From the August 2004 issue of Investment Advisor • Subscribe!

TAX ADVISOR- Look Beyond the Election Year

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In a presidential election year, the chief executive and members of Congress typically are too preoccupied with campaigning to bother much with tax changes. But over the past half-century, major new revenue laws have often come a year or two after the election is held.

Of the dozen or so major tax changes that have come through Congress since 1954, only two occurred in an election year. In contrast, all but one of the remainder were promulgated in the year or two after an election--there was one three-year outlier. The quick lesson is that investment advisors should not expect anything at all meaningful to happen in Washington on taxes for the rest of this year. But whoever wins in November, there is a good chance of a major change in the next 12 to 24 months. To try to discern--predict is far too exacting a word--what might happen in the Revenue Act of 2005 or the Taxpayer Relief Act of 2006, it is useful to look back on five decades of post-election tax lawmaking.

As anyone who has tried to complete any form beyond a 1040-EZ knows, taxes are anything but neat. However, 2004 marks the exact half-century since the first major piece of postwar tax legislation, the 1954 Revenue Act. Dwight Eisenhower had been elected in 1952, setting the pattern for election year-plus- two tax laws (E+2). He also had a solidly Republican Congress behind him.

"The most important change in our income tax structure over the last 25 years is the reduction in tax rates," wrote William C. Penick in his authoritative 1983 paper, The Evolution of the Federal Tax System: 1954-1983. Penick writes that "this started on a modest scale in 1964, was continued when the maximum tax on earned income was adopted in 1969, and reached fruition in 1981 with the reduction in the top individual rates and the top estate tax rate to 50%." The top bracket during World War II was a stunning 94%. A fair portion of the taxpaying population may know or at least have heard of such confiscatory tax levels, but it will surprise even many tax professionals to realize that those stiff levies lived on until the Revenue Act of 1964, the first in an election year.

JFK's Tax Cuts

In between those two, the Revenue Act of 1962 came two years into John Kennedy's presidency--E+2 again--and with the backing of a Democratic Senate and House. The goal was to stimulate domestic growth and international competitiveness, but in truth there were only minor additions and restrictions.

The '64 Act, under Lyndon Johnson and again with a Democratic Congress, lowered individual brackets from the range of 20% to 91% to the range of 16% to 77%. So not only did this law break the E+2 pattern, it also gave the tax-cutting mantle to the Democrats.

Richard Nixon, working with a Democratic Congress, made a serious effort at further bracket reductions in the Tax Relief Act of 1969, E+1. Although overall brackets only fell to the range of 14% to 70%, an important provision capped taxes on earned income at 50%. Today that sounds like no big deal. But remember that at the time only a tiny fraction of the population owned stock, and mutual funds were in their infancy. Most people, even high-level company executives, received most if not all their income from salary and bonuses. So that earned-income rate cap was much more significant at the time than any such provision would be today.

Nixon was also the first president to push through two tax bills in his tenure, a feat not repeated until Ronald Reagan's tax revolution. The Revenue Act of 1971, E+3 (or three years after Nixon's election in 1968), left brackets alone. But it increased exemptions, as well as the personal deduction. Nixon's successor, Gerald Ford, also had to contend with a Democratic Congress, and his Tax Relief Act in the 1976 election year streamlined the tax code and eliminated some of the more egregious tax shelters.

Ten years of tweaking had set the stage for a period of major changes. That period did not begin with Ronald Reagan but with the Revenue Act of 1978, E+2, under Jimmy Carter. His original goal was to increase capital gains taxes from the prevailing 50%. But his Democratic Congress rebelled and cut capital gains taxes almost in half, to 28%.

Reagan then got the ball rolling, and watched a Republican Senate and a Democratic House vie with each other in a tax-cut derby. The Economic Recovery Tax Act of 1981, E+1, is widely regarded as the best recent piece of tax legislation. It reduced the top bracket to 50%, established indexing for brackets starting in 1985, and made major reductions in the estate and gift taxes.

The Tax Equity and Fiscal Responsibility Act of 1982 marked the first time two major changes were promulgated in successive years. And how much had changed already! Deficits were looming for the first time, but neither the President nor Congress were willing to go back on the recent tax reduction. So they worked around the issue by cutting deductions, increasing the requirements for providing information, imposing more severe penalties, and expanding the Alternative Minimum Tax (AMT).

Reagan scored a trifecta with the Tax Reform Act of 1986 (TRA86), E+2, for his second administration. This was a wide-ranging simplification effort at broadening the tax base while reducing the individual burden. Top rates were reduced from 50% to 33%, to much acclaim. However, at the same time, the dreaded AMT was again strengthened, and more deductions were eliminated. Moreover, the 33% bracket did not apply to the highest income group, but to the second highest. That meant the top three brackets were 28%, 33%, and then 28% again at the peak.

That inversion ended with the Budget Act of 1990, E+2, for George H. W. Bush. With a solidly Democratic Congress, top rates were recalibrated to 28% and 31%. Capital gains taxes were capped at 28%. On the other hand, more deductions were eliminated or reduced.

Bill Clinton pushed through E+1 tax laws in both of his terms, the Budget Act of 1993 with a solidly Democratic Congress, and the Tax Relief Act of 1997 with a Republican Congress. In '93, new higher brackets of 36% and 39.6% were introduced, taking marginal rates past 40% and in some cases close to the 50% barrier that Reagan had broken only a few years before. Little changed in the '97 Act, other than the reduction of capital gains taxes from 28% to 20%.

George W. Bush kept the E+1 string going with the 2001 tax relief bill known as EGTRRA. Implemented at a time of budget surplus, it eliminated estate taxes in a 10-year phaseout, but did little to change the AMT. "Even with the new marginal tax rate cuts passed in 2001," writes Alan J. Auerbach in his 2002 paper, The U.S. Tax Reform Experience, "there has been substantial erosion of the tax law principles established by TRA86. The top marginal rate is nearly what it was prior to 1986, as is the relative tax treatment of capital gains.... The [current] law is, perhaps, even more complex than it was prior to TRA86."

What's In the Pipeline?

Holding to the pattern, there is not likely to be any further legislation this year. But there is plenty of material in the works on Capitol Hill to repeat the E+1 string of recent presidents, or at least to revert to the E+2 rhythm of past decades. Looking at pending legislation, there are many individual changes that could be significant, including shifts in deferred compensation and tax-shelter provisions. There are also a host of energy-related tax provisions and extraterritorial income (ETI) repeal provisions, which are mostly for corporate taxpayers. An additional 14 sections of the Internal Revenue Code are also slated for alteration. Much of the proposed legislation would affect nonresident aliens and "expatriate regimes." But there are also provisions to extend the statute of limitations in certain cases, and importantly, establish bounties for whistle-blowers. A "clean hands" provision is conspicuously absent from the whistle-blower rules--possibly creating a cottage industry for tax cheats to turn each other in.

Perhaps the biggest changes will be to the capital gains taxes, and to charitable deductions for intellectual property. In a provision ripe for populist exploitation, capital gains on sales of precious metals would be reduced from 28% to 15%. You can almost hear William Jennings Bryan decrying that one already. On the other hand, the top age for the "kiddie tax" would be raised from 14 to 18.

President George W. Bush has campaigned on a tax-cutting platform, but over the past 50 years every war has brought a tax increase. We are also seeing how having more women in Congress is influencing taxes involving families and communities. With the polls too close to call, the only sure bet is for high-net-worth individuals to work closely with their financial advisors and accountants to plan coherent strategies regardless of who prevails in November. Tax efficiency is still the preferred strategy, but advisors can craft plans that can build in flexibility when the next tax law is passed.

Susan Hirshman is a VP and planning strategist at JPMorgan Fleming Asset Management in New York, developing strategies to provide wealth solutions to the affluent market. She can be reached at susan.l.hirshman@jpmorganfleming.com.

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