TRADERS TAX REFORM 2005

WHAT'S IN YOUR TAX FUTURE? Additional income tax cuts, a new FairTax (national sales tax), or a Flat Tax (repeal of itemized deductions)? Or, a significant reversal of recent income tax cuts and tax increases to pay for huge deficits and spending needs. Republicans continue to preach tax reform, reduction and simplification. Key states are striking off on their own agendas to raise taxes. Is a tax war coming and how can you defend your tax plans?

By Robert A. Green, CPA.

This article was edited differently by Active Trader magazine and published in their December 2005 issue.

Watch out! There seems to be a new trend for state and locally elected officials departing from federal tax (reduction) laws in unprecedented ways, in order to raise state taxes and fend for themselves.

Hurricane Katrina whipped up tensions between federal, state and local politicians and exposed structural problems in allocating tax and spending dollars among federal, state and local governments. This may be the stick that breaks the camel's back on current high tensions between the federal government and states on tax policy.

Republicans are advocating further tax reduction, even in the face of new spending needs for hurricanes, the wars and Homeland Security. Blue states are rejecting tax cuts, and passing their own state tax increases.

There is plenty of talk about tax change, and what's an individual taxpayer to do?

The country is divided on tax policy
"Never has this country been so divided" is a popular theme in the media.

The popular fault lines are: red states vs. blue states; Republicans vs. Democrats; war vs. peace; and tax cutters vs. tax raisers.

Historically, big spending and higher taxes have been the policies of Democrats and blue states. It's important to note that most blue states have America's great cities. These cities may be financial money pits in need of financial support (taxes), but they are also great cultural nerve centers, where some of our greatest citizens and companies reside and contribute to America's success.

Lower spending and lower taxes has been the policies of Republicans and red states. These states also have some great cities but they have also thankfully succeeded in attracting new businesses and not been overwhelmed with spending in their cities. They benefited from the north to south migrations over the past few decades.

Republicans are in control of the federal government and President Bush has led the charge for significant tax reduction legislation. It's important to note that Republicans believe in supply side economics, which says that lower tax rates lead to higher tax revenues by encouraging more productive business behavior.

Some studies also show red states are currently receiving more federal tax dollars than blue states in federal state sharing. This trend can further escalate tensions between red and blue state tax factions.

Will Hurricane Katrina spending be a tipping point of thought?
Will huge spending needs in the Gulf States, traditionally in the red state stronghold, cause some red states to follow blue states in passing their own home state tax increases?

Some states are striking off on their own tax path.
Some blue state politicians are campaigning for and passing new state tax increases that fly in the face of recent federal tax reduction and reform. See the estate tax example below.

However, this is not (tax) business as usual. Historically, states have adhered to the federal tax laws. Nationally coordinated federal and state tax policy advanced nationwide business.

State tax policies have always differed from federal tax law on a state-by-state basis, but I sense a new disturbing trend here – for some (especially blue) states to depart from federal law in a more serious and potentially confrontational manner.

Americans expect volatile changes in the tax code; it's historically the trend and it's business as usual. Fiscal (tax) policy is an excellent forum for pork-barrel politics, and that's just part of the American success story (right or wrong).

It's reasonable for taxpayers to expect that when Democrats are in control of government, taxes may be increased or reduced more slowly than when Republicans are in control (usually advocating tax reduction). This is the classic battle. But the old ways for making tax change appear to be in jeopardy.

Replace the federal income tax with a national sales tax?
The federal government is proposing to repeal the federal income tax and replace it with a national sales tax of 23 percent (the "FairTax"). See Robert Green's "Is the Fair Tax a fair tax?" in the Feb. 2005 of Active Trader.

Consumers also seem keenly interested in FairTax as evidenced by the fact that "The FairTax Book" was number one on the best seller list for many weeks.

Fundamental tax changes conceived and made by politicians often have serious unintended consequences in a free market economy. It's the classic government planners vs. the free market, and case after case has exposed problems with central government planning.

In my opinion, FairTax has not been carefully thought out and I see some unintended market shocks.

The American economy is strong and considered consumer-led – we are the consumer-led engine to the world. I haven't heard one FairTax proponent explain the possible downside from raising price levels by 23 percent, the rate of the national sales tax.

Just try telling (great red-state company) Wal-Mart to raise their prices by 23 percent, so their partner Uncle Sam can get his share.

Wal-Mart operates on tiny operating income margins and even lower taxable income margins. Those numbers are much less than 10 percent, so even if they cut income taxes out of their pricing model, where do you squeeze in the other 23 percent?

How will states react to a national sales tax?
If you repeal the income tax on the federal level, what are states expected to do, since states piggy back the federal income tax laws?

Is it time for states to consider fending for themselves and departing from the federal tax system? If the federal government has a 23-percent national sales tax, won't that compete against a state sales tax, the life tax blood of most states, red or blue?

Doesn't a virtual economy afford more people the opportunity to move to a low taxing state? Traders and hedge funds can operate in a virtual environment. They are not wed to a local company's office or the stock exchange floors as floor traders are.

Traders can simply pack up the family and move to a low-taxing state if they choose to do so.

Exchanges are also becoming more automated and broker/dealers are becoming more Internet-based. So their people can also consider moves.

In the past, people and companies were more rooted in the ground and state tax differences were not as great as they may be going forward. So if you make people and companies less rooted because of the Internet and you raise the tax gap of high-taxing states vs. low-taxing states, it's reasonable to conclude that waves of additional people and companies will move from the Northeast and West coast to the south. That's additional blue state to red state migration.

Blue state taxation will be locked in a vicious cycle and theory trap. Tax millionaires more, encourage them to move out of state and then have fewer people to tax more to support the poorer people in the inner cities.

The only solution will be for Democrats to win control of Washington and raise taxes on the federal level for all Americans. So the stakes in Washington are greater than ever.

A Yankee blue state fires the first shot, targeting millionaires for estate taxes, even after the federal government phases out the estate tax.

Democrats in my home state of Connecticut just passed a new estate tax targeting wealthier Connecticut taxpayers. But didn't the federal government just phase out the estate tax?

I thought my estate tax planning could have a rest.

I live in Fairfield County, Conn., which is home to many hedge funds, financial service industry executives and CEOs. The average home in Fairfield country will trigger the new Connecticut estate tax.

So on the one hand, I can do tax planning based on federal taxes, and I also must keep my eye open to tax attacks from Connecticut, which are there to suit the state's interests.

I can also keep my eyes open to what's happening in New York State and City, and on a dime just move there instead. Maybe, I should just convince my wife to move to the sunny south? But we really like our lifestyle in New York City and Connecticut. It's a tough decision.

Doesn't this all sound unfair? We keep reading about tax reform, simplification and certainty, but I am being forced to deal with tax law uncertainty and politics in that tax arena.

We have two federal tax systems and soon to be 50 state systems – that's getting ridiculous. Most Americans are starting to wake up to the sneaky alternative minimum tax (AMT), the second federal tax system that's been part of federal and most state tax law for years.

Because AMT is not indexed for inflation and bracket creep and rate reduction, AMT is starting to hit the middle class. That's unfair since it was passed to defend against upper class tax abuse (shelters and avoidance).

So we have two federal income tax systems in America, the regular income tax and AMT. Taxpayers are forced to calculate their taxes under both scenarios and pay the higher. You also should plan your taxes around both systems.

Now taxpayers may have many diverging state tax systems to deal with, too.

Imagine if the federal income tax system is repealed, with one stated goal of not hiring accountants anymore to prepare your tax returns. That goal is defeated if you have to hire an accountant to prepare your state income tax returns.

If you have sources of income in many different states – and more Americans do each year with investment partnerships and telecommuting – you have complex different tax rules to follow in many different states.

A goal to take work from accountants just increases their work. Funny how it always comes out that way.

The best deal will be consensus and peace among tax writers.
It's in the interests of taxpayers and probably others to boot to have consensus on the tax front and not breach the historical compromises on tax policy.

It's in nobody's interests to have every state and city go off on their own tax path and cause tremendous complication, uncertainty and unproductive behavior of their taxpayers.

Should the US chase the EU or vice versa?
The European Union (EU) will be held back by tax confrontation. No EU state yet has made up their mind that they want EU federal taxation. Without EU federal taxes, it's hard to agree on EU spending on EU defense and more. Do we want that type of division in America?

A call for tax peace
Our politicians should cool it.

State and local politicians should not start tax class warfare against their millionaires. The millionaires can move too easily.

Republicans should not use low tax policy talk to undermine blue states and force them to reject their federal rules.

Fix it by making fiscal policy independent from politics like monetary policy
In my opinion, it's time to consider making fiscal (tax) policy independent from politics, just like monetary policy and the judicial branch of government.

But this is very unlikely and probably can never happen.

Congress uses fiscal policy as an integral part of pork-barrel politics, which combine taxes with pending programs.

Alan Greenspan and the Federal Reserve Bank do not raise or lower interest rates at the whim of politicians.

Look at the federal vs. state tax history
Historically, state income tax codes have conformed to the federal tax code.

Many states simply tax federal adjusted gross income (AGI) – the midpoint between gross income and taxable income.

States do have some modifications for additions and subtractions to AGI.

But for the most part, many states follow federal taxable income.

What vary by state are their income tax rates.

Federal and state tax consensus started to unravel in 2003 with the Bush tax cuts
When President George W. Bush and the GOP-led federal government started their tax cut initiatives in the early 2000s, many states considered breaching the historical piggy back alliance.

Many states such as California, New York, Massachusets and Connecticut did not accept all the latest tax cut changes and required modification additions and subtractions to add back federal benefits to AGI, and then subtracted the prior allowed state tax benefits. In effect, these states ignored some of the tax cut changes that affected them.

Other examples were California freezing net operating loss (NOL) deductions, a huge problem for the most populous trader state. NOLs protect traders more than any other tax benefit.

California is a trend setter
California is a high-taxing state and both creative and aggressive in its tax policies.

This is not appreciated by some of its taxpayers. The state's unique "public referendum" system has reversed many tax increases.

In the past, California tried to tax companies on their global income, not just their income in California. That would have caused some havoc in tax planning for companies in the state.

Look to California, New York, Connecticut, Massachusets and Illinois when it comes to a bellwether of federal vs. blue state tax changes.

Unfortunately, blue states may feel that red states and Washington have the edge. A GOP-led Congress and White House are pushing for further tax cuts, in line with the red state tax initiatives.

Their idea is to be friendly to business, reduce taxes on individuals and trust that supply-side economics will provide the necessary lifeblood of taxes for the government (increased tax revenues with lower tax rates). In a room of economists, many will agree and others won't. Whether supply-side economics works or not is beyond the scope of this article.

GOP Treasury Secretaries have called the current income tax code an abomination in serious need of major reform. Past Treasury Secretary O'Neill (during President George W. Bush's first term) said that tax code should be scrapped and entirely re-written. Current Treasury Secretary John Snow went one step further. He supports current new "Fair Tax" proposals to repeal the income tax code and replace it with a national sales tax of 23 percent.

GOP tax cuts have significantly reduced federal income tax rates, increased depreciation allowances, increased federal tax credits, phased out federal estate taxes and started an initiative to free portfolio income of taxes (think health savings accounts and lifetime savings accounts).

The blue states are fighting back
Notice that some of the above recent federal tax cuts only reduced federal taxes and did not reduce state taxes. For example, lowering federal tax rates did not cause a lowering of state tax rates.

Many states rejected the changes that affected them.

For example, Bush tax cuts increased depreciation allowances, but states did not comply. Bush tax cuts phased out estate taxes and now Connecticut passed its own estate tax.

The GOP also advocates a Flat Tax
That's when itemized deductions such as the precious mortgage interest expense, state income taxes, contributions and miscellaneous itemized deductions are disallowed (most already are in the AMT).

Taking away these itemized deductions can unduly hurt higher-taxing blue states more than lower-taxing red states. A Flat Tax can also cause blue state anger, cries for tax discrimination and independent tax policy.

If you can't deduct your state income taxes, it hurts a lot more when you pay higher state income taxes. All itemized deductions tend to run higher in the blue states, where there are higher priced homes as well (higher real estate taxes and mortgage interest).

States can also play unfair
Since the Internet took off as part of our economy, the federal government has pressured states to lay off subjecting Internet transactions to state sales taxes.

That consensus also appears to be falling apart.

There are new state initiatives to tax many more Internet-based transactions.

These state actions will cause additional uncertainty and havoc in the economy.

I predict the following
I predict Fair Tax will not pass because Wal-Mart and other businesses will not support it, consumers and states will reject it, and it's too divisive.

At this point, states and the federal government need to find consensus.

States have shown their hand in going off the federal standard and this should back off the more radical tax reformers.

I think that hurricane damage spending in the southern states will align red and blue states in a new dynamic.

Hurricane Katrina may be a tipping point for President Bush and GOP agendas and that includes tax.

I think it's in everyone's interests to further reform the tax code, but in a less drastic manner.

What should traders do?
Understand the tax lingo and decipher tax talk hype from reality.

Be on the lookout for your home state getting more aggressive on tax increases.

Don't consider an out-of-state trading entity if you live and trade from your home state, it won't work.

If your home state gets too aggressive on taxes for your taste, consider a move out of state.

Don't just try to change residence to a second home; many states are geared up to catch this and win.

You don't have to change political parties; there are many pockets of blue in some red states.

Think sunny southeastern Florida, it's a red state – by a hanging chad – and there are plenty of blue areas. The same goes for many states; they are red and blue.

If you relish the lifestyle of a blue-state city – and millions do – then just pay the piper a little more to live and work there. An argument can be made that where you pay higher taxes, you also make higher incomes.

But this argument does not bode well for traders, as it's a level playing field nationwide.

There are other ways for tax protection too.

If mortgage-interest deductions are in jeopardy with either the Fair or Flat Tax, why not reduce your mortgage interest? It's a good time to consider paying down or off your mortgage. I have always said that a mortgage for a trader is another margin loan and that sound risky.

If you are counting on benefiting from tax cuts over the next few years, like lower 15-percent tax rates on qualifying dividends and long-term capital gains, then take those benefits before tax rates are reversed up again. Of course, if the Fair Tax passes, there won't be any tax at all. So "wait until you see the whites of their (tax) eyes."

Encourage your blue state politicians to wake up and smell the tax coffee
Blue state politicians may not believe in supply-side economics, but if other states have much lower taxes, traders may move there.

A tax consumer may gravitate to the low-priced supplier, the lower-taxing state.

Encourage your home state to keep a lid on tax increases.

Here are some travel (tax) tips
Think of sunny Florida, a state with no income tax. It has the (very low) intangible tax, but you can go to cash at year-end to avoid that.

Or how about Nevada, another tax-free state? Trade the markets during the day and gamble in the casinos at night. If you prefer the country life, chose Lake Tahoe.

Texas has no individual income tax but it does have a tax on all entities. Husband/wife trading general partnerships are exempt from the Texas franchise tax on businesses.

Washington State is just like Texas – no individual income tax but a tax on entities. This is a trend in some states.

Bottom line
Tax planning is important on a short, medium and long-term basis. But the best laid long-term tax plans are vulnerable to rapid federal and state tax changes. The current environment is pitched for more volatile changes. Republican tax reformers are pushing to repeal the income tax code. Democrats are resisting tax cut changes, seeking to raise state taxes and seize control of Washington to reverse tax cuts. Tax policy and change are now an integral part of the political fault lines. It's hard to forecast politics, so just keep your tax decisions open and focused on the short term. Be ready to make tax changes on a dime.