Tax Prophet: FAQ October 20, 1996


Frequently Asked Tax Questions --October 20, 1996

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday October 20, 1996

 

The Presidential Tax Plans

ROBERT L. SOMMERS

Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

This World Wide Web Server is the creation and property of Robert L. Sommers , attorney-at-law. Copyright 1995-7 Robert L. Sommers, all rights reserved.


The Presidential Tax Plans

The presidential debates have been dominated by competing tax-cutting plans, which pit the collective good of the "village" against individual self-interest. What do these plans entail?

President Clinton's Plan

Narrowly-focused and modest, it aims at what he perceives is the collective social good. While his campaign trumpets tax breaks for education, his proposal is meager, paying only for a fraction of education costs, and is unavailable to many middle class taxpayers. Ironically, several new tax breaks will benefit upper income taxpayers. Here's the Clinton plan:

Clinton's Educational Benefits

Taxpayers with joint incomes under $70,000 (single filers with incomes less than $50,000), would get an annual $1,500 tax credit for the first two years of post-high school education ($3,000 in total). Students must maintain a "B" average. Students with a felony conviction for using dangerous drugs (including marijuana) are ineligible for the program.

In addition to the tax credit program, taxpayers meeting these income limitations may deduct $10,000 for total educational expenses. The $10,000 deduction is an overall limitation, regardless of how many children the family must educate.

Comment: The education program is well intentioned, but its eligibility requirements are too restrictive. There is too much government meddling with school-grading policies: Will the "B" average requirement lead to "grade inflation?" What about courses taught on a "pass-fail" system? Will students be discouraged from taking harder academic classes because of grade concerns?

Why should a prior drug conviction stop someone from later trying to improve his life? Does this restriction disproportionately impact minority groups, which may have a higher felony conviction rate for drug offenses?

Child Tax Credits

Clinton is offering a $300 per child tax credit for 1996, 1997 and 1998 tax years, and $500 per child in 1999 and thereafter, for families whose adjusted gross income (AGI) is under $60,000. The credit will be phased-out between $60,000 and $75,000.

Comment: This credit is narrowly targeted to the lower end of the middle class. Unfortunately, this credit and the educational benefits, will prove illusory to many middle class taxpayers.

Expanded IRAs

Clinton wants to double the current income requirements for IRA contributions. For joint filers, the deduction will be phased-out for incomes between $50,000 and $100,000. For single filers the phase out begins at $35,000 and ends at $70,000. The current $2,000 maximum contribution will be indexed for inflation. Also, he has proposed penalty-free withdrawals for major life expenses, such as education, training, first-time home purchases and financially devastating medical expenses.

Comment: Allowing penalty-free withdrawals for education expenses could be beneficial. IRAs have proven to be excellent wealth-generating vehicles since all earnings are tax-free until withdrawn.

Elimination of Capital Gains on the Sales of Residences

Clinton proposes eliminating $500,000 of taxable gain on sales of a principal residence by a joint filer ($250,000 for single filers), once every two years. The provision will replace the current once-in-a lifetime exclusion of $125,000 for taxpayers over age 55 and the tax-free deferral provisions for replacing a home of equal or greater value.

Comment: This is a huge tax break for those with expensive homes and will permit the downsizing of home ownership without tax. Those selling high-priced homes and moving to an area with lower housing costs could realize tremendous savings, enough to pay for educational costs and provide for retirement.

Senator Dole's Plan

Senator Dole's centerpiece is an unrestricted tax cut in income and capital gains taxes, which he believes will stimulate the economy and encourage investment and savings. Criticism against his approach is that it will increase the deficit. Here's the Dole tax plan:

Dole's Across-the-board Tax Cut

Personal income tax rates will be cut by 5% each year for three years beginning in 1997.

Comments: Cuts in personal income tax rates, the mantra of "supply-side" economics, were central to the Reagan tax plan, the Tax Reform Act of 1986. Those cuts lead to a huge increase in the national deficit because Congress failed to cut spending to match decreased revenues. Whether this will occur under the Dole tax-cut proposal has been the subject of non-stop debate.

Curiously, this income tax cut will subject approximately 6.6 million taxpayers to the complicated alternative minimum tax (AMT), according to the Congressional Joint Committee on Taxation, and may prove of little actual benefit to wealthy taxpayers because of current AMT provisions.

Capital Gains Cuts

The maximum capital gains rate will be halved. The maximum rate will be 14%.

Comment: Cuts in capital gains taxes disproportionately benefit the richest Americans, since they have the excess capital to invest and generate capital gains. Cuts in capital gains are supposed to stimulate investment and economic growth because those receiving the tax cuts will reinvest in the U.S. economy. This is known as "trickle-down" economics.

Another tenant of trickle-down economics is that individuals should be making investment decisions, not the government; therefore, by taking money out of the hands of government (by reducing taxes) and placing that money in the hands of individual investors and entrepreneurs, society will benefit.

There are solid arguments for treating capital gains differently than ordinary income: Capital gains occur when an asset is sold at a profit which means the investor took an investment risk which should be rewarded. Also, an investor might wait many years before realizing his capital gain and inflation will have reduced the "real gain" substantially. The counter-argument is that capital gains relief unfairly benefit the richest Americans at the expense of the middle-class -- whose taxes must be raised or government benefits reduced to pay for the capital gains cut. Further, those who benefit from these tax breaks are under no obligation to reinvest those savings in the U.S. economy.

Tax Credit of $500 and IRA Withdrawals

Senator Dole provides a $500-per-child tax credit for children under 18 for families earning $110,000 a year ($75,000 for single heads of household). For taxpayers with AGIs over these limits, the benefit will be phased out at the rate of $25 for every $1,000 of additional AGI. Penalty-fee IRA withdrawals for educational expenses is also permitted, plus repeal of the tax increase on social security income passed by Congress in 1993.

Comment: The IRA provisions are similar to Clinton's proposal and will benefit families paying for education. The child tax credit will help families with larger incomes under the Dole proposal. Reduction of social security tax increases will appeal to the elderly, but at what federal cost?

Education Investment Accounts and Deductions for Student Loans

Dole has offered a $500 per year, per child, tax-free investment into an Educational Investment Account for couples with AGIs of $110,000 or less and single head of household filers with AGIs of $75,000 or less. These accounts may be funded with the child tax credit or after-tax dollars. Funds may be withdrawn tax-free after 5 years to meet education costs.

Interest on student loans will qualify as an itemized deduction for 5 years. This benefit will be phased-out for single taxpayers with AGI's between $45,000 and $60,000, and joint filers with AGIs between $65,000 and $85,000, and will be adjusted for inflation.

Comment: Dole's education proposals are smaller in scope and contain less governmental regulation than Clinton's. Also, more middle-class taxpayers will qualify under the Dole proposals. The interest deduction for student loans addressed a major problem: recent college graduates bear enormous education debts and must repay both the interest and principal from after-tax dollars. The interest deduction will lessen this burden.

Elimination of Capital Gains on Residences

Like Clinton, Dole proposes eliminating capital gains on the sale of a residence. The Dole plan provides for an exclusion to $250,000 for joint filers during the first 10 years of ownership; however, his exclusion for couples grows to $500,000 (at the rate of $25,000 per year for years 11 through 20). Dole's plan is less ambitious than Clinton's and because Dole will cut capital gains to 14%, his savings are less dramatic. My comments about Clinton's proposal apply here.

Estate Tax Relief for Family Businesses and Farms

Dole proposes an additional $1,000,000 exclusion from estate taxes for family-owned businesses and farms.

Conclusion

Tax policy has taken center-stage in the 1996 campaign for presidency. The Clinton plan reflects general satisfaction with the economy. Modest in scope, it uses tax cuts to target "socially desirable" investments. The Dole plan is much more aggressive and incorporates the tax-cut philosophy of supply-side economics to stimulate economic growth.

Does the economy need tax cuts, or is it on the right track? Will the projected economic growth under the Dole plan actually materialize? Will it be enough to off-set the tax revenue loss, or will it balloon the national deficit? Does the Clinton plan go far enough? Do government targeted tax cuts work? These questions will be answered by the voters on November 5th.




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