US Administration's Tax Planning Creates Confusion

by Mike Godfrey, Tax-News.com, New York

31 January 2003

With President Bush's proposed tax-cutting package running into criticism both inside and outside Congress, the non-partisan Congressional Budget Office has projected shortfalls of $199 billion in 2003 and $145 billion in 2004 in its semiannual report to the House and Senate Budget committees, up from $145 billion and $111 billion six months ago. The CBO estimates don't take the proposed tax cuts or any war with Iraq into account.

North Dakota Senator Kent Conrad, the Senate Budget Committee's ranking Democrat, pounced on the figures, saying: "His policies have plunged the nation back into deficits and debt, Social Security and Medicare are threatened, and the administration is shortchanging domestic priorities." But Republicans said the deficits were as expected and simply proved the need for the tax cuts. Senate Budget Committee Chairman Don Nickles of Oklahoma said Congress must work to "restore growth in our economy and restrain the growth in spending or we will never balance the budget."

John Snow, the President's nominee for Treasury secretary, faced critical questioning of the 10-year $674bn tax cut package during his confirmation hearings by the Senate finance committee on Wednesday, perhaps reflecting widening uncertainty about the economic impact of the package, and particularly about the dividend tax cut. The administration has not helped clarity by letting it be known that it is considering sweeping changes in retirement-savings policy , including greatly expanding Roth individual retirement accounts (IRAs), in a move that would likely raise government revenue in the short term.

Some initial estimates of the cost of the dividend tax cut ignored income which investors currently put into 'tax-free' investments such as municipal bonds and normal (non-Roth) IRAs. Once changes to IRAs are factored in, it becomes next to impossible to estimate the cost of the dividend tax changes. The new plan would encourage savers to switch from traditional IRAs to Roth-style accounts, which don't offer up-front tax deductions, and indeed which wouldn't need to if fed with tax-free dividends. Roth IRAs are tax-free on distribution, unlike regular IRAs.

There are also suggestions that dividends would only be tax free if the tax foregone was no higher than a company's mainstream income tax bill in the relevant (or immediately preceding) period (sounds something like the Advance Corporation Tax system recently abandoned in the UK), leading to the possibility of partial tax-exempt dividends, non-exempt dividends, and other nightmareish scenarios which would create endless fun for journalists and tax advisers but little joy for investors.

The administration's goal, of simplifying and expanding tax-free savings instruments, is praiseworthy, but the announcement of such plans alongside the dividend tax cut has merely created confusion. The Treasury has yet to comment officially on any proposed savings sector changes.

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