HURRICANE AID AND NEW TAX EXPENDITURES THREATEN PROPOSED TAX CUTS; DEFICIT MAY INCREASE

President Bush urged Congress to provide tax incentives to invigorate areas destroyed by Katrina and to pay for relief initiatives, already over $70 billion, by reducing nondefense spending. Bush administration’s proposals for defense and homeland security may portend a $400 billion deficit in fiscal year 2006.

Revenue shortfalls may force Congress to eliminate preferential rates for capital gains and most corporate dividends scheduled to expire in 2008. Senate Finance Chair Chuck Grassley (R-Iowa) accused the Bush Administration of stalling a bipartisan healthcare bill, and warned of a “domino effect” that would doom the investment tax cuts.

The House narrowly passed a bill intended to increase oil-refining capacity by easing regulatory constraints, and also to avert a projected home heating-oil crisis in New England this winter by enlarging a federal oil reserve in New York harbor. The bill also proposed federal penalties (up to $11,000 per incident) for price gouging by oil companies or retailers of petroleum products. Although Republican House leaders refused to allow debate concerning increased fuel efficiency standards, the Senate may revisit that issue and may also endorse a proposal allowing states to waive a federal moratorium banning drilling for natural gas on federal land off their coastlines.

The Energy Policy Act of 2005 provides new tax credits for the purchase of (i) hybrid, fuel cell, advanced diesel and other alternative power vehicles placed in service after 2005, and (ii) qualifying residential solar water heating, photovoltaic equipment and fuel cell property (up to a maximum credit of $2,000). The Act also provides for (i) a new $2,000 business tax credit for the construction of new energy efficient homes, and (ii) a new deduction for energy efficient commercial buildings.

The President’s Advisory Panel on Tax Reform is due to report November 1. Many Eastern European countries have recently adopted a flat tax. Romania’s S&P credit rating is now investment grade; tax revenues in Russia have increased dramatically since adopting a 13% flat tax. The Wall Street Journal, citing Code “complexity,” urged the Panel to reject fairness arguments and “endorse a simple, broad-based,  single-rate tax system. (“The World is Flat,” 10/7/05).

However, Congress is unlikely to abandon progressive tax rates. Americans and Western Europeans view the flat tax with contempt. German Chancellor Schröder seized upon his opponent’s named choice of a flat-tax advocate for finance minister, warning that Germany should not host an “unjust tax experiment.” His opponent’s lead in the polls evaporated. Contrary perhaps to popular view, new IRS data show that the top 1% of taxpayers paid more than a third, and the top half of taxpayers paid for all but 4%, of total personal income tax in 2003, demonstrating the “steeply progressive nature of the federal income tax,” according to Joint Economic Committee Chair Rep. Jim Saxton (R-N.J.).

Thus far in 2005, 91 U.S. companies have announced plans to repatriate about $206 billion in foreign profits under a one-year tax break enacted as part of the American Jobs Creation Act of 2004. While U.S. companies generally pay U.S. income tax on foreign source income, profits permanently reinvested overseas are generally excepted. During 2005, companies may repatriate profits from overseas operations at a special rate of 5.25%, rather than the typical effective rate of 25%. Although job growth cannot be tied directly to the tax provision, employment growth has been moderate in 2005, and unemployment fell to 4.9% in August, a four-year low. Companies are required to file board-approved plans to the Treasury Department for “approved uses,” although they are not required either to isolate funds or to show that spending on approved uses exceeds that which would have otherwise occurred.

Mutual funds invested in Latin American funds and funds specializing in natural resources are expected to make large capital gains payouts in December. Under federal law, mutual funds are required to pay out any net realized capital gains to their shareholders each year. These gains, which derive from stock trades or other investment income, may be either short-term or long-term. The type of gain — and therefore its tax treatment to investors — is based upon how long the fund held the particular security, and not how long the investor owned the mutual fund. Since short-term capital gains are taxed at the taxpayer’s regular income tax rate, investors should be careful about investing in these funds in the final weeks of 2005. Note that funds held in a tax-favored retirement account such as an IRA are not subject to current tax on capital gains. Accordingly, capital gains distributions to these accounts do not pose a similar concern.

As U.S. Treasury Secretary John Snow  embarks on a trip to China, central-bank head Zhou Ziaochuan said that China must reexamine the value of its currency in light of its soaring trade surplus. Chief Asia economist for Credit Suisse First Boston, Don Tao, said China will address currency reform “at its own pace.”

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