A lot of taxpayers--who have just received their W-2 records of wages and withholding from employers--are in for distressing news as they fill out their tax returns between now and April 15. This year, experts say, many people are likely to find themselves coming up short and paying more to the IRS instead of receiving a refund.
How can that be, when tax rates have been reduced by the Tax Reform Act of 1986? Mainly it's because rates did not come down fully in 1987, but many tax deductions disappeared. "It was the whipsaw year," says tax accountant Stephen Kunkel of Pannell Kerr Forster & Co. "You lost the deductions, but you didn't yet have the lower rates." And that means many people will find that taxes were under-withheld from their paychecks, or that they lack sufficient deductions to adjust gross income to taxes withheld.
For example, middle- and high-income taxpayers, and those covered by corporate pension plans, can no longer deduct up to $2,000 per person for individual retirement accounts. And the two-earner deduction that used to clip as much as $3,000 from the gross income of working couples is also gone. Other deductions, for credit card interest or union and professional dues, have been reduced.
What is in their place? New withholding schedules were supposed to adjust for lost deductions. But the first W-4 forms were so complex that people couldn't understand them. So the IRS brought out new W-4s, but "sacrificed accuracy for simplicity," in doing so, says Richard Poladian, tax partner of Arthur Andersen & Co. Therefore, suggests Poladian, "a large number of taxpayers will find April 15 a darker day than usual."
Who's he talking about? The more than 40 million taxpayers who itemize deductions. It should be noted that the majority of the 107 million returns the IRS expects to receive will not be itemized, that tax time won't change much for most short-form taxpayers and that the IRS predicts that tax year 1987's average refund will be $11 higher than that of 1986.
But the agency concedes that working couples and people receiving interest and dividend income are likely to have been under-withheld and thus face further tax payments. Similarly, self-employed individuals, if they paid estimated tax based on their 1986 returns, are likely to come up short because of lower deductions.
Significantly, H & R Block, the company that prepares 10% of all returns, is offering to adjust clients' withholding forms to ensure refunds next year. The expectation this year, says Thomas Bloch, head of the company's tax division, is that many taxpayers "will be surprised and disappointed."
Effect on Spending Seen
Their reactions will range from mild irritation to fear and trembling. People like a refund, even though economists say it's not economically rational to get one--that a tax refund means you lent money interest-free to the government. But most people don't think that way. They want withholding to cover their taxes and also give them a welcome windfall in May or June. Many will miss it this year.
And some will be in trouble without it. There could be a short-term effect on consumer spending and investment as money market funds are drawn down, certificates of deposit are cashed in and mutual funds redeemed to raise money to pay Uncle Sam. Car and appliance sales may not be brisk.
The longer-term outlook offers only brief relief. To be sure, 1988 will be a less anxious tax year: Rates will be low, and withholding errors corrected. But be prepared for big moves to raise taxes next year--whichever party wins the White House. Already there is a bipartisan national commission in Washington studying new kinds of consumption taxes that their advocates say would reduce the federal deficit and encourage savings.
The irony is that Congress had a way of encouraging saving--the tax-deferred IRA that swelled savings accounts between 1982 and 1986. But Congress cut back IRAs when it lowered tax rates while broadening tax collections to cut the deficit. Result? The country has a persistent deficit, lower savings and many taxpayers who will wonder this spring if tax reform hasn't played a cruel trick on them. Better luck next time.