January 1996 Bulletin

Is flat tax on horizon?

By Joel M. Blau

Joel M. Blau is vice president and senior financial counselor, AMA Investment Advisers, L.P., an affiliate of the American Medical Association.

The Republicans, in their takeover of Congress, have made tax reform a priority item on their political agenda. There is considerable talk now of a "flat tax" -a tax system with one tax rate and few or no deductions.

What are the chances that a flat tax system will become reality? Certain aspects of the flat tax are controversial, and many experts believe that converting to such a system is too drastic to win approval. On the other hand, there are indications that voters want to see radical tax reform, and the concept of a flat tax in some form is rapidly gaining in popularity. In any case, most Washington analysts agree that dramatic tax reform is not likely to precede the 1996 elections.

Currently, there are many different proposals being discussed that share the same goals: to simplify the tax code, eliminate loopholes, and reduce the cost of tax compliance. One of the more popular proposals is the plan endorsed by House Majority Leader Rep. Richard K. Armey (R-Texas). Under his plan, individuals would pay an initial flat tax of 20 percent for two years, then 17 percent thereafter.

As an encouragement to Americans to increase their level of savings, capital gains, interest and dividends would be totally exempt from taxation. This would cause a negative impact on tax exempt municipal bonds. If the tax incentive of holding municipals was removed, the underlying value of the bonds would decrease. Bond market traders have already begun to anticipate this possibility by narrowing the yield spreads of tax-free versus taxable bonds. Businesses would pay tax at the same rates as individuals. In addition, businesses would be able to deduct, as opposed to depreciate, capital expenditures such as medical equipment.

Most high income physicians would obviously benefit from a substantial reduction in marginal tax rates. Middle class taxpayers would probably experience a modest tax increase while lower income families would benefit from greater standard deductions. If there was an elimination of the mortgage interest deduction, homeowners could see a substantial decline in their property values.

Another area poised for reform is qualified retirement plans. The changes here could affect contribution deductions as well as the limits on distributions. The Internal Revenue Service recently announced the changes in limitations for tax year 1996. The 401(k) maximum contributions will be increased to $9,500 from the current $9,240. The annual threshold amount regarding excess distributions from qualified plans is increased from $150,000 to $155,000. The $30,000 limitation applicable to defined contribution plans remains unchanged.

If a flat tax is to be enacted, many of the current proposal features will likely be modified. Some deductions may survive and some exclusions may prove to be too costly. While the details remain uncertain, it appears that ultimately, there will be significant reform of the tax code.

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