Tough tax questions face the next president

A growing unintended burden on middle-income people, and a dearth of corporate receipts raise issues of fairness.

When both presidential campaigns talk about tax policy, it is not surprising they focus on tax cuts.

With April 15 just around the corner, nothing sounds better than a plan to slice the size of the check taxpayers must write to Uncle Sam.

The appeal of that theme is on full display on the campaign trail, but fiscal experts say it's also increasingly clear that the next president will face significant tax-code challenges that could result in voters paying higher taxes or facing a more aggressive Internal Revenue Service presence in their lives.

Outlining his economic policies, Senator Kerry told an audience at Georgetown University last week that under his plan "99 percent of American businesses and 98 percent of Americans will get a tax cut." Kerry did call for higher, Clinton-era tax rates for those making over $200,000.

Meanwhile, President Bush staged his own economic forum at South Arkansas Community College. A key part of his message: "Everybody who pays taxes ought to get relief if we're going to have relief."

But promises of tax cuts tell only part of the story. Experts say the next president will face a number of challenging tax policy questions. The issues in question are seldom included in campaign rhetoric, since they involve tough choices, including:

• Inadequate revenue. "Whoever is president will continue to face huge budget deficits. "They cannot solve those by capping spending," says Charles Davenport, senior contributing editor at Tax Analysts, a nonpartisan publisher. The war in Iraq adds to the problem. On NBC's "Meet the Press" last Sunday, Senator John McCain of Arizona said, "we are going have to ask for more money after the election, and it's going to increase the ... deficit."

• An explosion in the number of middle-income taxpayers paying the Alternative Minimum Tax. The tax was adopted in the late 1960s to make sure the wealthiest Americans paid at least some taxes. "It now affects substantial numbers of middle-income taxpayers and will, absent a change of law, affect more than 30 million taxpayers by 2010," writes IRS taxpayer advocate Nina Olson in her annual report to Congress. The cost of fixing the problem: upwards of $450 billion over the next 10 years, according to figures from the Urban-Brookings Tax Policy Center.

• A sizable gap between what the government is owed and what it collects. "The tax gap is more than $300 billion in revenue we think we should be collecting and are not," says Peter Orszag of the Urban-Brookings Tax Policy Center. "Some of that is nonreporting [of income], some of it is aggressive use of tax sheltering."

• A major erosion in corporate tax revenue. Congress's General Accounting Office recently reported that 61 percent of US-owned companies and 71 percent of foreign-owned firms paid no taxes in the US from 1996 to 2000, when profits were booming. Last year, corporate taxes fell to just 7.4 percent of government receipts, versus 20.3 percent 40 years ago.

One reason for falling corporate tax revenues is so called "corporate inversions." In these transactions a new foreign corporation, typically located in a no- or low-tax country, replaces a US company as the parent corporation of the business.

Another factor in the erosion of tax receipts from corporate America is inadequate IRS auditing activity. Face-to-face audits of corporations - where IRS auditors show up at the company's place of business - fell from 15 per 1,000 corporations in 1999 to 7 per 1,000 in 2003, according to data released this week by Syracuse University's Transactional Records Access Clearing House. "Government data show that major IRS programs to enforce the tax laws against businesses and corporations are continuing to slump," the study said.

All of the major issues facing the tax system add to ebbing confidence about its fairness, experts say.

"The next president has to work hard so that the public regains some confidence in the tax code," says Joel Friedman, senior fellow at the Center on Budget and Policy Priorities. "No one likes to pay taxes, but it goes down easier if you know your neighbor and the man across town are paying."

One key issue in the fairness debate is whether recent tax-law changes have biased the tax system against those whose income is derived largely from wages and salaries and toward those who get large dividend and capital-gains payments.

Bush ideas "like lifetime savings accounts and lower taxes on dividends and capital gains - all of that is taking the tax burden off of capital," notes Charles Davenport of Tax Notes.

Allan Sloan, a Newsweek columnist, argued this theory provocatively last week, saying Bush would make it harder for people starting up the economic ladder while showering rewards on the rich.

Bush and his economic team defend his tax plan as reducing the burden for all payers, and tax cuts on "capital" as spurring job creation and investment.

Beyond cosmic fairness questions, several tax cuts are set to expire at year end, including a higher child tax credit, relief from the so-called "marriage penalty," and an expansion of the number of people in the lowest (10 percent) bracket. "If they are not extended before a new president comes in, they will probably be a top issue," early in 2005, says Mr. Orszag.

Congress is also still wrestling with replacing a tax subsidy for US exports that the World Trade Organization ruled was illegal. Since March, retaliatory tariffs have been imposed by the European Union.

For all the tax issues facing the president in 2005, there is no guarantee that action will be forthcoming quickly. "History has shown we are capable of dealing with [such issues] unfortunately in a very incremental way," says Joel Friedman of the Center on Budget and Policy Priorities.