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Old questions of fairness follow the latest tax loopholes Shrewdest among wealthy are finding more shelters


Ten years ago this week, the United States put into effect what political leaders hailed as a fairer tax system, wiping out shelters that many wealthy Americans used to prevent much of their income from being taxed, while lowering maximum tax rates.

For years, affluent citizens who had used shelters paid far lower taxes than others who earned the same income. Oil-drilling ventures and real estate partnerships flourished for no reason other than the circumvention of taxes.

After Congress passed a sweeping overhaul of the tax code in 1986, these loopholes largely disappeared and the richest Americans were forced to pay more.

Now the tax engine is shifting into reverse. Top tax rates have crept up again, though they are still lower than they were before the 1986 tax overhaul.

And the shrewdest among the wealthy, in collaboration with eager expert advisers, are finding ingenious new shelters to keep the tax collector at bay in three big areas -- their salaries and bonuses, investment profits and estates.

These techniques are not available to most Americans. And they are spreading largely without attention from policy-makers in Washington, even though they are costing the Treasury money.

Exactly how much money, no one knows. But the amount is expected to grow significantly.

The appearance of the latest tax shelters raises old questions of fairness. They are chipping away, tax experts say, at a longstanding principle that the American tax system should be progressive -- that the well-to-do should pay the biggest share of their income.

Some of these techniques replace gimmicks that Congress stripped from the tax code 10 years ago. For example, Congress cut the annual limit on tax-deferred investments in Individual Retirement Accounts and 401(k) employee savings accounts to $9,500 from $30,000.

But now, new deferred pay plans help some executives skirt that limit by delaying income taxes for years, even decades, sometimes on millions of dollars in pay. Hundreds of thousands of higher-paid managers have been offered these plans by their employers, most in the past few years.

Congress in 1986 also closed some loopholes in the estate tax, which is incurred when wealth is handed from one generation to the next. But today new kinds of trusts allow the most prosperous and resourceful citizens to leave homes, family businesses and stock options to their heirs with minimal taxes.

And even as a bull market has exposed a large number of middle-class Americans to the capital gains tax through their mutual fund investments, some Wall Street firms have started offering complex deals that let their top customers get most of the benefits of selling a valuable asset without actually having to sell it and pay the tax on the profit.

"The more these products multiply," said Richard McGahey, former executive director of the Congressional Joint Economic Committee, "it feeds the perception that the system is unfair."

The reforms of 1986 and subsequent increases in maximum tax rates in 1991 and 1993 helped make the federal income tax system more progressive, as measured by effective tax rates, according to the Congressional Budget Office. Some analysts fear that avoidance maneuvers will erode those gains.

One concern is that higher-income taxpayers are already reaping a growing share of the nation's economic wealth. Research by economist Edward N. Wolff of New York University shows that from 1983 through 1992, the richest 20 percent of the population saw its share of the nation's wealth grow to 83.7 percent from 81.3 percent.

The Clinton administration's response to the latest twists in tax avoidance has been to propose closing some loopholes, chiefly those that Wall Street is peddling to avoid capital gains taxes.

Congress has responded with a chilly indifference, and the most energetic advocacy has been on the side of cutting taxes, flattening tax rates and clipping the powers of the IRS.

The IRS response has mostly been a tower of ad hoc "private letter" rulings, brief decisions that permit one specific tax-avoidance technique. These rulings, although tailored to the facts of one case, often become a key ingredient of the next popular tax-avoidance device to emerge. Even when the agency fights back in court, its track record is poor, lawyers say, as its workload has outstripped its budget and its litigation staff.

Positions on what should be done to change the tax system diverge in large part on differences in definitions of fairness. According to numerous surveys, most Americans think that the fairest tax system is one in which the rich pay a larger share of their income in taxes than the less-rich do.

But many say fairness is achieved when everyone with the same income pays the same tax. And others say fairness prevails when all taxpayers pay the same percentage of their income to the tax collector

Jack Kemp, the former vice presidential nominee, and Steve Forbes, the publishing executive turned presidential candidate, campaigned for the single tax rate, calling it a flat tax. This presumably simpler approach, its proponents said, would promote growth and lead to less wasteful spending on tax

accountants and lawyers.

End-runs around the tax code, some economists and business executives contend, are the inevitable result of a system that, in their eyes, still penalizes savings and investment while rewarding spending and borrowing.

"You ought to encourage people to get wealthy," said Theodore Forstmann, a Wall Street investment banker who served on a national panel set up last year to advise Republican leaders on tax reform. "You don't want to penalize people for that."

Yet tax lawyers say privately that most of the proposed alternatives to the current system would be equally vulnerable to tax avoidance. The reason is that wealthy people can make adjustments in how they receive and use their money to take maximum advantage of the smallest loophole.

A pure flat tax, one that applies the same tax rate to any level of income and to income from any source, would be least prone to gimmickry, economists say.

But a flat tax's vulnerability to circumvention grows once income generated by investments is exempted, as proposed by Forbes, whose investments generate most of his income.

In the debate over how the nation should tax itself, the ability of the wealthy to engineer a way around their tax burden will need to be considered, said Herbert Stein, who was chairman of the Council of Economic Advisers under President Richard M. Nixon.

"Financial engineering should be addressed," he said. "People are now saying that since the upper income can escape taxes, why not make it available to everyone? But that will make it very hard to finance the government's activities."

Pub Date: 12/29/96

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