Happy 2005!

Last year’s tax letter ended with the hope that 2004 would see the end of foreign and fiscal wars. If anything, things got worse on both battlefronts and 2004 ended with a level of natural calamity that seemed almost biblical. The scale of destruction and the extent of the human tragedy in Southeast Asia almost obliterated the rest of what occurred this past year.

With the tsunami such a recent occurrence, it is hard to view the tax events of 2004 with any comparable degree of significance. In some ways, however, I think that the tsunami is a possible metaphor for what may be happening in the world of public finance. If you believe, as many past designers of the American tax system did, that the common wealth is created by a tax policy that requires those of means to collectively assist those without means, then what is occurring in the arena of tax legislation at the national, and to a somewhat lesser extent at the state level, is in effect the quake that is setting of a barely perceptible “tsunami”, a growing wave that will effectively dismantle 70 years of social construction. Far fetched, alarmist? Some economists have suggested that the Bush tax revolution has shifted more money to the upper class from the lower and middle-income levels than at any time in our Union’s history.

President Bush Sr. had the misfortune to promise no new taxes and then had to retrench in the face of economic reality. His son sadly has ignored economic reality and thus avoided retrenching but at a great cost to us all. Rather than developing tax policies to deal with the massive deficits that he has created by his blind and almost “religious” commitment to lower taxes, President Bush Jr. will leave each of us and untold numbers of future generations with an individual share of the national deficit hundreds of times greater than the $300 average refund that he sent to us in 2002.

Because 2004 was an election year, the tax legislation was somewhat muted. There were two tax bills passed: the American Job Creation Act, or AJCA and the Working Families Tax Relief Act. Interestingly, the tax bills didn’t have a lot to do with “job creation” and had more to do with benefiting business than working families. One of the main provisions allows American corporations to repatriate the earnings of their foreign subsidiaries with 85% of those earnings being free of tax. Business purchases of SUVs over 6,000 pounds which had escaped the deduction limits imposed on other personal vehicles, were trimmed somewhat. Leasehold improvements for restaurant and qualified nonresidential improvements were granted a 15 year depreciation life instead of the previous 39 years. Both business startup costs and organizational expenditures of up to $5,000 each can now be deducted in the initial year of operation with the balance amortizable over 15 years instead of the previous 5. Domestic producers which includes a wide array of activities from traditional manufacturing to architecture and software development are eligible to deduct the current year’s applicable domestic production percentage times the lesser of the qualified production activities or the net income but not more than 50% of the wages for that year. The production credit is only available to businesses that have taxable income. The theory seems to be that reducing taxes on businesses encourages job creation.

For individuals, the lower capital gains rate of 15% remains in effect for long-term gains and qualified dividends but so does the limit on overall capital losses to a net loss of $3,000. All of the previous phase out provisions and the alternative minimum tax exposure remain in place. Phase outs are a now-you-see-it, now-you-don’t mechanism for masking the fact that the effective tax rate is actually higher than the officially stated tax rate. Normally allowable deductions, exemptions and tax credits are “phased out” for taxpayers with incomes above the threshold. The alternative minimum tax to which more and more taxpayers are becoming subject similarly recalculates the taxpayer’s tax by disregarding otherwise allowable state and real estate tax deductions.

Charitable deductions for automobiles, boats and planes have been sharply curtailed. Previously, the donor could deduct the fair market value of such donations. Now, the deduction will be limited to the gross sales proceeds that the recipient charity actually gets for the item. The charity is required to provide the donor and the IRS an acknowledgement of the proceeds and for donated items valued at more than $5,000, the donor must obtain an appraisal by a qualified appraiser.

At the state level, the legislature accepted Governor Schwarzenegger’s proposal to close last year’s fiscal gap by borrowing billions dollars and by taking from the schools in 2004 a portion of the funding that the voter-approved Proposition 98 would have guaranteed them. For their part, local governments agreed to let the state confiscate the 2005 portion of the vehicle license revenues that they were entitled to if the Governor in turn agreed not to oppose Proposition 1A whose passage by voters prevents the state from making future raids on local tax revenues. Local governments and school districts face a funding crisis comparable to the aftermath of the infamous Proposition 13 whose primary effect has been to shelter corporate property owners from re-assessment and shift the majority portion of property taxes from commercial to residential owners. The whole tax system is in need of a realistic overhaul.

2005 promises to be an interesting year. Iraq has become a quagmire. There are deficits on every level of government. The President has added Social Security revision to the federal mix. In California, the Governor, having reneged on a deal he made with School Districts to reinstate in 2005 their full Prop 98 entitlement, will not be able to count on that constituency to help him convince the legislature to pass this year’s budget. We seem to have moved a long way from John Kennedy’s “Ask not what your country can do for you! Ask what you can do for your country”. We will no doubt muddle through; but a large dose of inspiring idealism would make the hard medicine needed to reverse these deficits go down easier.

2004 saw significant changes at Morton & Associates, Inc. Three of the staff completed the requirements for their CPA certificates and Mary decided that it was time to fully retire. From Jack, James, Chris, Edward and Jason our best wishes for the year ahead.