Win Some, Lose Some : Tax Reform Has Been a Mixed Bag

Jan Duncan writes off tax reform as a big loss. The Los Angeles surgeon says his tax bill will quadruple this year, due to a change in how his medical practice is being taxed. And tax reform has prompted him to change his finances in other ways: He doesn’t plan any more contributions to his individual retirement account, and he has refinanced his home, partly to pay off some consumer debts.

But to Hyman Gordon, reform has been considerably less traumatic. The Los Angeles retiree is far more worried about how rising interest rates have cut the value of his bond investments. “Taxes have not had as great an impact as my bond losses,” Gordon said.

Sweeping Changes

When President Reagan signed the Tax Reform Act of 1986 last Oct. 22, many experts proclaimed it the nation’s most sweeping tax package ever, and said it would alter dramatically the ways consumers and businesses save, spend and invest.

Yet as the new tax law approaches its first anniversary, its impact has been decidedly mixed. Some high-income earners who once found refuge in tax shelters have been hit hard, but many middle-income and lower-income taxpayers have yet to feel any significant change.

For many individuals--and for the economy as a whole--tax reform has been largely overshadowed by rising interest and inflation rates and other factors.

The new set of rules has produced many of the expected results, and some surprises. As predicted, consumers are shifting away from credit cards and other non-mortgage types of debt, which are losing deductibility, and toward home-equity loans, which largely retain their tax advantage. Sales of tax shelters, from windmill investments to apartment buildings, have plummeted.

Also to no one’s surprise, tax reform has discouraged some people from putting funds into individual retirement accounts and certain types of real estate, while stimulating sales of tax-favored insurance products.

So far, tax reform has defied some predictions. It has not slowed economic growth or business capital spending as much as had been anticipated. And, even with a higher capital gains tax, the change is widely believed to have helped boost stock prices earlier this year, as many investors put into the market money that, under the old tax code, would have gone into tax shelters and real estate.

The reform also has failed to reverse a decline in savings. Investor interest in tax-free bonds, expected to get a boost from tax reform, instead has slumped as interest rates have risen. Charitable contributions, expected to be hurt by reform, instead show signs of continued growth. Limited partnerships that emphasize income over tax breaks are enjoying strong growth in sales.

Although tax reform was dubbed tax simplification, for many taxpayers it has been anything but simple. The complicated new rules and forms have frustrated many people.

“Tax laws are sufficiently complicated that even a smart person can no longer do his own return,” said Richard B. Ross, executive director of the Chicago-based Center for the Study of Investor Behavior.

Many analysts pointed out that a year may not be enough time to assess the full impact of the new rules. Many taxpayers won’t notice what is different until they file their returns for 1987 next April 15, and learn whether they owe money or will get refunds.

Full Effect Delayed

And, many provisions of the new law are not effective until 1988 or 1989. For example, most workers have yet to see any major effect on their pensions or other employee benefits, because many changes in this area will not be in place until 1989.

Many taxpayers also are postponing major investment decisions, worried that Congress may raise tax rates soon, researcher Ross said.

“It may be another two or three years before we can know for sure whether the expected effects will occur,” said Allen Sinai, chief economist for the brokerage firm of Shearson Lehman Bros.

“Tax reform’s been a non-event” for many individuals so far, said Stephen B. Love, a certified public accountant and financial planner in Torrance.

Mixed results were expected. By lowering tax rates and tossing out a host of deductions and special tax privileges, supporters of tax reform hoped to spur savings and investment in interest-bearing assets such as bonds, while hurting tax shelters and certain real estate and other investments that primarily provided tax breaks instead of income.

Confusion’s Impact

One of the biggest impacts so far has been the confusion of trying to wrestle with new rules and forms, particularly the W-4 withholding form. One result: increased demand for accountants, tax preparers, tax-guide books and other aids.

“We had a dozen people wanting help with their W-4s,” said James Kirby, a Fullerton accountant who said clients had never before needed his help with the form. The extra work prompted Kirby to add to the five-person staff at his small accounting firm.

Another source of headaches for higher-income taxpayers has been the alternative minimum tax--or AMT--designed to ensure that taxpayers with large write-offs pay at least some tax. The complicated AMT could force some taxpayers to reverse their investment strategies, because many otherwise deductible items are not deductible under the AMT.

Doctors, lawyers, accountants and other self-employed professionals also are up in arms about one provision that requires them to shift from paying their taxes on a fiscal-year basis to a calendar-year basis. Paying on a fiscal-year basis allowed these professionals to, in effect, defer taxes from one year to the next. With the change, many will have to cough up hefty one-time payments.

“It takes a lot of the fun out of working,” said Duncan, the Los Angeles surgeon. He said that nearly all of his profits this year will go to Uncle Sam, leaving him little for other investments.

Expectations Fulfilled

Despite the confusion and anger, tax reform has fulfilled expectations in some key areas as taxpayers adjust to new rules.

Tax reform spurred a massive sell-off of stocks and other capital assets late last year as investors rushed to beat a rise in the top long-term capital gains tax rate from 20% in 1986 to 28% this year and 33% in 1988.

Also late last year, consumers rushed to purchase autos, boats, furniture and other big-ticket items while they could still deduct the sales taxes on them. Tax reform eliminated the sales-tax deduction.

Interest in several tax-reduction schemes has waned, because the new rules limit their usefulness. One such gimmick that has been stopped cold: Clifford trusts, a method by which taxpayers shifted assets to their children and had the income taxed at the children’s lower rate.

Another tax-saving vehicle stung by reform has been individual retirement accounts. New rules curb the deductibility of IRA contributions from higher-income taxpayers with company-sponsored pension plans. Income in IRAs, however, can still accumulate, tax deferred, until withdrawn.

“Technically, there are still some advantages in IRAs, but (without the initial deduction) it just doesn’t sound like it’s worth the trouble,” Duncan said.

Many higher-income taxpayers are seeking alternative retirement savings vehicles with attractive tax benefits. One such alternative, single-premium life insurance--coverage paid for with one big premium and providing tax-deferred savings benefits--has enjoyed a sharp boom in sales, said Stephanie V. Enright, a Torrance financial planner who is putting many of her clients into such plans.

Tax reform also has been effective in discouraging investments in tax shelters. Registrations of privately placed limited partnerships--shelters that offer the biggest tax breaks for wealthy individuals--had dropped 60% in the first eight months of this year from the same period last year, according to Robert A. Stanger & Co., a Shrewsbury, N.J., firm that monitors shelters.

Many investors who in past years rushed to buy shelters now are trying to sell them, in some cases at far lower prices than they paid. With fewer write-offs from shelters, many of these taxpayers are likely to see their tax bills go up this year and next.

“Ninety percent of my clients are going to end up paying more taxes,” said Charles C. Mann, president of Professional Financial Advisors, a Mission Viejo financial planning firm.

The reduced attractiveness of shelters is forcing high-bracket investors to look for economically sound investments that generate income rather than tax breaks. “That’s a new way of thinking” for many wealthy people, said Roger Schwarz, a Los Angeles financial planner.

“The new game is to earn money and pay your taxes,” said Jack Alber, 65, a Beverly Hills businessman who will no longer put money into certain bond-investment programs that function as tax shelters. “It (tax reform) closed the loopholes we were working with.”

This search for income has sparked sales of publicly offered limited partnerships, which differ from privately placed limited partnerships in that they stress income instead of tax write-offs. Sales of these limited partnerships were up 37% in the first eight months, Stanger said.

Tax reform also has pounded many investors in real estate, particularly in office and apartment buildings, the primary beneficiaries of past tax breaks. With their tax benefits cut dramatically, investments in these buildings have slowed and prices have been depressed in some parts of the country, said Dennis J. Jacobe, director of research for the U.S. League of Savings Institutions, a trade group for savings and loan associations.

“I’m not going to get nearly the write-off I had before,” said Ed Jenkins, 57, a Lawndale, Calif., real estate broker who owns several apartment buildings in the Los Angeles area. Fortunately, however, prices on the buildings have not declined, Jenkins said. “So I’m going to hang on to them and ride it out a few years to see what else happens to the tax law.”

As expected, a boom in home-equity loans has been triggered, partially at the expense of auto and credit-card loans. Tax reform generally preserved interest deductions on mortgage-related loans such as home-equity loans while phasing out deductions on non-housing debt.

Home-equity debt outstanding, although not growing as fast as some bankers had hoped, is nonetheless expected to double this year from $35 billion at the end of 1986, according to the National Second Mortgage Assn., a trade group representing lenders.

Although tax reform has been like a hurricane in blowing over tax shelters and other old standbys, it has caused barely a ripple in some other areas.

Such appears to be the case with the savings rate, which continues to fall despite lower tax rates starting from Reagan’s first major tax revision in 1981. Savings as a percentage of disposable income fell to 1.8% in August and has generally ranged between 3% and 3.5% all year, down from about 4.3% last year, said Sandra Shaber, an economist with the Futures Group, an economics consulting firm in Washington.

“Maybe if it were not for tax cuts, the savings rate could’ve been worse. Who knows?” Shaber asked.

Why the lower savings? Shearson Lehman’s Sinai suggests that consumers, optimistic about recent rises in employment and economic growth, have simply decided to spend their extra after-tax dollars rather than save them. Consumers also are enjoying a “wealth effect” from a 5-year-old bull market in stocks that has prompted them to spend rather than save, Sinai suggested.

Some economists suggest, however, that the figures understate consumer savings. One source of the understatement: Individuals have been saving through such vehicles as pensions, IRAs and the popular 401(k) company retirement-savings plans, and these accounts may not get counted in savings statistics, they say.

In 401(k) plans, an employee contributes part of his salary to a tax-deferred savings plan, often matched by an employer contribution. The salary portion contributed to the 401(k) is not taxed until the funds are withdrawn.

Tax reform also has had unexpectedly little impact on most employee benefits. Reform did cut maximum annual contributions to 401(k) plans to $7,000 from $30,000, hurting high-paid executives. But many companies have offset these cutbacks with promises of additional benefits in other plans. And the 401(k) restriction has had little effect on lower-paid employees, who were not contributing more than $7,000 a year anyway.

“For the rank-and-file employee, tax reform has had very little impact,” said Charles I. Harris, a vice president in the Los Angeles office of Towers, Perrin, Forster & Crosby, a nationwide employee benefits consulting firm.

Tax reform also was expected to lead to a surge in formation of employee stock ownership plans (ESOPs), by continuing and expanding tax breaks for companies offering the plans. Although there was an initial rush of interest on the part of companies after passage of tax reform and several highly publicized new ESOP proposals--such as the employee buyout of the Avis rental car company--the actual number of new plans formed has fallen far short of expectations, Harris said.

Still Legitimate Shelter

Individual investment in tax-free municipal bonds has not been boosted, although bonds remain one of the few legitimate shelters. Sales of mutual funds in intermediate-term and long-term municipal bonds, the major vehicle for investors who dabble in tax-exempt bonds, have declined 4.8% this year through August, compared to the same period a year ago. That followed healthy increases in previous months.

The culprit: rising interest rates, which cut the value of existing municipal bonds by as much as 15% back in April and early May, and scared many investors away.

“Who cares if the bonds are tax-free when people are losing 15% on their investments?” said Steven E. Norwitz, spokesman for T. Rowe Price Associates, a mutual fund company based in Baltimore.

Tax reform also has drastically reduced the supply of new tax-exempt bonds hitting the market, thanks to new restrictions on issuance of municipal bonds. That has caused a shakeout among bond dealers that last week resulted in the largest dealer, Salomon Bros., announcing that it will withdraw from the market.

Yet not all of reform’s unexpected results have been unpleasant.

Charitable organizations, which last year were lamenting the tax change, amid forecasts that it would cut donations by $10 billion or more, are relieved at evidence that contributions may not decline after all.

Giving Seems Unaffected

A recent survey conducted by the American Assn. of Fundraising Counsel and the Gallup Organization found virtually no effect on giving this year. In the poll, about 80% of individuals with household incomes of more than $40,000 said they planned to give as much or more this year, said Lawrence A. Clancy of the association.

“The reason why people give is not because of taxes,” Clancy contended. “People give because they believe in something, and with added disposable income this year, they have money to give.”

Clearly, some investors have yet to realize the full impact of many tax changes. One such area involves new rules governing mutual funds, which require investors to pay taxes on fund-management fees, will, in effect, make investors pay Uncle Sam on income they don’t actually receive.

“What they’ve done to mutual fund investors should have created an uproar, but people have been making so much money on mutual funds, they just don’t care,” said Jay Goldinger, an investment broker with the Beverly Hills firm of Cantor, Fitzgerald & Co. “But once you get a bear market in stocks,” he said, “people are going to care about that 1% or 2%” they will have to pay in extra taxes.