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2004-01-05 -- State Budgets Still Reeling, Corporate taxation declines

New York Times, January 5, 2004


By JOHN M. BRODER

LOS ANGELES, Jan. 4 - After three consecutive years of dismal fiscal
news at the state level, officials are beginning to detect signs that
the worst may be over. But state budgets will continue to be stressed
by slow job growth and rapidly rising health care costs, and battles
in state capitals over taxing and spending will continue to rage,
analysts say.

The growing national economy and the rising stock market have begun to
be felt in the states; tax revenues in most states rose slightly in
the second half of last year for the first time since mid-2001.

Governors, legislatures and budget directors welcomed the news after
three years in which state officials had to contend with a cumulative
$200 billion in budget shortfalls. But officials warned that many
states were entering the new year and preparing for next year still
facing substantial budget deficits.

Over the past three years, total spending at the state level rose, at
most, by one-half percent, a marked change from the record of the
previous 25 years, in which spending growth averaged 6.5 percent a
year.

"In quite a large number of states, budgets will be smaller in actual
dollar amounts than they were two or three years ago," said Scott
Pattison, executive director of the National Association of State
Budget Officers, based in Washington. "That's pretty unusual and
significant. The good news is it appears most states have hit bottom
and are slowly climbing out, but boy, the bottom was deep. It's going
to be hard coming out of that."

States have responded by greatly cutting spending and raising fees on
all kinds of services, from fishing licenses to divorce filings. Sales
taxes rose in 17 states, while 10 states, including New York,
increased income taxes, although most made the increases temporary.
Many states resorted to one-time remedies to raise revenue, including
accelerating tax collections in Michigan and deferring salary payments
into the next fiscal year in Virginia. States have borrowed against
pension funds and tobacco settlement payments and offered amnesty to
delinquent taxpayers to encourage them to make overdue payments.

In California, state general fund spending in the current fiscal year,
which began July 1, is projected to fall to $73 billion from $78
billion the previous year. This week, Gov. Arnold Schwarzenegger will
present a budget for the coming fiscal year that must address a
projected shortfall of at least $14 billion. Governor Schwarzenegger
has vowed not to raise taxes, and the success of his plan hinges on a
March referendum approving the sale of $15 billion in bonds to cover
the deficit.

California has coped with its fiscal crisis with one-time budget
gimmicks and deep cuts in spending on higher education, health care
and numerous programs, from parks to the arts. The fiscal crisis has
also had profound political implications, leading at least in part to
the recall of former Gov. Gray Davis, a Democrat, and the rollicking
election that brought Mr. Schwarzenegger, a Republican, to power in
November.

States from coast to coast are facing similar fiscal problems and the
political fallout that accompanies them. In Alabama, a conservative
Republican governor, Bob Riley, who said he had never voted for a tax
increase in his three terms in Congress, proposed the largest tax
increase in the state's history to cover a deep budget deficit.

Mr. Riley devised the $1.2 billion tax package to protect the state's
poorest citizens, but opponents seized on provisions like a tax on
services like car repairs to build public sentiment against it.

Voters roundly rejected the tax increase in the fall, and now cuts
have begun. Five thousand nonviolent offenders are being paroled early
from prisons, troopers have gone to a four-day workweek, and schools
have run out of money for textbooks and computers.

In Oregon, Gov. Theodore R. Kulongoski, a Democrat, negotiated with
Republicans in the State Legislature to win passage of an $800 million
package of tax increases to address a projected $1 billion budget
shortfall. The plan included a temporary increase in the state income
tax and new taxes on tobacco and businesses. Oregon does not have a
sales tax.

But antitax forces in the state, including members of the Libertarian
Party and conservative Republicans, collected more than 50,420
signatures to put the governor's plan before the voters in a February
referendum. Even the plan's supporters expect it to be rejected, which
would force Governor Kulongoski to cut spending by $800 million.

Defeat of the tax plan would "end the Oregon Health Plan as we know
it, cutting it by hundreds of millions of dollars, and cause deep cuts
in K-12 education, as much as $400 million or $500 million," said
Peter Bragdon, the governor's chief of staff.

Like several states, Oregon broadened medical coverage in the boom
years of the late 1990's. Now, with budgets shrinking and health care
costs rising at double-digit rates, states are cutting back severely
by raising eligibility requirements and eliminating coverage for
hundreds of thousands of people.

According to the Center on Budget and Policy Priorities, a nonprofit
research group in Washington that tracks the effects of government
policies on low-income people, 34 states have cut spending on Medicaid
and the State Children's Health Insurance Program over the past two
years.

Missouri, for example, lowered the income limit for eligibility for
Medicaid to $11,750 from $15,260 for a family of three, and tightened
the requirements in other ways, eliminating benefits for as many as
42,700 people. Florida has stopped granting children's health benefits
to new applicants, putting them on a waiting list instead; this has
affected 44,000 children. Texas increased monthly premiums for the
children's health program and imposed an asset test for families.
Those and other changes will drop as many as 494,000 Texans from the
ranks of the insured.

In all, the center estimates, 1.2 million to 1.6 million poor people
have lost their health benefits as a result of cuts at the state
level.

The last time states faced such difficult fiscal conditions was after
the 1990-91 recession. But the response to the current slowdown has
been vastly different, said Arturo Perez, a senior fiscal analyst in
Denver for the National Conference of State Legislatures.

He said that in 1991, states raised taxes by $15.4 billion, about 5.4
percent of the previous year's tax collections. In 2003, by contrast,
states raised taxes by $7.8 billion, or 1.5 percent of revenue from
the year before. Mr. Perez said that politicians have become tax-shy
in the past decade.

"Look what happened to Florio and Cuomo and others who supported tax
increases in campaigns after that period," Mr. Perez said, referring
to two former governors, James J. Florio of New Jersey and Mario M.
Cuomo of New York, who lost to rivals who campaigned against unpopular
tax increases. "That lesson hasn't been lost."

Widespread opposition to tax increases prompted officials to
compensate by raising excise taxes on alcohol and tobacco and a
variety of charges for state services, calling them user fees rather
than taxes.

Alaska raised fees on rental cars. Arkansas imposed a 3 percent excise
tax on beer and doubled, to $150, the fee for reinstatement of
drivers' licenses revoked for drunken driving. Georgia tripled the
cigarette tax to 27 cents a pack. North Carolina increased the fee the
state charges for analyzing pap smears. Ohio raised the elevator
inspection fee. Texas is erecting tollbooths on state highways,
raising college tuitions and imposing a $1,000 surcharge on drunken
driving convictions.

Massachusetts raised the fee for a marriage license to $50 from $4.
New Jersey raised the divorce filing fee to $250 from $200.

Last spring, the New York State Legislature voted to raise taxes and
borrow about $4 billion to avoid deep cuts to education and medical
services for the poor that Gov. George E. Pataki had proposed to close
an $11.5 billion budget gap. The governor vetoed most of the
Legislature's plan, but lawmakers from both parties overrode him.

A reluctance to raise taxes or cut spending was among the chief causes
of the current fiscal fix, said Ray Scheppach, executive director of
the National Governors Association, based in Washington. Federal tax
policy, unfinanced mandates for programs like domestic security, and
ever-rising Medicaid costs all contributed to what will be long-term
fiscal problems, no matter how the economy performs over the next 12
months, he said.

"I think we've bottomed out and it's going to get better," Mr.
Scheppach said, describing the states' fiscal plight as the worst
since World War II. "But not a lot better."


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IRS Speeds Corporate Tax Audits
Fast-Track Method May Miss Fraud


"Tax experts agree that corporate tax avoidance has become a serious
problem. Corporate tax receipts -- already in a long, steady
decline -- fell to $132 billion in the fiscal year that ended Sept.
30, the lowest since 1993, even before adjusting for inflation.
Expressed as a percentage of total tax receipts or as a share of the
economy, corporate tax receipts this year will be at their
second-lowest level since the Great Depression. Only 1983's receipts
were lower.

In 1970, corporate tax revenue was 17 percent of the government's tax
take, before it began its long slide. This year, it will be about 7
percent of the total."



Washington Post, Monday, December 29, 2003

IRS Speeds Corporate Tax Audits
Fast-Track Method May Miss Fraud

By Jonathan Weisman
Washington Post Staff Writer

The Internal Revenue Service is fundamentally shifting its approach to
auditing business tax returns, hoping to rapidly expand the number of
businesses it audits by shrinking the time and scope of many of those
tax examinations.

With corporate tax receipts at record lows, IRS Commissioner Mark W.
Everson recently declared that corporate audits, which now take an
average of 38 months, should be completed in less than half that time.
Everson believes that by hastening the audits, the IRS will collect
more taxes because more companies will fear that audits are coming.
But others say faster audits will miss major tax fraud and would only
embolden corporate tax cheats.

Everson said dramatic change is necessary to overcome the agency's
"scandalous" complacency in a worrisome deterioration in corporate
attitudes toward paying taxes. Corporate auditors are still finishing
work on tax returns from 1997, or even earlier, he said. The IRS was
not even a "player" in uncovering the corporate scandals that erupted
in the late 1990s because "we were not even near the year these
returns were filed, which is inexcusable," said Everson, who took
control of the agency in May.

"What I'm trying to do is re-center the agency," said Everson, who
spotlighted the corporate auditing problems during his confirmation
hearing in March. "Incremental progress in this area is not success.
I'm looking for a real rupture in the way we do audits."

But the architects of the new strategy say Everson has gone too far,
too fast, tying the hands of the agency's best auditors and putting
too much power in the hands of potential tax cheats. By declaring that
audits should take 15 to 18 months, Everson is virtually guaranteeing
that IRS auditors will miss tax dodges, fail to explore suspicious
transactions, or even walk away from audits that are on the verge of
finding wrongdoing, said B. John Williams Jr., the recently departed
IRS chief counsel.

"It's a bad way to run a railroad," Williams said.

Larry R. Langdon, the former chief of the IRS's large and mid-size
business division who formulated much of the new auditing approach,
agreed. "At one level, I appreciate [Everson's] energy and
enthusiasm," he said. "At another level, he needs to understand the
complexity of the situation. He tends to see these things in black and
white when in reality, they're shades of gray."


Tax Receipts Slide Lower


For most businesses, the IRS is simply not a factor in deciding
whether to comply with the tax code, IRS officials concede. While the
nation's 1,300 largest corporations face constant IRS scrutiny,
148,000 mid-size companies face an audit rate of 4 percent, or perhaps
once every 20 years.

"That's atrocious," Everson said.

The new audit methods are designed to give businesses with good tax
compliance records far more say in what books they will show the IRS
and how quickly an audit should end. That way, outgunned corporate
auditors could focus on suspected cheats and recognized tax-evasion
schemes.

But working auditors, tax lawyers and IRS veterans say that in the
push to expand the number of audits, federal tax sleuths will be
discouraged to follow the winding money trails that obscure corporate
tax cheating.

"There used to be a point of no return, where when you found something
wrong, you were there, and you were going to stay there," said one
corporate tax auditor, who spoke only on condition of anonymity out of
fear of being fired. "There was no way they were going to get you out,
and you had the power of the IRS behind you.

"Now, even if you find the adjustment, find actual fraud, management
is still throwing you out of the building," the auditor said.

Langdon said that when he devised the limited-scope audit process, he
envisioned perhaps a quarter of new audits using the procedure. That
would cut those audit times in half, he said, but barely dent the
overall average audit time. To reach Everson's time limit, nearly
three-fourths of all corporate audits would have to use the procedure,
threatening the intention of reserving the limited audits only for
taxpayers with good compliance records, Langdon said.

An IRS lawyer, who also spoke on condition on anonymity, said there is
already a "strong push to walk away from audits" in order to prepare
for 2003 tax returns that IRS supervisors want to be handled according
to Everson's schedule.

"The exam people were told to clear out their inventory before
18-month cycle begins," he said. "It's happening now."
Schemes Abound

Much of the recent decline in corporate taxation mirrors the slow
economy. The longer-term trend was exacerbated by changes in federal
tax law and the increasing complexity of business tax structures,
including the vast overseas operations of multinational corporations.

Congress has made it easier for small businesses to organize
themselves as partnerships or what are called S corporations, leaving
business revenue to be taxed as individual income. Another big factor
is the proliferation of stock options, which also effectively shift
the tax burden from employer to employee, since they can be deducted
from corporate tax bills once exercised.

But one piece of the puzzle is cheating, IRS, Treasury and independent
tax experts say.

"The [declining] numbers are prima facie evidence that something
significant is going on," said Douglas A. Shackelford, an accounting
professor at the University of North Carolina's Kenan-Flagler Business
School. "It's such a huge, central question, it's hard to work in the
tax field and not wrestle with this."

Tax-sheltering estimates range from insignificant numbers proffered by
senior Treasury Department officials to $20 billion a year, a number
floated by a high-ranking IRS source.

"There's no question that the aggressiveness and use [of tax shelters]
is going up in a very, very significant way, and is being promoted by
very sophisticated users," said Charles O. Rossotti, the former
internal revenue commissioner. "The system has deteriorated over a
long-term basis. The IRS has slowed down the deterioration, but it's
still going on."

Facing increasingly sophisticated corporate tax offices, increasingly
hostile tax courts and stubbornly tight budgets, the IRS has retooled.

Last December, the agency's large and medium-size business division
established what it calls the limited issue focused examination
(LIFE), which allows businesses with good tax records to sit down with
the IRS and agree on audit plans, including time limits. A company
would know just what records the IRS was interested in. It would agree
to produce records expeditiously and limit its appeals of IRS
decisions.

The division also reorganized from regional offices, each with broad
authority, to industry-focused offices. Chicago would have the retail
and pharmaceutical group; New Jersey, heavy manufacturing; Detroit,
automotive; Houston, energy, and so on. Each of the groups would focus
on aggressive tax avoidance strategies particular to its industry.

"For the first time, we have the ability to say there is an issue
regarding XYZ provision of the [tax] code sweeping an industry. We
need that raised in every audit in this industry," said Pamela F.
Olson, undersecretary of the Treasury for tax policy.

A "pre-filing" system was also set up, so companies could bring up
transactions of questionable legality before a formal audit so they
could be resolved before they surprise auditors. And a fast-track
program was begun, allowing appeals officials to come into an audit
when just two or three issues remain and mediate the issues on the
spot, thus avoiding the appeals process altogether.

IRS economists and academic consultants are poring over statistics to
establish a computer-based model of a "normal" corporate tax return.
That way, IRS computers could finger odd returns for further
examination.

And Everson is organizing meetings to come up with more ways to save
time.

"There are some people in the [IRS] workforce who would prefer to have
no change in the way they've done business for 20 years," said Robert
E. Brazzil, an IRS director in the large and mid-size business
division. "We have to learn to do business differently."

Langdon said all the efforts have one goal: to focus scant IRS
resources on the most fruitful targets instead of chasing lower-risk
companies. With quick audits, more companies will feel the IRS's tap
on the shoulder.

"We were looking for a more rational way to put real targets in the
audit crosshairs," said Michael P. Dolan, a former acting internal
revenue commissioner, now at KPMG LLP.

But even before the changes were implemented, the IRS was aware of
serious risks inherent in expedited examinations, IRS officials
concede. Rigid audit plans, agreed upon ahead of time, would clip
auditors' "peripheral vision," as one tax lawyer put it, allowing some
companies to skirt the tax law even as an IRS auditor is examining
records that may be a page away from blatant fraud.

Such complaints are already coming in to the National Treasury
Employees Union, which represents IRS agents and auditors. Colleen M.
Kelley, the union president and a former IRS agent, said auditors feel
stifled by increasingly standardized procedures, a limited auditing
scope and far more supervisory control.

"Is there change? Oh yeah," Kelley said. "And is it something that is
proving to be hard, especially for auditors and agents who are used to
making those judgments? Certainly."

Donald C. Alexander, a former internal revenue commissioner, joked
that the word "focused" was slipped into LIFE's abbreviation "to make
the acronym turn out correctly. Without it, look what it would be: a
LIE."

Deborah M. Nolan, Langdon's successor at the IRS large and mid-size
business division, said the new procedures allow auditors to follow
trails off audit plans if solid evidence indicates problems. If a
shelter that was not disclosed ahead of time appears in the records,
she said the audit plan is automatically voided.

But a Bush administration official, speaking on condition of
anonymity, acknowledged that such rules may not work in the real
world.

"Any time you're dealing with a bureaucracy, you have to write the
rules with a certain amount of rigidity, and people with no judgment
will follow the rules to the letter," the official said. "They decide
the rules are set, and they can't use their judgment. And you have
managers who will say you can't deviate from the rule."
New Rules, New Problems

The new focus on industry groups has also raised questions. If, for
example, the retail group is trained to look at one set of tax issues
and the financial, insurance and real estate group at a different set,
what will happen when one industry group's tax tricks jump to another
group?

The problem is that accounting firms and corporate tax offices are too
plugged in to what the IRS is focusing on, an IRS official said.
Focusing on particular issues simply changes the behavior of tax
cheats.

"About 24 hours after they set up that industry matrix, it began to
unravel," Dolan conceded.

IRS leaders, including Everson, say much of the griping is from career
IRS auditors who are too comfortable with their old methods to
willingly adopt the changes. A corporate auditors would routinely
spend years on one company's books, eating at the corporate cafeteria
and getting reimbursed for the mileage between their homes and their
targets.

"Does it make sense spending literally five or six years auditing
routine matters that won't produce much when there are people out
there promoting billion-dollar shelters in the open market?" Rossotti
said. "I used to say to some of these people, 'You're not in the
auditing business. You're in the archaeology business.' "

So far, the business division has begun about 500 LIFE examinations of
mid-size businesses and more than 100 among the largest companies,
Brazzil said. And the numbers are increasing rapidly. The last thing
the IRS needs to do is wait until the all kinks are worked out of the
new procedures and all of the concerns are answered before moving
forward at full steam, Everson said.

"Of course, there could be some problems, but we're going to address
them as we go along," Everson said. "Speed counts."