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Lost in the counting of chads in the Florida recount is the reality that there are now four major political forces
fighting for control of the government, not just the two major political parties. The Republican and Democratic
parties have split into congressional and presidential forces, each with it’s own agenda regarding gaining power
over the legislative or administrative branches of government.

Over the last 30 years, gerrymandering has become brutally effective in locking up seats in the US House of
Representatives for one of the political parties. In the past election only about two dozen House seats were
seriously contested, allowing the remaining incumbents the freedom to take partisan stances that appeal to their
narrow constituencies. In comparison, the presidential candidates have adopted more centrist positions because
their constituencies alone are incapable of delivering enough votes to deliver an election.

The re-election of Bill Clinton in 1996 and the conduct of the 2000 campaign underscore this divergence
between the presidential parties and their congressional counterparts. This year Republicans in congress
appealed to their supporters by passing a series of tax bills that eliminated the estate tax and marriage penalty,
and dramatically raised retirement savings limits. These changes clearly would not survive pre-announced
presidential vetoes. The congressional Democrats responded by proposing a new prescription drug benefit.
Because of current Republican control of Congress, these proposals also amounted to campaign posturing rather
than serious legislation. The whole episode was more theater than substance, as predicted in last year’s
newsletter. Where is the Whig Party when we really need it?

The presidential race will be decided by the disposition of a statistically insignificant number of disputed ballots
in Florida by divining voter intent. What might be more to the point would be to divine the intent of the 50% of
eligible voters that didn’t show up on Election Day. If one political party or the other gained the support of 20%
of these no-shows in 2004, they would likely be claiming to have a mandate. This is difficult to do when you
only have 25% support from eligible voters. It is clear that the pitches of both presidential candidates were ineffective
in motivating voters on the margins. The mixed signals sent between the congressional and presidential
parties are a major factor in voter cynicism.

Year 2000 tone-deafness award

The envelope, please. The clear winner is the congressional Republicans for attempted estate tax repeal. There
is much to dislike in the current estate tax structure, but this bill probably cemented the feelings of some voters
that the congressional Republican Party is more interested representing wealthy constituents than in doing
something equitable from a tax administration standpoint.

One of the hidden benefits of our current estate tax system is that the tax basis of assets in a decedent’s estate
are adjusted to fair market value at date of death. Individuals holding highly appreciated assets permanently
avoid income tax on this appreciation in value when assets pass through their estates. In these instances,
incurring some estate tax is a substitute for income tax that is avoided. Exempting this form of income
permanently from taxation narrows the nation’s tax base.

It was only 15 years ago when the tax code was restructured to lower marginal rates but broaden the tax base by
restricting certain deductions and tax all income in the same manner. This direction was reversed under George
Bush Sr. and Bill Clinton as both increased marginal income tax rates while simultaneously lowering taxes on
capital gains.

Gore misses the boat on reform; Social Security taxes will be a big issue for 2004

If you carve out a preferential system of taxation for certain types of income (low taxes on capital gains, no
income or estate taxes on untaxed appreciation), this cost has to borne by other sources (assuming the cost of
operating government remains constant). The clear loser over the past 15 years has been the wage earner whose
income is subject to both income and employment taxes. For 2001 the Social Security wage base is increasing
from $76,200 to $80,400. This is a 5.5% jump and far outpaces the 2.7% inflation rate that is used to index tax
brackets, personal exemptions, and the standard deduction. In the five years from 1996 to 2001, the Social
Security wage base has increased by 28%, an increase of 5.1% per year. The taxpayers who really bear the brunt
of the employment tax assault are two wage earner families where both incomes are less than the Social
Security wage base. These income are subject to both income and wage taxes.

Younger workers view employment taxes with suspicion because they know that unlike private pensions, the
Social Security system is unfunded and encompasses significant transfers of wealth from contributors to retirees.
What private sector retirement plan could get away with netting participants a 1% to 2% rate of return? All
those attorneys currently working on the Florida recount would have a field day suing the plan’s trustees.

The handling of the Social Security system also has the potential to be a significant women’s rights issue. Over
65% of women currently work, and two income families are becoming the rule rather than the exception. The
Social Security benefit of a second wage earner in a family is penalized because on the death of the spouse, the
spouse’s benefit, if larger, is inherited and the lower wage earner’s benefit is lost. This rule has the effect of
making the lower wage earner’s benefit a less valuable single life annuity. We are not sure that working women
are interested in subsidizing the nuclear family.

In the end, the 2000 election could end up being the turning point for Social Security reform. George Bush Jr.
promoted some privatization of the system and still managed to carry the senior citizen vote in Florida. So it is
possible to propose changing the system and not automatically lose an election. Al Gore represented the status
quo with respect to administration of the plan, and by association, the current system of employment taxes.
This may partially explain his inability to defeat Bush Jr. despite a low unemployment rate.

If one believes that resistance to Social Security taxes will increase as the burden of employment taxes grows,
the party that manages to adopt reform of the system as a populist issue for younger voters may come out ahead
in the future. One thing that would give these taxes more legitimacy with these voters would be to manage the
system like a defined contribution plan where individuals truly own their account balances.

The private sector has been moving away from defined benefit pension plans to cash balance arrangements for
the past decade because of demographic changes in the workforce. Pork barrel politicians tend not to like this
idea because it puts the honey pot off limits. The party that reaches out to alienated younger voters could wind
up with a winning coalition in 2004. Stay tuned.



Year 2000 Current Developments

  1. The recent recount-aided swoon in the stock market highlights the need for investors to review their
    portfolios before year-end.
    The general rule is to accelerate the recognition of losses and defer gain recognition.
    However, investors should be careful about making portfolio decisions based on tax strategy alone. Many
    large corporations have seen their market valuations punished for failing to meet the earnings expectations of
    Wall Street. It’s OK to consider the tax effect of portfolio changes, but having portfolio decisions driven by tax
    factors misses the bigger picture.

  2. The IRS has broadened attacks on tax shelters through the issuance of new regulations and
    registration requirements.

    Action: Don’t make investment decisions driven by the promise of tax benefits. If promised tax benefits
    looks too good to be true, they probably will be challenged.

  3. It now appears that the US senate is split 50-50 between Republicans and Democrats, and the
    Republican majority in the US House of Representatives has narrowed.

    Action: Don’t hold your breath waiting for the repeal of the estate tax and other tax goodies pass by
    congress but vetoed by President Clinton.

  4. Regulations were issued this year covering procedures that allow pension plan administrators to protect plans
    from disqualification in the event that a defective rollover contribution is inadvertently accepted. Plan administrators
    will be allowed to distribute the defective rollover plus any earnings attributable to the rollover within a
    reasonable time after determining that the rollover is defective. The regulations provide the criteria that would
    allow a plan administrator to conclude that a rollover is valid.

    Action: Plan administrators should revise procedures to meet the requirements of the new regulations in
    determining the validity of rollovers. If you don’t want to deal with complying with the regulations, the
    safest approach would be not to accept any rollover contributions.

  5. With recent increases to the Social Security earnings base and the uncapping of the Medicare earnings
    base in 1993, exposure of income from pass-through entities to employment taxes has increased.

    Correspondence reviews of individual returns has inadvertently been made easier by reporting under the passive
    loss rules since individuals are required to declare whether their participation in an activity meets the material
    participation standards in determining whether the activity is active or passive.

    Before the use of pass-through entities became a popular way of conducting business, IRS audits would question
    the reasonableness of compensation declared by corporations in order to change wage deductions into nondeductible
    dividend distributions. With the rise in employment taxes, taxpayers are more interested in putting
    a cap on their earned income since wage deductions for pass-through entities are a not an issue except for S
    corporations.

    A taxpayer’s income from a pass-through entity may be considered to be self-employment income. This is
    determined by the nature of the entity (S Corporation, limited liability Company, limited partnership), the
    individual’s status as a managing member or general partner, provisions in LLC or partnership agreements, the
    nature of the business, and participation declarations in the taxpayer’s individual income tax return.

    Action: Owners of pass-through entities should review their LLC or partnership agreements to make sure
    that passive income is not inadvertently exposed to employment taxes by omissions in these documents.
    Business owners operating through multiple legal entities should review their business entity structure to minimize
    exposure to employment taxes. Exposure to employment taxes should be considered in legal entity selection
    for new business ventures.

  6. Effective retroactive to January 1, 2000, the reduction of Social Security benefits for working seniors aged 65
    to 69 has been repealed. Previously benefits were reduced $1 for every $3 of wages or self-employment income
    above $17,000. However, individual aged 62 through 64 will still lose $1 of benefits for every $2 of wage
    income over $10,080.

    Action: Anyone age 65 should consider commencing Social Security benefits. Working seniors should
    examine options to defer payment of private pensions until past anticipated retirement or at 70 1⁄2 (the
    latest allowable starting date).

  7. The IRS has encountered difficulties in matching taxpayer names on tax returns to records in the Social
    Security system. The main sources of these problems are taxpayers with multiple Latin surnames and female
    taxpayers who have recently married or use hyphenated last names after marriage. (We honestly don’t know
    what the IRS will do about hyphenated multiple Latin surnames.) Discrepancies will trigger the issuance of
    error notices.

    Action: Female taxpayers who have undergone recent name changes should check with the Social
    Security Administration to see what name is on the system for their Social Security number. SSA records
    should be adjusted to reflect legal name changes. Make sure the name used on tax filings matches
    EXACTLY to the name on the Social Security records.