Committee Chairman Bill Archer, R-Texas, and Senate Finance Committee Chairman William Roth, R-Del., both have expressed interest in eliminating the marriage penalty. Other GOP leaders have not been as specific. House Speaker Newt Gingrich, R-Ga., for instance, said he wants to enact a tax-cut bill every year, but has not identified yet his preferred tax cut for 1998.

Broad proposals to eliminate the marriage penalty for taxpayers in all income groups are very costly, so legislators probably will look at ways to target the proposal. One approach under study by a group headed by Rep. Kenny Hulsoff, R-Mo., would eliminate the penalty by excluding some interest and dividends from income for married couples.

Others predict that the eventual compromise will be that Clinton’s targeted proposals (see below) will be aimed at couples who are harmed by the penalty, thus giving both Democrats and Republicans something from a deal.

In addition to looking at the marriage penalty, Archer has asked Joint Committee on Taxation Chief of Staff Ken Kies to examine the limit on itemized deductions and the phaseout of the personal exemption.

Roth also has a tax-cut wish-list, but wants cuts other than marriage penalty relief considered, depending on whether and how much of a surplus emerges. Roth probably will not get his first choice, an across-the-board tax cut, but historically he favors smaller cuts for all taxpayers, not moderate ones for specific groups.

Other less-costly options identified by Roth include expanding tax-favored education benefits or individual retirement accounts, eliminating the marriage penalty, and increasing the exemption for the alternative minimum tax to ensure middle-class families are not subject to it.

White House View: President Clinton favors small-scale targeted tax cuts. He has cautioned that the projected budget surplus might not materialize and that many legislators may be trying to spend money they do not have. He also has touted the benefits of the lower interest rates that will result from buying down the national debt.

The administration is searching for a tax initiative to respond to Republican proposals to cut taxes. Rather than push for expensive cuts, the administration traditionally has sought targeted reductions that cost less, but still capture headlines.

The President plans to unveil, as part of his fiscal 1999 budget, a tax cut designed to help offset child-care costs. Under consideration are proposals to expand the dependent care credit for workers or a tax incentive for businesses that provide child-care benefits to workers, according to administration officials.

The child-care tax credit proposal for employers under consideration is based on a plan by Sen. Herb Kohl, D-Wis., that would provide employers with a 50% credit to cover up to $150,000 in total annual day-care expenses.

Also to be included in the budget are tax incentives to fight global warming. The tax incentives will be combined with cleanup programs, and the modest initiative is expected to cost $5 billion. Clinton also is exploring the idea of granting small businesses relief designed to make it easier for them to offer retirement benefits to their employees.

Some legislators argue the President should propose payroll tax cuts because the taxes are regressive, hitting lower-income workers the hardest. Sen. Ted Kennedy, D-Mass., endorsed the idea of eliminating the cap on payroll taxes to provide relief for lower-income wage earners.

The payroll tax issue also has generated some interest from Republican members. Sen. John Ashcroft, R-Mo., proposed using any possible budget surplus to make payroll taxes deductible.

To Cut Or Not To Cut: Other members of Congress, such as House Budget Committee Chairman John Kasich, R-Ohio, argue that any surplus should be used to reduce the federal debt.

Others say any surplus should be applied to new spending initiatives. House Transportation Committee Chairman Bud Shuster, R-Pa., suggested more money should be spent on improving and maintaining the nation’s transportation infrastructure. Members advocating a strong defense suggest that more weapons systems and other military systems be constructed.

If a surplus emerges, Democrats and Republicans will decide how to spend the money after calculating their potential political gains and losses. Faced with the choice of spending or saving, politicians usually opt to spend money they control, often in the form of tax cuts, and that tendency probably will be enhanced this election year.

The exact state of the federal budget will be revealed on Jan. 28, when the Congressional Budget Office unveils its budget projections. The extra money probably means there will be less red ink than anticipated in fiscal 1998 and 1999. It also means the government will be in the black sooner than 2002, the year last summer’s budget deal projected the government’s books would show a surplus.

Fiscal year 1997, which ended Sept. 30, produced a federal budget deficit of $23 billion. During October and November 1997, the federal government deficit was $24.4 billion lower than the same period from the year before, enabling those who say there will be money for a tax cut to make a good case in the coming months.

The naysayers, on the other hand, contend that economic forecasting is an inexact science and the impact that the downturn in the Asian economies will have on the U.S. economy has yet to be determined.

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2. Extenders, Revenue Raisers, and Other Recurring Issues

Though tax cuts top the political agenda, business-oriented tax increases still pose a threat. Even with the bright budget prospects, Clinton probably will propose again some of his previously offered and rejected tax increases aimed at businesses. Items such as the proposal to curtail the dividends-received deduction are expected to be proposed again, while others could be forgotten, such as the proposals to limit the tax advantages of so-called century bonds and to require investors to determine their basis in securities using the average of their holdings.

Congress generally will oppose the so-called loophole closers, but could wind up going along with a few to enlarge the size of the tax cut or to pay for other initiatives.

There also will be pressure to extend the research tax credit, the deduction for contributions of stock to private foundations, and the work opportunity tax credit beyond June 30, 1998. Congress usually reinstates the extenders when they lapse, if not prior to the expiration date, then retroactively once they have officially expired.

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3. IRS Restructuring

The effort to restructure the Internal Revenue Service heads the list of unfinished business from last year. The Senate declined to consider the IRS restructuring bill in 1997 because its leaders said the proposal needed to be refined. The House overwhelmingly approved its version of the bill in a 426 to 4 vote.

Roth and others want to be certain the bill they approve does not create more problems than it fixes. Legislators also delayed the issue until this year because the media paid close attention to the Senate Finance Committee’s 1997 hearings on taxpayer problems, and they hope similar attention will be paid to the measure this time around.

The bill approved by the House created a public-private sector board of directors to recommend budgets and strategic plans for the IRS. The board’s purpose is to improve management of the agency by infusing it with private sector standards and approaches to problem solving.

The measure also includes taxpayer rights initiatives, such as treating communications between accountants and their clients in the same privileged fashion as communications between lawyers and their clients; shifting the burden of proof in Tax Court to the government in cases brought against individuals and small corporations; and netting tax underpayments and overpayments by smoothing the interest differential between taxpayers and the government during periods of mutual indebtedness.

President Clinton now favors the IRS overhaul bill, and the charges that he reversed his position probably will have a harder time sticking as time passes. Some GOP congressional leaders said the President merely jumped on the band wagon once he realized there was widespread support for IRS restructuring.

The revenue offset in the IRS restructuring bill reverses the portion of the Tax Court’s decision in Schmidt Baking that addresses vacation pay. The Schmidt Baking revenue offset also is used in several other pending bills. Often lawmakers use the same offset in two bills; when one is enacted, they then have to find a replacement for the offset in the bill that has not been enacted.

In the decision, the Tax Court held that an irrevocable letter of credit securing the employer’s accrued vacation and severance pay liability satisfied the requirement that payment be made within two-and-a-half months of the close of the taxable year and thus took the payment out of the deferred compensation rules that would have delayed the employer’s deduction.

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4. Technical Corrections

The House-passed IRS restructuring bill includes technical corrections that fix various problems with the Taxpayer Relief Act of 1997. The Senate declined to act on the measure last year.

Included in the House-passed package are changes that fix the capital gains rules to provide that net short-term capital losses will first offset gains taxed at the highest capital gains rate; prevent avoidance of penalties on early withdrawals from traditional IRAs when rolling over to Roth IRAs; and clarify the residential exclusion rule to provide that if a home is sold before the two-year period expires, the taxpayer may exclude gain up to the fraction of the $250,000 exclusion that is equal to the fraction of the two years that the taxpayer owned the home.

The Senate opted not to consider a technical corrections bill in 1997 because its leaders wanted the IRS and taxpayers to work with the new law for at least part of the 1998 filing season before enacting technical changes. They want to see if additional technical corrections will be identified before they place their stamp on the bill marked up by the House Ways and Means Committee.

The Joint Committee on Taxation staff’s General Explanation of Tax Legislation Enacted in 1997 -- the so-called "Blue Book" -- contains numerous references to additional glitches from the Taxpayer Relief Act that might need fixing, providing a roadmap of sorts for Senate taxwriters to follow.

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5. Tax Simplification

Targeted simplification of the Internal Revenue Code also will re-emerge as an issue next year. As with years past, Congress and the President will explore ways to make the tax law easier to administer in selected areas.

In order to improve the nation’s competitive position in the international marketplace, Reps. Amo Houghton, R-N.Y., and Sander Levin, D-Mich., will dust off their international simplification bill and re-propose those provisions that did not get enacted as part of the Taxpayer Relief Act of 1997.

Congressional aides cautioned that the portions of the previous international simplification that were the least controversial politically and least expensive already have been enacted. Enacting further international simplification may prove difficult because Congress already enacted those provisions that do not have much opposition, congressional aides warn.

President Clinton also is considering further pension simplification for small businesses in his fiscal 1999 budget. As with changes enacted as part of the Small Business Job Protection Act and the Taxpayer Relief Act, the President is looking at ways to simplify pension law compliance for small businesses and encourage them to offer retirement benefits for their employees.

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6. Internet Taxes

A bill granting a temporary moratorium on certain taxes relating to the Internet is moving through both the House and Senate.

The Senate version was reported favorably by the Senate Commerce Committee. The Senate Finance Committee has requested the bill be referred to it before it moves to the floor. The jurisdictional issue must be resolved before the measure can proceed.

The bill would impose a four-year moratorium on any state or other local jurisdiction imposing a tax on access to or use of the Internet or an on-line provider, transmission of data over the net, and transactions through the net. The legislation does not apply to income taxes, or sales and use taxes on goods sold via the Internet.

In the House the bill has been referred to the Judiciary and Commerce Committees. Ways and Means also is likely to request a referral of the bill.

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7. Tax Reform

The election year excitement and interest in IRS restructuring also has stirred up interest in reforming the entire tax system. It is important to remember that discussion and debate among legislators about an issue does not mean necessarily that a new law will be the result.

House Majority Leader Dick Armey, R-Texas, and Rep. Billy Tauzin, R-La., are holding town meetings across the country to debate their proposals to replace the progressive income tax with a flat tax or a consumption tax.

Another item generating excitement is Rep. Steve Largent’s, R-Okla., bill calling for the repeal of the Internal Revenue Code. The proposed legislation is intended to emphasize the flaws in the current tax system and force legislators to choose a better system.

President Clinton also is expected to express guarded interest in tax reform when he delivers his state of the union address Jan. 27. He probably will repeat (and not go much further) his pledge that only proposals that are fair to all Americans, help the economy, and do not harm the budget will receive consideration by the White House.

The White House will have to tread carefully on the reform issue because of internal Democratic party politics and because of the impact the issue could have on the Clinton presidency. Clinton wants to advance, to whatever extent possible, Vice President Al Gore’s presidential ambitions by talking about reform, an issue that will be central to the 2000 presidential campaign. However, the President does not want to distract his administration from the goals he sets, so he will choose his words carefully when discussing reform -- a secondary issue for the President.

Clinton’s characterization of the issue also will have to take into account House Minority Leader Dick Gephardt's, D-Mo., proposal to broaden the tax base and levy a 10% income tax on most Americans. Gephardt is Gore’s primary contender for the Democratic nomination in 2000.

The tax reform issue also influences the battle between Democrats and Republicans over who will control Congress in 1998 and who will control the White House in 2000. Republicans, on one hand, are thankful that Clinton plans to remain taciturn over tax reform because the GOP fears Democrats could gain the upper hand by using the debate as an opportunity to play the rich against the poor.

Alternatively, if Clinton expresses strong support for reform, Republicans could gain because the issue would advance in voters minds. As a result, Republicans would gain the most credit because they have been pushing for fundamental tax change for several years.

Despite recent interest in the issue, the lack of consensus among policymakers means no large-scale reform bill will be enacted, but enough interest remains to keep it on the agenda. Expect the debate over tax reform to continue in 1998, with some congressional hearings, but no decisions are anticipated until and unless the full weight of the executive branch is placed in support of the issue.

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8. Estate Tax Relief

Conservative Republicans also will push for additional estate and gift tax relief in 1998.

Many legislators, including Senate Majority Leader Trent Lott, R-Miss., are unhappy with the "death tax" reform that was enacted in 1997 because they say the phase-in of the new estate and gift tax exemption is too slow and too stingy. Reform proponents argue that small businesses and family farms are harmed by the new estate tax, which is more trouble than it’s worth.

More generous estate tax relief was dropped from the final version of the Taxpayer Relief Act because of the Clinton administration’s concern that the proposed changes helped only the richest Americans.

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9. Miscellaneous Leftovers

Another leftover item from last year is the bill to reinstate the provisions President Clinton struck from the Taxpayer Relief Act using the line-item veto. Like other bills, it was not taken up in the Senate, after the House approved it.

The bill would reinstate the provisions that temporarily exempt a taxpayer’s foreign personal holding company income and foreign base company services income and allow a deferral of gain on certain sales of farm product refiners.

Much of the discussion over the provisions focused on whether a revenue offset is needed and what the offset should be. The bill passed by the House raised money by selling the government’s excess supply of the mineral palladium and by changing insurance reimbursement rules at the State Department.

The repeal of the vacation component of the Schmidt Baking case also is used to offset the cost of the proposal to expand IRAs to cover primary and secondary school costs. The House passed an education IRA expansion bill (H.R. 2676) 230 to 198, but efforts to bring the measure up for a vote in the Senate failed.

Clinton strongly objected to the bill on the grounds that it could undermine the nation’s public education system. Labor unions also oppose expanding education IRAs because public schools have the support of organized labor since more teachers in public schools tend to belong to labor unions than teachers in private schools. Whether Senate leaders can resurrect the measure next year remains to be seen.

The severance pay component of Schmidt Baking is used to offset the revenue loss of two trade bills: the Caribbean Basin Initiative bill (H.R. 2644) and the fast-track trade bill (H.R. 2621). The CBI parity bill was rejected by the House and the fast-track trade bill was pulled from the schedule in the House due to fears that it would be voted down. The prospects for both bills next year also are uncertain.

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10. Conclusion

The upcoming year will be dominated by election year politics, and almost everything that Congress does -- from deciding how much to cut taxes to deciding when to quit for the year -- will be influenced by the election. One thing that 1998 will have in common with other years is that tax will be high on the political agenda.

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