|
CHAPTER |
| 3 |
| Revenue Options |
|
Change in Revenues |
|
||||||||||
|
|
Raise all tax rates on ordinary income by 1 percentage point |
+21.1 |
+30.4 |
+30.3 |
+43.7 |
+50.8 |
|
+176.3 |
|
+445.2 |
|
|
|
Raise all ordinary tax rates and AMT rates by 1 percentage point |
+38.1 |
+56.5 |
+59.9 |
+62.5 |
+66.0 |
|
+283.0 |
|
+667.8 |
|
|
|
Raise all ordinary tax rates, AMT rates, and dividend and capital gains rates by 1 percentage point |
+38.8 |
+59.9 |
+62.6 |
+65.3 |
+67.2 |
|
+293.8 |
|
+685.6 |
|
|
|
Raise the top ordinary tax rate by 1 percentage point |
+3.9 |
+5.5 |
+5.5 |
+6.4 |
+7.3 |
|
+28.6 |
|
+75.5 |
|
|
|
Raise the top two ordinary tax rates by 1 percentage point |
+4.6 |
+6.6 |
+6.6 |
+8.6 |
+10.2 |
|
+36.6 |
|
+100.9 |
|
|
|
Raise the top three ordinary tax rates by 1 percentage point |
+5.2 |
+7.5 |
+7.4 |
+10.6 |
+12.7 |
|
+43.4 |
|
+121.0 |
|
|
|
Raise the top four ordinary tax rates by 1 percentage point |
+7.6 |
+11.0 |
+11.0 |
+18.7 |
+23.0 |
|
+71.3 |
|
+200.5 |
|
|
|
Raise the tax rate on ordinary taxable income over $1 million for joint filers ($500,000 for others) by 5 percentage points |
+12.0 |
+17.0 |
+16.9 |
+19.0 |
+21.3 |
|
+86.2 |
|
+224.3 |
|
Under current law, individuals will face six statutory rates on taxable income earned through tax year 2010: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent. After 2010, those tax rates are scheduled to revert to the five brackets—15 percent, 28 percent, 31 percent, 36 percent, and 39.6 percent—that were in effect before the Economic Growth and Tax Relief Reconciliation Act of 2001 was enacted.
Depending on his or her total taxable income, an individual may face several different rates (see the table below). For example, in 2007, a person filing singly with taxable income of $35,000 would pay a tax rate of 10 percent on the first $7,825 of income, 15 percent on the next $24,025, and 25 percent on the last $3,150. The starting points for those tax brackets are indexed to increase with inflation each year.
|
0
|
|
0
|
|
|
10
|
|
15
|
|
|
7,825
|
|
15,650
|
|
|
15
|
|
15
|
|
|
31,850
|
|
63,700
|
|
|
25
|
|
28
|
|
|
77,100
|
|
128,500
|
|
|
28
|
|
31
|
|
|
160,850
|
|
195,850
|
|
|
33
|
|
36
|
|
|
349,700
|
|
349,700
|
|
|
35
|
|
39.6
|
|
Not all income that goes to individuals is taxed at those rates, however. Income from long-term capital gains (gains on assets that are held for more than one year) is subject to lower rates under a separate schedule. The same is true for income from dividends through 2010. Taxpayers subject to the alternative minimum tax (AMT)—another method of computing federal income tax liability—face statutory rates of 26 percent and 28 percent.
This option would increase statutory rates under the individual income tax in several alternative ways:
Boosting all statutory tax rates on ordinary income by 1 percentage point would increase revenues by a total of $176.3 billion over the five-year period from 2008 to 2012. Under that alternative, for example, the top rate of 35 percent in 2010 would rise to 36 percent, and the top rate of 39.6 percent thereafter would increase to 40.6 percent. Rates for the AMT would remain the same as under current law. Thus, the revenue impact of raising all of the ordinary tax rates would diminish over time as more taxpayers became subject to the AMT and therefore were not affected by the rise in regular rates.
Raising AMT rates as well as allof the regular tax rates by 1 percentage point would increase revenues during the 2008–2012 period by $283.0 billion. That revenue impact would be less affected by the number of taxpayers subject to the AMT because such taxpayers would face higher statutory tax rates, too. If, in addition to raising the ordinary and AMT rates, lawmakers boosted the separate tax rates on capital gains and dividends by 1 percentage point, federal revenues would increase by a total of $293.8 billion over the next five years.
Alternatively, lawmakers could target specific individual income tax rates. For example, boosting only the top statutory rate on ordinary income by 1 percentage point would raise $28.6 billion over the 2008–2012 period. Most people who face the top rate in the ordinary rate schedule are not subject to the alternative minimum tax, so the AMT would not limit the impact of that increase in regular tax rates.
A final alternative would be to create an additional bracket at the top of the regular rate schedule by raising the tax rate on ordinary taxable income in excess of $1 million for joint filers ($500,000 for other taxpayers) by 5 percentage points. Income above those levels would be taxed at a rate of 40 percent through 2010 and 44.6 percent thereafter, which would increase revenues by $86.2 billion over five years.
As a way to raise revenues, a boost in tax rates would have some administrative advantages over other types of tax increases because it would require only relatively minor changes to the current tax-collection system. Rate hikes would also have drawbacks, however. Higher tax rates would reduce people's incentives to work and save. In addition, they would encourage taxpayers to shift income from taxable to nontaxable forms and to increase spending on items that are tax-deductible, such as home mortgage interest and charitable donations. In those ways, higher tax rates would cause economic resources to be allocated less efficiently than they might be otherwise.
The estimates shown here incorporate the assumption that taxpayers would respond to higher rates by shifting income from taxable to nontaxable or tax-deferred forms. (Such a shift might involve substituting tax-exempt bonds for other investments or opting for more tax-free fringe benefits instead of cash compensation.) However, the estimates do not incorporate potential changes in how much people would work or save in response to higher statutory tax rates. Such changes are uncertain and would depend in part on whether the federal government used the added tax revenues to pay down debt or to finance tax cuts or additional spending.
|
Change in Revenuesa
|
-0.5
|
-2.3
|
-2.4
|
-97.8
|
-174.7
|
|
-277.7
|
|
-1,221.9
|
|
In the past six years, the Congress and the President have enacted several tax laws that substantially alter the individual income tax system: the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the Working Families Tax Relief Act of 2004 (WFTRA), and the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). EGTRRA reduced tax rates, created a 10 percent tax bracket, increased the value of the child tax credit, provided relief from the marriage penalty and the alternative minimum tax (AMT), and made many smaller changes to the tax code. The main provisions of EGTRRA were originally scheduled to phase in gradually between 2001 and 2010; the entire law was slated to expire in 2011. JGTRRA accelerated the phasing in of some of those provisions. It also further lessened the burden of the AMT and reduced the tax rate on income from capital gains and certain dividends. WFTRA extended several of the provisions that had been accelerated under JGTRRA—the larger child tax credit, marriage-penalty and AMT relief, and the 10 percent tax bracket—for various lengths of time. TIPRA extended the reduced rates on capital gains and dividend income through 2010 and provided relief from the AMT in 2006. Finally, the Pension Protection Act of 2006 permanently extended the provisions of EGTRRA that deal with retirement savings.
This option would make permanent nearly all of those changes to the individual income tax, including AMT relief. (The exception would be the reduced tax rates on capital gains and dividends, which are discussed in the next option.) Provisions of EGTRRA that are set to expire in 2011 would instead continue at the levels specified for 2010; provisions that are due to expire earlier would remain at the level specified for the final year before they would otherwise have reverted to the 2001 level. Provisions that were accelerated or expanded by JGTRRA, WFTRA, or TIPRA would continue at the fully phased-in level. Together, those changes would reduce revenues and increase outlays by a total of $277.7 billion over the 2008–2012 period.
Extending those provisions would have various effects on how efficiently the economy functions, with the effects depending in part on how the extensions were financed. One important channel for those economic effects is through the lower marginal tax rates (the rate that applies to a taxpayer's last dollar of income) that would be associated with extending the provisions. Higher marginal tax rates distort various decisions—for example, by encouraging people to shift income from taxable to nontaxable forms (which could be accomplished by substituting tax-exempt bonds for other investments or tax-free fringe benefits for cash compensation). Higher rates also motivate people to spend more on tax-deductible items, such as home mortgage interest and charitable donations. Lower tax rates can reduce those distortions and allow investment to be allocated to whatever use has the highest economic return, thus leaving people better off. Lower marginal tax rates can also encourage people to work and save more (unlike lower average tax rates, which can encourage people to work and save less).
The broader economic impact of lower tax rates, however, depends on how the rate reductions are financed. Financing tax cuts through higher budget deficits would reduce national saving, which would impair long-term economic growth and could offset any positive economic effects of the lower tax rates.
Permanently extending EGTRRA's individual income tax provisions would have mixed effects on the complexity of the tax system, which some people advocate simplifying. Certain provisions, such as relief from the AMT, simplify the tax code for some taxpayers. Other provisions, such as the expansion of tax-favored accounts for education savings, complicate the tax code.
Besides effects on economic efficiency and the complexity of the tax code, equity (fairness) is another key consideration in assessing tax policy. EGTRRA's individual income tax provisions reduce income taxes by a larger share of previous after-tax income for higher-income households than for lower-income households. However, although the reductions relative to income would be greater for higher-income households, extending EGTRRA's provisions would not significantly alter the shares of income taxes paid by different households across the income distribution.
|
Change in Revenues
|
+0.4
|
+1.4
|
-1.6
|
-13.9
|
-17.7
|
|
-31.4
|
|
-208.5
|
|
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced the special tax rates that apply to most long-term capital gains (gains on assets that are held for more than a year). The rate at which those gains are taxed depends on the income of the individual who realizes them. Gains realized by people whose income puts them in the top four tax brackets for ordinary income (25 percent, 28 percent, 33 percent, or 35 percent) are now taxed at a 15 percent rate, compared with 20 percent before JGTRRA. Gains realized by people whose income puts them in the two lowest brackets (10 percent or 15 percent) are taxed at a 5 percent rate, down from the pre-JGTRRA rate of 8 percent or 10 percent. In a major change, JGTRRA also extended the new 5 percent and 15 percent tax rates on capital gains to dividends from U.S. and some foreign corporations. (Dividends had previously been taxed at the higher rates on ordinary income.)
JGTRRA's rates on capital gains and dividends had been scheduled to last through 2008, with the 5 percent rate falling to zero that year. However, the Tax Increase Prevention and Reconciliation Act of 2005 extended the zero and 15 percent rates through 2010. Starting in 2011, rates on capital gains are scheduled to revert to 10 percent or 20 percent for gains held up to five years and to 8 percent or 18 percent for many gains held longer than five years. Tax rates on dividends are scheduled to return to the rates on ordinary income, which would range from 15 percent to 39.6 percent at that point.
This option would permanently extend the zero and 15 percent tax rates on capital gains and dividends. Such a change would reduce revenues by $31.4 billion over the 2008–2012 period and by $208.5 billion over the 2008–2017 period. The reduction in revenues over 10 years would be much greater than the drop during the first five years because the option would not affect current-law tax rates until January 1, 2011.
The main rationale for lower tax rates on capital gains and dividends is that they reduce the extra tax burden that the law previously placed on equity invested in C corporations (companies subject to the corporate income tax). Most large businesses and some small ones are organized as C corporations. The return on the equity invested in such companies is corporate profits. Once a firm has paid corporate income tax (typically 35 percent) on those profits, it can either distribute the remaining profits to shareholders as dividends, which are then taxed at the individual level, or it can retain and reinvest them. Reinvested earnings presumably increase a corporation's value (by roughly the amount invested), so they also raise the value of the firm's stock. When individuals sell that stock, they pay capital gains taxes on the reinvested earnings. Thus, the return on equity invested in C corporations is often taxed twice: once as corporate profits and a second time as dividends or capital gains. By reducing tax rates on the latter types of income, current law lessens—but does not eliminate—the extra tax burden.
Those extra taxes on corporate profits distort investment to some degree. They prompt some investment to be shifted from C corporations to other types of businesses—such as S corporations, partnerships, sole proprietorships, or limited liability companies—and to owner-occupied housing. The additional taxes also encourage C corporations to finance more of their investments by selling bonds rather than stock (because corporations can deduct interest payments on bonds) and by retaining earnings rather than paying dividends (because individuals normally pay lower tax rates on capital gains and can defer realizing the gains). Those distortions interfere with the allocation of investment to whatever use has the highest economic return. Consequently, they reduce economic efficiency and leave most people less well off.
Current law mitigates those distortions by lessening the extra tax burden—but only for a short period. Because the lower rates on dividends and capital gains expire at the end of 2010, investments made after that time will not benefit from them. In addition, many investments made between 2003 and 2010 will benefit only partially from the lower tax rates because some of the returns will not be earned until after 2010. Hence, many of the gains in economic efficiency that could result from the lower rates will not be realized unless current law is perceived to be permanent.
Other options for reducing the extra tax burden on corporate equity have been widely discussed. Under one alternative, dividends and capital gains paid from profits that had been fully taxed at the corporate level would themselves be exempt from taxation at the individual level (see Revenue Option 25). Another approach would end the practice of allowing firms to deduct interest costs from their taxable income and would tax other types of businesses at the same rate as C corporations.
Compared with those other options, the lower rates provided under current law are less complete and less targeted, though simpler. They remove less of the extra burden from the return on corporate equity than those alternatives would. They also apply more broadly because they are not limited to dividends and gains from fully taxed corporate profits. Corporations (like individuals) receive extra tax deductions and credits for certain investments; thus, the return on those investments is less burdened under current law than is the return on fully taxed profits. Furthermore, people realize capital gains from investments in unincorporated businesses and individually owned property, and neither type of investment is subject to the tax on corporate profits. Such imprecise targeting reduces the effectiveness of current tax rates on capital gains and dividends because it fails to lessen the burden on fully taxed corporate earnings relative to all other returns on investments. Complete and targeted leveling of the tax burden would be more complicated to administer, and policymakers in the United States have never tried it. Targeting could be improved, however, with little additional complication by limiting the lower capital gains tax rates to gains on shares of C corporations.
The main argument against extending the lower tax rates on dividends is that the previous rates that applied to dividends may not have distorted the allocation of investment. Some analysts believe that the tax on dividends affects returns to stock owners but not corporations' decisions to invest. In that view, reducing the tax rate on dividends to no more than 15 percent provided a windfall to shareholders. Economists are currently investigating the degree to which the tax on dividends distorts investment. (Most analysts agree, however, that the tax on capital gains distorts investment decisions by C corporations, so the rationale for taxing capital gains on corporate stocks at a lower rate is not subject to the same question.)
The taxation of capital gains is one of the more complex parts of the individual income tax. Permanently extending the zero and 15 percent tax rates would reduce some of the complexity present under current law. It would preserve other sources of complexity, however, such as the rules that are needed to limit taxpayers' ability to convert ordinary income into capital gains and the different tax rates that apply to gains from the sale of specific types of assets. (Greater simplicity is discussed in the next option.)
|
Change in Revenues
|
+1.1
|
+5.1
|
+4.6
|
+3.9
|
+1.2
|
|
+13.5
|
|
+8.4
|
|
When a taxpayer sells an asset whose value has increased since it was purchased, the taxpayer realizes a capital gain, which is generally subject to taxation. Gains realized on assets that are held for more than a year (long-term capital gains) are taxed at various rates, many of which are lower than the rates that apply to ordinary income. Which tax rate a capital gain is subject to depends on the year in which the gain is realized, the type of asset sold, how long it was held, and the taxpayer's other income—a level of complexity that requires people to make numerous calculations to determine their tax liability.
This option would simplify that process by allowing taxpayers to deduct from their taxable income 45 percent of their net realizations of long-term capital gains—whether or not they itemize their other deductions. The remaining 55 percent of their gains would be taxed as ordinary income. With the deduction, a taxpayer's actual rate on capital gains would be 55 percent of his or her marginal rate on ordinary income (the rate on the last dollar of income). In 2008, for example, someone in the 25 percent tax bracket for ordinary income would face a rate of 13.75 percent on capital gains; someone in the 35 percent bracket would face a rate of 19.25 percent. (Taxpayers subject to the alternative minimum tax would adjust for its lower rate structure by treating 31 percent of the deduction as income taxable under the alternative tax.) This option is a variant of the exclusion that applied to capital gains before 1987.
Those changes are designed to be roughly revenue neutral over the 2008–2017 period, under the assumption that they would be enacted at the end of 2007 and take effect on January 1, 2008. Under current law, tax rates on capital gains are scheduled to rise abruptly at the beginning of 2011; relative to current law, this option would increase revenues by a total of $13.5 billion over the next five years (in an irregular pattern) but would reduce revenues by a total of $5.1 billion over the following five years.
The tax rates that apply to capital gains under current law are highly varied and complex. For example, through 2010, taxpayers who are in individual income tax brackets of 25 percent or above and who sell corporate stock owned for more than a year will pay 15 percent in taxes on their realized gains. Starting in 2011, however, they will pay 20 percent—unless the stock was purchased in 2001 or later and held for at least five years. In that case, the applicable rate will be 18 percent. Taxpayers in the 10 percent or 15 percent bracket of the individual income tax face a 5 percent rate on gains through 2007 and then no tax on capital gains through 2010. Beginning in 2011, those taxpayers will face rates of 10 percent on gains from assets held for up to five years and 8 percent on gains from assets held for more than five years. An exception to all of those rates exists for original stock from certain start-up businesses that is held for more than five years. Gains from such stock are generally taxed at an effective rate that is half of the taxpayer's rate on ordinary income, up to a maximum of 14 percent. Through 2010, that maximum alternative rate turns out to be similar to the top rate of 15 percent on gains from other types of stock.
Gains on many other assets face the same rates as gains on corporate stock, but there are exceptions. Some unrecaptured depreciation on real estate is classified as a capital gain and taxed at ordinary income tax rates, up to a maximum of 25 percent. Gains from the sale of gold, art, or other collectibles are also taxed at ordinary rates, but up to a maximum of 28 percent. Taxpayers who are subject to the alternative minimum tax face different rates on gains from selling collectibles or original stock issues of certain start-up companies.
The variety of rates forces taxpayers with long-term gains to make many calculations to determine their tax. On their 2006 returns, for example, taxpayers with gains from most sales of assets or with qualifying dividends must figure their tax by completing a worksheet with 19 lines. If a taxpayer has a gain on a qualifying start-up business or a collectible, he or she must instead complete a worksheet with 7 lines and then another with 37 lines. For a gain on depreciated real estate, worksheets with 18 and then 37 lines are required. Beginning in 2011, the forms will become even more complicated because different rates will be applied to most gains on assets held for at least five years.
The main advantage of this option is that it would substantially lessen the burden of complying with the capital gains tax by replacing the current worksheets with just three or four lines on the schedule for reporting capital gains. The new calculation would be similar to the calculations required between 1942 and 1986, when the tax code excluded a portion of capital gains from taxpayers' adjusted gross income. Unlike that exclusion, however, this approach would not understate the income of taxpayers with gains when determining eligibility for tax credits and other advantages intended for lower-income people.
The main disadvantage of this option is that it would overturn several provisions of the tax code that policymakers, for various reasons, have decided are desirable. In particular, the option would eliminate separate capital gains rates for assets that are classified as collectibles or held for more than five years (whether issued by a start-up business or not). Furthermore, all deductions for depreciation would be recaptured at ordinary tax rates instead of some depreciation benefiting from rates that are capped at 25 percent. Care is warranted, therefore, in weighing the reasons for those provisions against the benefits of simplification.
In 2003, tax rates on dividends were reduced to equal the rates on capital gains in order to offset some of the extra burden that dividends and capital gains on corporate stock bear because of the corporate income tax (see the previous option). Under current law, that parallel treatment will continue through 2010. Parallel treatment could be retained in this option by extending the same 45 percent deduction to qualifying dividends. A further step to reflect the unique tax burden on corporate stock would be to allow the deduction only for dividends and gains on corporate stock and to tax gains on other assets as ordinary income. (Revenue Option 25 addresses the integration of corporate and individual income taxes more completely.)
|
Change in Revenues |
|
|
|
|
|
|
|
|
|
|
|
|
|
Make the current exemption amounts permanent and index the AMT for inflation |
-21.3 |
-57.3 |
-67.3 |
-56.7 |
-34.0 |
|
-236.6 |
|
-522.5 |
|
|
|
Apply some regular deductions and exemptions to the AMT |
-29.6 |
-78.7 |
-91.5 |
-74.9 |
-39.1 |
|
-313.8 |
|
-627.2 |
|
|
|
Eliminate the AMT |
-34.1 |
-88.6 |
-100.1 |
-81.1 |
-40.6 |
|
-344.5 |
|
-668.1 |
|
As its name implies, the individual alternative minimum tax (AMT) is an alternate method of computing federal income tax liability. A minimum tax was initially enacted in 1969 amid concerns that taxpayers with substantial income were aggressively using tax preferences to reduce their tax liability to very low levels—in some cases, to zero. The Tax Reform Act of 1986 largely established the present form of the AMT; policymakers have modified the tax several times since that law was enacted.
In recent years, the AMT has begun to affect growing numbers of taxpayers. As a result, lawmakers have enacted a series of temporary measures to reduce the number of people subject to the tax. This option would either make some of those measures permanent, make further changes to limit the scope of the AMT, or do away with the minimum tax entirely. Those alternatives would reduce federal revenues by as much as $34.1 billion in 2008 and $344.5 billion over five years.
To compute liability under the AMT, taxpayers must include several additional items in their taxable income that are excluded under the regular income tax, such as the deduction for state and local taxes, personal exemptions, and the standard deduction. The additional items also include tax preferences that only taxpayers with complex financial circumstances generally use: for example, the deduction for some intangible costs associated with drilling for oil and gas. Under the AMT, the total of those adjustments is replaced with an exemption—in tax year 2006, $42,500 for single filers and $62,550 for married couples filing a joint return—that phases out at higher income levels. Taxpayers subtract the exemption from their income to determine their alternative minimum taxable income, which is taxed at two rates: 26 percent on the first $175,000 and 28 percent on the remainder. Taxpayers must pay the higher of their liability under the AMT or under the individual income tax.
The size of the AMT exemptions was temporarily increased by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the Working Families Tax Relief Act of 2004 (WFTRA), and the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Before 2001, the exemptions were $33,750 for single filers and $45,000 for joint filers. EGTRRA raised those amounts to $35,750 for single filers and $49,000 for joint filers for tax years 2001 and 2002. JGTRRA increased the exemptions further—to $40,250 and $58,000 for both 2003 and 2004—and WFTRA extended those amounts through 2005. TIPRA raised the exemptions to $42,500 and $62,550 for 2006. Under current law, the exemptions revert to their pre-EGTRRA levels beginning in 2007.
Unlike the tax brackets and exemptions for the individual income tax, the brackets and exemptions for the AMT are not indexed to increase with inflation each year. At any given level of nominal income, taxpayers will see their liability under the individual income tax decline over time as the value of the standard deduction and personal exemptions rises with inflation. Moreover, as the size of the lower tax brackets grows, more income is taxed at lower rates. With the AMT, by contrast, the lack of indexation means that liability at a given level of nominal income remains the same. Therefore, as nominal income grows with inflation over time, AMT liability will exceed liability under the individual income tax over a larger and larger portion of the income distribution, shifting increasing numbers of taxpayers to the AMT from the individual income tax.
Policymakers could reduce the number of taxpayers subject to the AMT in several alternative ways. One approach would be to make the exemption amounts enacted in TIPRA permanent and to index both them and the AMT brackets for inflation after 2007. Under that approach, 6.2 million taxpayers would be affected by the AMT in 2010 (the peak year)—rather than 30 million under current law—and revenues would be $236.6 billion lower over the 2008–2012 period than they would be otherwise.1 A second alternative would be to allow taxpayers to take the standard deduction, personal exemptions, and deduction for state and local taxes when computing their tax liability under the AMT. That change would reduce the number of people affected by the AMT to 2.8 million in 2010 and cut revenues by $313.8 billion over the 2008–2012 period. A third alternative, which was included in the 2005 report of the President's Advisory Panel on Federal Tax Reform, would be to eliminate the AMT altogether. That alternative would move the estimated 30 million taxpayers who would have been subject to the AMT in 2010 back to the individual income tax, at a revenue cost of $344.5 billion over five years.
A major benefit of all three of those approaches would be simplification. Taxpayers who are now affected by the AMT or who are close to being affected by it must calculate their tax liability twice. As the number of such taxpayers rises sharply, the complexity of many tax returns will increase. Many taxpayers will join the AMT's ranks not because they are sheltering a large amount of income but because they have many dependents or high state and local taxes. This option would simplify the tax system by making fewer taxpayers subject to the alternative tax.
Another rationale for providing relief from the AMT would be to mitigate the perhaps unintended consequences that an unindexed AMT would have on certain features of the tax system. For example, if the AMT is not modified, it will begin to limit the value of the standard deduction and personal exemption under the regular income tax. That process alone will make some taxpayers subject to the AMT, beyond those whom the tax was originally intended to target, and will increase their tax liability over time.
Potential disadvantages of providing relief from the AMT, besides the large reduction in revenues, involve issues of fairness and economic effects. First, the approaches in this option would primarily benefit higher-income taxpayers. Second, the changes would affect people's incentives to work and save. Relief from the AMT would alter the marginal tax rate (the rate that applies to the last dollar of income) faced by taxpayers who are currently subject to the alternative tax. Some taxpayers would see their marginal rates increase under these alternatives, although more would see their marginal rates decline. AMT relief might reduce some people's tax liability, which would allow them to achieve the same level of after-tax income with less income before taxes and thus, to some extent, affect their work behavior. On balance, how the changes in this option would affect incentives to work and save is not clear; the overall impact would depend on taxpayers' relative responsiveness to those incentives.
|
Change in Revenuesa
|
+0.4
|
+2.1
|
+2.5
|
+5.5
|
+7.9
|
|
+18.4
|
|
+81.8
|
|
Various parameters of the tax code are indexed to increase at the rate of inflation each year, as measured by the consumer price index for all urban consumers (CPI-U). Those parameters include the amounts of personal and dependent exemptions, the size of the standard deductions, the income thresholds that divide the different rate brackets in the individual income tax, the amount of annual gifts exempt from the gift tax, and the thresholds and phaseout boundaries for the earned income tax credit, the child tax credit, and several other, minor credits. Indexing allows those tax parameters to grow over time in nominal terms but keeps them relatively stable in real (inflation-adjusted) terms.
This option would use the chained CPI-U, an alternative measure of inflation, rather than the standard CPI-U to index parameters of the tax code. Both measures are calculated by the Bureau of Labor Statistics; however, the Congressional Budget Office estimates that the chained CPI-U is likely to grow 0.3 percentage points more slowly than the standard CPI-U. Indexing with that lower measure would increase the amount of income subject to taxation over time and thus result in higher tax revenues. The net revenue increase would be relatively small in 2008 (about $400 million) but would grow in subsequent years, reaching $7.9 billion in 2012 and totaling $18.4 billion over that five-year period. (Using the same alternative measure for all federal benefit programs that are indexed for inflation would reduce spending by $34.5 billion over the five-year period and by nearly $140 billion through 2017.)
A rationale for indexing tax parameters by less than the full increase in the CPI-U is that many analysts believe the CPI-U overestimates changes in the cost of living. The CPI-U measures inflation on the basis of price changes for a fixed basket of goods. According to many analysts, that method fails to fully account for increases in the quality of existing products, the value of newly introduced products, and the extent to which households can maintain their standard of living by substituting one product for another when the price of a good changes relative to the prices of all other goods. To explicitly address the substitution bias inherent in the CPI-U, the Bureau of Labor Statistics created the chained CPI-U.
Using the chained CPI-U to index tax parameters would be difficult to implement, however, because that measure is subject to revisions. In addition, because indexing with that lower measure would raise the amount of taxable income and thus tax revenues over time, it would result in an increased burden on taxpayers.
|
Change in Revenues |
|
||||||||||
|
|
Reduce the maximum mortgage on which interest can be deducted from $1 million to $400,000 |
+4.2 |
+4.9 |
+5.7 |
+7.2 |
+8.3 |
|
+30.3 |
|
+88.1 |
|
|
|
Convert the mortgage interest deduction into a credit |
+21.7 |
+31.2 |
+34.2 |
+37.8 |
+41.0 |
|
+165.9 |
|
+418.5 |
|
The tax code treats investments in owner-occupied housing more favorably than other investments. For example, if a person owns a house and rents it out, he or she pays taxes on the rental income (net of expenses such as mortgage interest, property taxes, depreciation, and maintenance). The owner also pays a tax on any capital gain when the house is sold. If, instead, the owner lives in the house, no rent changes hands, so the tax code does not require the owner to report the rental value of the home as gross income. Yet the owner can deduct mortgage interest and property taxes from his or her other income in computing income tax liability. The owner can also exclude from taxation as much as $250,000 of any capital gain (or $500,000 if filing a joint return) when the home is sold.
In part, the rental value of housing services is excluded from income because it is difficult to determine that value when no rent changes hands. It is simple, however, to exclude expenses in calculating taxable income. In fact, housing-related expenses other than mortgage interest and property taxes cannot be deducted from a homeowner's income. Moreover, current law limits the amount of mortgage interest that can be deducted to the interest on up to $1 million of debt that a homeowner has incurred to buy, build, or improve a first or second home, as well as interest on as much as $100,000 in other loans (such as home-equity loans) that the owner has secured with the home, regardless of the loans' purposes.
This option would further restrict the mortgage interest deduction in one of two ways. The first alternative would lower the maximum mortgage amount eligible for the interest deduction from $1 million to $400,000. That change would raise taxes for 1.2 million people with large mortgages in 2008, increasing revenues by $4.2 billion in that year and by $30.3 billion over the 2008–2012 period. The lower cap would affect more homeowners over time as incomes and housing prices rose.
The second alternative would replace the current deduction with a 15 percent tax credit for interest on mortgages of $400,000 or less on a primary residence only. (In 2005, the President's Advisory Panel on Federal Tax Reform proposed a more complex variant of that approach.) That alternative would increase taxes for an estimated 28.6 million people in 2008 but lower them for some other taxpayers. In all, the change would increase revenues by $21.7 billion in 2008 and by $165.9 billion over five years because the reduced benefits to taxpayers in higher rate brackets would exceed the increased benefits to taxpayers in lower brackets.
The main rationale for curtailing the mortgage interest deduction is to improve the efficiency of the economy. The deduction encourages people to invest more in owner-occupied housing than they would if all investments were taxed equally. As a result, the owner's return on additional investment in housing, aside from the tax advantages, is likely to be lower than returns on additional investment in businesses. Reducing the maximum mortgage on which interest could be deducted should make affected homeowners less willing to invest in homes relative to stocks, bonds, savings accounts, and their own businesses. Between 1981 and 2005, 37 percent of net private investment in the United States went into owner-occupied housing. That share is large enough that less investment in owner-occupied housing—even for larger homes alone—could eventually boost capital in other sectors of the economy and increase total economic output.
Another advantage of limiting the mortgage interest deduction is that it would discourage taxpayers from borrowing against their homes to fund tax-favored retirement savings accounts, such as 401(k) plans and individual retirement accounts. That practice takes advantage of tax savings on both transactions and thus provides an incentive for people to pay down their mortgage debt more slowly and contribute more to retirement accounts than they would if mortgage interest were not deductible. Such transactions reduce revenue without increasing net saving, because the higher retirement contributions are offset by larger amounts of outstanding mortgage debt.
A drawback of limiting the deductibility of mortgage interest suddenly and deeply is that home values, home construction, and mortgage lending would most likely fall abruptly, particularly for larger houses. Those rapid declines would create hardships for owners of such homes, for builders, and for lenders. Lowering the cap gradually, or with substantial advance warning, would greatly reduce the hardships of adjusting to the change. Nonetheless, over the long run, the shift of investment from housing to other activities would mean less home construction and less increase in the value of homes than would occur under current law.
Another drawback is that this option might reduce home ownership. Greater home ownership contributes to social and political stability, according to its advocates, by strengthening people's stake in their communities and governments. In addition, home ownership motivates people to maintain their homes and may bolster neighborhoods by reducing mobility. Individuals typically do not consider those benefits to the community when deciding whether to rent or own, so a subsidy to promote home ownership may tilt their decisions in the direction of the community's interest.
The mortgage interest deduction, however, may be an ineffective means of inducing renters to become homeowners. Despite that tax treatment, the United States has about the same rate of home ownership as Canada, the United Kingdom, and Australia, which do not allow mortgage interest to be deducted. The deduction's effect on home buying may be small because lower-income households—which face greater barriers to home ownership—benefit less from it than higher-income households do. One reason is that the deduction has value only for owners whose total deductions exceed the standard deduction, so they have a reason to itemize. Lower-income homeowners are less likely to have deductions that large. Another reason is that the entire amount of the mortgage interest deduction can be used to reduce taxes only by people whose other deductions exceed the standard deduction. Lower-income people are less likely to have that many other deductions. Finally, for homeowners who itemize, the tax savings increase with their income tax rate and mortgage size. For example, an owner in the 15 percent tax bracket saves 15 cents per dollar of mortgage interest deducted, whereas an owner in the 35 percent bracket saves 35 cents. That larger saving per dollar deducted is magnified for higher-income households because they tend to buy larger homes with bigger mortgages.
The second approach in this option—replacing the mortgage interest deduction with a tax credit—would redirect the tax advantages of home ownership to lower-income taxpayers. Currently, many homeowners find themselves unable to take advantage of the deduction for mortgage interest. According to the President's Advisory Panel on Federal Tax Reform, only 54 percent of taxpayers who pay mortgage interest receive a tax benefit. Converting the mortgage interest deduction to a 15 percent credit would equalize the interest rate subsidy to borrowers regardless of their tax bracket and whether they itemized deductions.
The potential effectiveness of a 15 percent credit in getting more people to become homeowners is uncertain, however. That rate may be too low to encourage enough additional home ownership to improve neighborhoods and community participation. Alternatively, encouraging some people to own homes could reduce their flexibility with regard to job locations.
|
Change in Revenues |
|
||||||||||
|
|
End the current deduction |
+10.5 |
+42.1 |
+41.9 |
+53.3 |
+88.3 |
|
+236.1 |
|
+694.4 |
|
|
|
Cap the deduction at 2 percent
of adjusted gross income |
+6.7 |
+26.6 |
+26.3 |
+34.7 |
+62.2 |
|
+156.5 |
|
+471.5 |
|
In determining their taxable income, taxpayers may either claim a standard deduction or itemize certain expenses to deduct from their adjusted gross income (AGI). Such expenses have long included state and local taxes on income, real estate, and personal property. Under the American Jobs Creation Act of 2004, taxpayers who itemized deductions in 2004 and 2005 had the choice of deducting their state and local sales taxes, which previously had not been deductible, instead of their state and local income taxes. That provision was extended for 2006 and 2007 by the Tax Relief and Health Care Act of 2006.
This option would curtail the deductibility of state and local tax payments, either by eliminating the deduction or by allowing taxpayers to deduct such taxes only up to an amount equal to 2 percent of their AGI. Eliminating deductibility completely would increase federal revenues by a total of $236.1 billion between 2008 and 2012. Setting a ceiling for the deduction at 2 percent of AGI would raise revenues to a lesser degree: by $156.5 billion over that five-year period.
The federal income tax deduction for state and local taxes is effectively a federal subsidy to state and local governments. As such, it indirectly finances spending by those governments at the expense of other uses of federal revenues. Both variations of this option would substantially reduce the incentive that the current subsidy provides for state and local government spending. However, research indicates that total state and local spending is not very sensitive to that incentive.
Some proponents of curtailing the deduction argue that the federal government should not subsidize state and local governments in this manner; others argue that the deduction largely benefits wealthier localities, where many taxpayers itemize, are in the upper tax brackets, and enjoy more-abundant state and local government services. Because the value of an additional dollar of itemized deductions increases with the marginal tax rate (the rate on the last dollar of income), the deductions are worth more to taxpayers in higher income tax brackets than to those in lower brackets. Additionally, the deductibility of taxes may deter states and localities from financing services with nondeductible fees, which may be more efficient.
One argument against eliminating or restricting the current deduction involves the equity of the tax system. A person who must pay relatively high state and local taxes is less able to pay federal taxes than is someone with the same total income and a smaller state and local tax bill. The validity of that argument depends at least in part on whether people who pay higher state and local taxes also benefit from more publicly provided goods and services.
|
Change in Revenues
|
+26.6
|
+53.5
|
+54.7
|
+90.3
|
+127.2
|
|
+352.3
|
|
+1,040.6
|
|
Under current law, taxpayers may deduct various items from their taxable income, such as state and local income and property taxes, interest payments on home mortgages, contributions to charities, employee business expenses, moving costs, casualty and theft losses, and medical and dental expenses. A taxpayer benefits from itemizing those deductions if together they exceed the amount of the standard deduction. Some itemized deductions (such as the one for medical expenses) are limited to the amount in excess of a percentage of the taxpayer's adjusted gross income (AGI). For high-income people, the tax code lowers the value of itemized deductions by gradually reducing how much of those deductions taxpayers can subtract when their AGI rises above a certain level. (Under the Economic Growth and Tax Relief Reconciliation Act, or EGTRRA, that reduction is gradually being phased out, but it is scheduled to return in 2011 with EGTRRA's expiration.)
As with any deduction, the tax benefit of itemizing deductions rises with a taxpayer's marginal tax bracket (the bracket that applies to the last dollar of income). For example, $10,000 in itemized deductions reduces tax liability by $1,500 for someone in the 15 percent bracket but by $3,500 for someone in the 35 percent bracket.
This option would limit the tax benefit of itemizing deductions to 15 percent for people in marginal tax brackets above 15 percent, thus increasing revenues by $26.6 billion in 2008 and by $352.3 billion over five years. Of the roughly one-third of taxpayers who itemize deductions, about 40 percent are in tax brackets over 15 percent and therefore would receive smaller deductions under this option. (In 2007, those taxpayers would be single filers with taxable income of at least $31,850 and joint filers with income of at least $63,700.)
One rationale for curtailing the benefit from itemized deductions is economic efficiency. Limiting itemized deductions to 15 percent could have two efficiency-related benefits. First, to the extent that some current deductions provide larger subsidies for certain activities than is optimal for the most efficient allocation of society's resources, limiting the overall size of the tax benefit for itemized deductions might result in a more efficient allocation of those resources. Second, such a limit would weaken the link between a given deduction and a household's marginal tax bracket, thereby reducing the potentially inefficient variation that exists among households in the size of the deduction per dollar of activity. As a result, economic efficiency would improve in the case of deductions that are intended to subsidize socially beneficial activities (such as home ownership and charitable donations), though not in the case of deductions that are designed to measure income more accurately (such as the deduction for medical expenses)—but only if households in different marginal tax brackets do not differ systematically in the extent to which their decisionmaking is influenced by the subsidy that a given deduction provides. (In cases in which higher-income taxpayers are more sensitive to a subsidy than lower-income taxpayers are, eliminating the link between a deduction and a household's marginal tax bracket could worsen economic efficiency.)
Like other restrictions on itemized deductions, the one in this option could create incentives for taxpayers to avoid the constraint by converting itemized deductions into reductions in income. For example, taxpayers might liquidate some of their assets to repay mortgage loans, thus reducing both their income (from the assets) and their mortgage payments. Or they might donate time or services to charities rather than cash.
Another potential advantage or disadvantage of this option is that it would alter relative tax burdens. Reducing the benefit from itemized deductions would raise average tax rates disproportionately among upper-income taxpayers. It would also cause people who incurred high levels of deductible expenses to bear larger tax burdens relative to those of people who had fewer such expenses. That outcome might be viewed as more problematic in the case of deductions that are intended to defray costs of an involuntary nature and to better measure underlying income, such as the deductions for casualty losses or business expenses.
|
Change in Revenues
|
+7.8
|
+19.9
|
+21.4
|
+24.1
|
+25.6
|
|
+98.8
|
|
+249.8
|
|
Current law allows taxpayers who itemize deductions to deduct the value of their contributions to qualifying charitable organizations—up to a maximum of 50 percent of their adjusted gross income (AGI) in any year. By lowering the after-tax cost of donating to charities, the deduction provides an added incentive for such donations. In 2003 (the most recent year for which data are available), $145.7 billion in charitable contributions were claimed on 38.6 million tax returns.
This option would further limit the deduction for charitable donations—while preserving a tax incentive for donating—by allowing taxpayers to deduct only contributions that exceed 2 percent of their AGI. That change would extend the same tax treatment to charitable contributions that now applies to unreimbursed employee expenses, such as job travel costs and union dues. That approach would increase revenues by $7.8 billion in 2008 and by a total of $98.8 billion over the 2008–2012 period.
An argument for limiting the tax deductibility of charitable contributions is that a significant share of those donations would be made even without a deduction. In that case, allowing taxpayers to deduct contributions is economically inefficient because it results in a large subsidy (loss in federal revenue) for a very small increase in charitable giving. For taxpayers who contribute more than 2 percent of their AGI to charity, this option would maintain the current marginal incentive to donate but at much less cost to the federal government. People who make large donations are often more responsive to that tax incentive than are people who make small contributions. Moreover, smaller contributions are apt to be a source of abuse among taxpayers, some of whom overstate their charitable donations in the belief that the government is probably unwilling to incur the costs involved in determining the legitimacy of small contributions.
A potential disadvantage of this option is that total charitable giving would decline. People whose contributions do not exceed 2 percent of their AGI would no longer have a tax incentive to make donations; as a result, many of them would reduce their contributions. Although larger donors would still have an incentive to give, they would have slightly lower after-tax income because of the smaller deduction, which could lead them to reduce their contributions as well (though by a smaller percentage than among taxpayers whose donations do not exceed the 2 percent threshold). Another effect of creating a 2 percent floor for deducting charitable contributions is that it would encourage taxpayers who had planned to make gifts over several years to lump the donations together in one tax year to qualify for the deduction.
|
Change in Revenues |
|
||||||||||
|
|
Allow nonitemizers to deduct up to $100 of charitable donations ($200 for joint filers) |
-0.2 |
-0.7 |
-0.7 |
-0.9 |
-0.9 |
|
-3.4 |
|
-7.9 |
|
|
|
Allow nonitemizers to deduct charitable giving of more than $250 ($500 for joint filers) |
-0.7 |
-2.8 |
-2.9 |
-4.0 |
-4.3 |
|
-14.7 |
|
-38.7 |
|
Current tax law gives taxpayers an extra incentive to make donations to charitable organizations by allowing them to deduct the value of donations (up to a maximum of 50 percent of their adjusted gross income) if they itemize deductions. In 2003, 38.6 million tax returns claimed $145.7 billion in itemized charitable deductions. Taxpayers who do not itemize, however, are not permitted to deduct charitable contributions. In 2003, such taxpayers donated an estimated $30 billion to charities.
This option would expand the charitable deduction by letting people who chose not to itemize deductions take an “above-the-line“ deduction from taxable income for some gifts to qualified charities. Nonitemizers could claim that deduction in addition to the standard deduction.
An above-the-line deduction for charitable contributions could take various forms. One alternative would allow nonitemizers to deduct up to $100 if filing singly or $200 if filing a joint return. That approach would decrease revenues by $0.2 billion in 2008 and by $3.4 billion over the 2008–2012 period. Another alternative would only allow nonitemizers to deduct total contributions in excess of $250 for single filers or $500 for joint filers. That change would have a larger effect, reducing revenues by $0.7 billion in 2008 and by $14.7 billion over five years.
Either approach would lower the after-tax cost of charitable giving for some nonitemizers, thus encouraging them to increase their donations. Under the first alternative, only taxpayers who would otherwise have given less than $100 to charity in a year would have an additional incentive to donate—and that incentive would only extend to contributions totaling $100 or less. Under the second approach, all taxpayers with taxable income of more than $250 and adjusted gross income of more than $500 would have an incentive to contribute at least $250 a year, and those who already donate that much would have a greater incentive to give more.
To the extent that charitable activities are currently provided at a less than socially optimal level, the main advantage of this option would be to increase contributions. The first approach would give more taxpayers a tax reduction to offset the cost of their donations. The second alternative might be more effective at boosting charitable donations, however, because it would lower the after-tax cost of additional giving for the many nonitemizing taxpayers who already contribute more than $250 to charity. In general, proponents argue that either approach would be a step toward equalizing the tax treatment of itemizers and nonitemizers.
Creating an above-the-line charitable deduction would have at least three drawbacks, however. First, it would be a costly way—in terms of forgone revenue—to expand charitable contributions. Many nonitemizers who already make such contributions would receive a tax benefit even if they did not increase their donations. Overall, any rise in donations would most likely be small relative to the cost in lost tax revenue, since the after-tax cost of giving probably has a bigger effect on decisionmaking among itemizers than among nonitemizers. Moreover, especially under the first alternative, the after-tax cost of giving an additional dollar to charity would not change for the many taxpayers who currently donate more than $100 a year.
Second, to the extent that the standard deduction incorporates an implicit allowance for charitable contributions, nonitemizers are already effectively deducting their donations. Because nonitemizers have the option of itemizing deductions, their decision not to do so suggests that they are better off claiming the standard deduction. This option would thus allow nonitemizers to explicitly deduct some of their contributions in addition to benefiting from the implicit allowance incorporated in the standard deduction.
Third, by substantially increasing the number of tax returns that claim a deduction for charitable contributions, this option would significantly raise either the costs of tax enforcement or abuse by taxpayers who overstate their charitable donations.
|
Change in Revenues
|
+0.7
|
+2.8
|
+2.7
|
+2.6
|
+2.5
|
|
+11.3
|
|
+22.6
|
|
The tax system provides two types of assistance for employed taxpayers who incur expenses to care for children under age 13 or disabled dependents. The first type is a tax exclusion, in which the amount of such expenses provided by an employer is excluded from an employee's taxable income. The second type of subsidy is a tax credit, which is equal to a percentage of a taxpayer's expenses for child or dependent care. The credit is available only to people who do not use the employment-based exclusion.
This option would eliminate both types of subsidy beginning in 2008. That change would add $0.7 billion to federal revenues in 2008 and a total of $11.3 billion through 2012. (In the case of the tax exclusion, including employers' contributions for child or dependent care in taxable income—and thus in the wage base from which Social Security benefits are calculated—would also increasefederal spending for Social Security over the long run.)
Taxpayers are eligible for the exclusion if their employer either provides child or dependent care directly or offers a qualified plan that provides it. As much as $5,000 in child and dependent care expenses may be excluded from the taxable wages of employees. However, the amount excluded may not exceed the employee's earnings or, in the case of married taxpayers, the wages of the lower-earning spouse.
Taxpayers who do not receive the employment-based subsidy can claim a nonrefundable credit against their income tax for child or dependent care costs. The credit is limited to expenses of $3,000 for one dependent or $6,000 for two or more dependents. (As with the exclusion, the total amount of qualifying expenses may not exceed the earnings of the taxpayer or, in the case of a couple, those of the lower-earning spouse.) For taxpayers with adjusted gross income (AGI) of $15,000 or less, the credit equals 35 percent of qualifying expenses; that rate phases down to 20 percent for taxpayers whose AGI is at least $43,000. The 20 percent rate is the one that applies to most taxpayers. It results in a maximum credit of $600 for one dependent or $1,200 for two or more dependents. (The current parameters of the child and dependent care credit were established in the Economic Growth and Tax Relief Reconciliation Act of 2001. If that law expires as scheduled in 2011, both the amount of allowable expenses and the rate structure of the credit will revert to their previous, lower levels.)
Although the credit and the exclusion subsidize the same activities, they provide significantly different benefits. For example, a high-income taxpayer with one child could see his or her income taxes reduced by as much as $1,750 under the employment-based exclusion but by only $600 under the credit. In addition, by lowering taxable income, the exclusion reduces an employee's payroll taxes, whereas the credit does not.
One rationale for eliminating both the exclusion and the credit is to make the tax system less complex by simplifying how people calculate their income taxes. Moreover, several other provisions of the tax system—such as personal exemptions, the child credit, and the earned income credit—reduce taxes for families with children. Another argument for removing subsidies for child and dependent care would be fairness: Taxpayers who are alike in other respects face unequal tax burdens depending on whether they opt to pay for child care rather than choosing parental or informal care.
A rationale against eliminating the exclusion is that employer-provided dependent care could be considered part of the cost of employment. The tax code permits some other employment-related expenses (such as the cost of moving to a new job or purchases of supplies and equipment in excess of 2 percent of income) to be deducted from employees' taxable income. In addition, research has shown that among couples, the extent to which the lower-earning spouse works is particularly sensitive to tax rates. Both the exclusion and the credit lower the cost of working for taxpayers with dependents. In the absence of those tax subsidies, a lower-earning spouse could decide to stop working and care for dependents rather than pay someone else to do it. Consequently, eliminating the subsidies might lessen the labor force participation of those spouses.
|
Change in Revenues
|
+8.1
|
+19.0
|
+19.8
|
+20.5
|
+21.8
|
|
+89.2
|
|
+209.3
|
|
Current tax law treats benefits that replace income for unemployed, injured, or disabled people in different ways. Unemployment benefits are fully taxable, whereas benefits paid under workers' compensation programs (for work-related injuries or illnesses) are exempt from taxation. Disability benefits (for non-work-related injuries) may be taxable or not depending on who paid the premiums for the disability insurance. If those premiums were paid by an employer, the benefits are taxable (although the recipient's tax liability may be partly offset by the special income tax credit given to elderly or disabled people). If the employee paid the premiums for disability insurance out of after-tax income, the benefits are not taxed.
This option would eliminate existing taxes on income-replacement benefits. However, it would include in employees' taxable income several taxes, premiums, and contributions that employers pay. Specifically, taxes paid under the Federal Unemployment Tax Act and the various state unemployment programs, 60 percent of premiums for workers' compensation (that is, excluding the part that covers medical expenses), and the portion of insurance premiums or contributions to pension plans that funds disability benefits would all become taxable under the individual income tax. Together, those changes would increase revenues by $8.1 billion in 2008 and by $89.2 billion through 2012. Over the long term, the revenue gain would result almost entirely from adding workers' compensation premiums to taxable income. (Including those various items in employees' taxable income, and thus in the wage base from which Social Security benefits are calculated, would also increase federal spending for Social Security over the long run.)
Treating different kinds of income-replacement insurance similarly would eliminate the current, somewhat arbitrary discrepancies that exist in the taxation of various income-replacement benefits. For example, people who were unable to work because of injury would not be taxed differently depending on whether the injury was related to their previous job. Furthermore, this option would spread the tax burden among all workers covered by such insurance rather than place the burden on people unfortunate enough to need benefits, as is currently the case with unemployment insurance and employer-paid disability insurance.
This option would not eliminate all of the disparities in the treatment of income-replacement benefits, however. For example, the income-replacement portion of adjudicated awards and out-of-court settlements for injuries that were not related to work and not covered by insurance would remain entirely exempt from taxation. Also, recipients of the supplemental unemployment benefits that lawmakers occasionally appropriate during economic downturns would receive those benefits tax-free, even though no employer-paid taxes had been included in their taxable income. Another disadvantage of this option is that exempting unemployment benefits from taxation would reduce the incentive for unemployed people to accept available work.
|
Change in Revenues
|
+1.4
|
+2.1
|
+2.2
|
+2.3
|
+2.4
|
|
+10.4
|
|
+23.6
|
|
Many workers receive part of their compensation in the form of noncash employer-paid benefits that are not subject to income or payroll taxes. For example, current law excludes the premiums that employers pay for employees' group term life insurance from the employees' taxable income. The amount that can be excluded is limited to the cost of premiums for the first $50,000 of insurance. Employer-paid life insurance is the third largest tax-exempt fringe benefit (after health insurance and pensions) as measured by lost federal revenues.
This option would eliminate that exclusion by counting all premiums for employer-paid life insurance in employees' taxable income. That change would increase federal revenues by a total of $10.4 billion over the 2008–2012 period—$6.2 billion in individual income tax revenues and $4.2 billion in payroll tax revenues. (However, including employers' contributions for life insurance in taxable income, and thus in the wage base from which Social Security benefits are calculated, would also increase federal spending for Social Security over the long run.)
The main rationales for not excluding life insurance premiums from taxation would be to enhance the efficiency and equity of the tax system. Like the tax exclusions for other employment-based fringe benefits (such as child care), the exclusion for life insurance premiums creates an incentive for employees to buy more life insurance than they would if they had to pay the full cost themselves. That subsidy results in employees' receiving more compensation in the form of life insurance and less cash compensation, which is fully taxed. In terms of fairness, excluding premiums from taxation allows workers whose employers purchase life insurance for them to pay less tax than workers who have the same total compensation but must buy their own insurance. Moreover, self-employed people cannot exclude their life insurance premiums from taxable income. Finally, the exclusion links the size of the tax incentive to a household's marginal tax rate (the rate on the last dollar of income), which generally results in larger subsidies for taxpayers with higher income.
Another argument for this option is the relative ease with which it could be implemented. Unlike the value of some other noncash benefits, the value of employer-paid life insurance can be accurately measured. As a result, employers could report the insurance premiums they paid for each employee on the employee's W-2 form and compute withholding using the same method that they use for wages. Indeed, employers already withhold taxes on the premiums they pay for life insurance over the $50,000 limit.
Some opponents of eliminating the tax exclusion argue that people systematically underestimate the financial hardship that their death might bring to their family and thus purchase too little life insurance. If that view is correct, the incentive offered by the exclusion has benefits for society because people who bore the full cost of life insurance would purchase too little of it. (In that case, a more efficient method for encouraging people to buy life insurance would be to extend favorable tax treatment to all purchasers instead of only to workers whose insurance is provided by their employers.)
|
Change in Revenues
|
+26.5
|
+45.5
|
+58.1
|
+72.5
|
+87.5
|
|
+290.1
|
|
+999.2
|
|
Although they are part of many employees' total compensation, employer-paid premiums for health insurance are exempt from individual income taxes and payroll taxes. Besides that exclusion, current law offers employees another tax advantage for health-related expenditures: Spending from employer-sponsored flexible spending accounts (FSAs) and health savings accounts (HSAs) is also tax-exempt.
This option would limit the extent to which employer-paid health insurance premiums and health spending from FSAs and HSAs were excluded from taxation. Specifically, it would include in employees' taxable income any contributions that employers or employees made for health insurance and for health care costs (through accounts such as FSAs) that together exceeded $910 a month for family coverage or $340 a month for individual coverage. Those limits—which are based on the average health insurance premiums paid by or through employers in 2005—would not be indexed for inflation.
Such a restriction would increase revenues from income and payroll taxes by a total of $290.1 billion over the 2008–2012 period and by nearly 2.5 times that amount over the following five years. (However, including employers' contributions for health care coverage in taxable income—and thus in the wage base from which Social Security benefits are calculated—would also increase federal spending for Social Security over the long run.)
Many analysts believe that the tax preference for employer-provided health insurance distorts the markets for health insurance and health care. Those two markets are closely linked. Current tax law provides incentives for health insurance plans to cover routine expenses as well as large, unexpected costs because routine charges are subsidized only if they are paid through an insurance plan. That factor can drive up overall health care costs. Under this option, employees and their employers would have an incentive to economize, which could reduce upward pressure on health care prices and encourage the use of more-cost-effective types of care.
Limiting the tax exclusion for employer-paid health insurance premiums could have other benefits as well. It would reduce the incentive that companies have to offer special health care packages to top executives. In addition, it would create a more level playing field between employer-provided and other forms of health insurance.
One argument against this option is that setting fixed dollar limits on excluded health care spending would have different effects in different locations. For example, the additional costs subject to taxation would be greatest for workers who lived in areas where health care was more expensive and whose firms offered generous health benefits. Limiting the subsidy for employer-paid insurance premiums would probably result in employees' paying a larger share of their premiums directly, which might induce some workers to forgo health insurance. Finally, this option might lead some firms to stop offering health insurance coverage. A key factor in evaluating the effects of less employment-based coverage is whether alternative insurance pools would develop outside the context of employment.
|
Change in Revenues
|
+11.4
|
+23.1
|
+23.7
|
+25.6
|
+27.6
|
|
+111.4
|
|
+260.5
|
|
Life insurance policies and annuities often combine features of both insurance and tax-favored savings accounts. (An annuity is a contract with an insurance company under which, in exchange for premiums, the company agrees to make a series of fixed or variable payments to a person at a future time, usually during retirement.) The investment income from the money paid into life insurance policies and annuities—sometimes called inside buildup—is not included in taxable income until it is paid out to the policyholder. If that accumulated income is left to the policyholder's estate or used to finance life insurance (such as in the case of whole-life policies), it can escape inclusion and taxation entirely. The tax treatment of inside buildup is similar to the treatment of another type of investment income, capital gains.
Under this option, life insurance companies would inform policyholders annually of the investment income that had been realized on their account—just as mutual funds do now—and policyholders would include those amounts in their taxable income for that year. In turn, disbursements from life insurance policies and benefits from annuities would no longer be taxable when they were paid. That approach would make the tax treatment of investment income from life insurance and annuities match the treatment of income from bank accounts, taxable bonds, or mutual funds. (Investment income from annuities purchased as part of a qualified pension plan or qualified individual retirement account would still be tax-deferred until benefits were paid.) Those changes in tax treatment would increase revenues by $11.4 billion in 2008 and by a total of $111.4 billion over the 2008–2012 period.
By taxing the investment income from life insurance and annuities as it was realized, this option would eliminate a tax incentive to purchase such insurance. Whether that outcome would be a benefit or a drawback depends on whether the current incentive is considered beneficial. Encouraging the purchase of life insurance is useful if people systematically underestimate the financial hardship that their death will impose on their family and thus buy too little life insurance. Encouraging the purchase of annuities is helpful if people tend to underestimate their retirement spending or life span and thus buy too little annuity insurance to protect themselves from outliving their assets. However, little evidence exists about how successful the current tax treatment is in reducing underinsurance.
A disadvantage of the present treatment is that it provides no tax incentive to buy term life insurance, because such insurance has no savings component on which to defer taxation. (Term life insurance provides coverage for a specified period of time and pays benefits only if the policyholder dies during that period. Otherwise, the policy expires without value.) Term insurance accounts for a major share of all life insurance policies.
If some incentive to purchase life insurance is indeed considered a useful part of the tax system, an alternative approach may be to encourage such purchases directly by giving people a tax credit for their life insurance premiums or by allowing them to deduct part of those premiums from their taxable income. (Annuities already receive favorable tax treatment through special provisions for pensions and retirement savings.)
|
Change in Revenues
|
+1.0
|
+5.1
|
+5.3
|
+5.6
|
+5.9
|
|
+22.9
|
|
+57.0
|
|
U.S. citizens who live in other countries must file a tax return each year but may exclude from taxation some of the income they earn abroad: up to $82,400 for single filers and $164,800 for joint filers in calendar year 2006. (Those amounts are indexed for inflation.) The tax exclusion for overseas income—along with one for foreign housing and the usual personal exemptions and deductions—means that U.S. citizens who reside abroad and earn close to $100,000 may not incur any U.S. tax liability, even if they pay no taxes to the country in which they live. Moreover, U.S. citizens with foreign-earned income above the exclusion amount receive a credit for taxes they pay to foreign governments, which may also eliminate their U.S. tax liability on that income. (The Tax Increase Prevention and Reconciliation Act of 2005 included several technical changes that made the tax exemption less generous overall.)
This option would retain the credit for taxes paid to foreign governments but would require U.S. citizens living overseas to include all of the income they earned abroad in their adjusted gross income. As a result, U.S. citizens residing in foreign countries with higher tax rates than those in the United States would generally not owe U.S. taxes on their earned income, whereas those living in lower-tax countries could have some U.S. tax liability. That change would increase revenues by $22.9 billion over the 2008–2012 period.
One rationale for eliminating the partial exclusion for foreign earnings is that U.S. citizens with similar income should incur similar tax liabilities, regardless of where they live or what level of services they receive. That principle is violated if people can move to low-tax foreign countries and escape U.S. taxation while retaining their U.S. citizenship. In addition, the existing exclusion represents an implicit subsidy to corporations that employ U.S. citizens abroad, because those companies can pay their employees less than they would if the income were fully subject to U.S. taxes. Moreover, ending the exclusion for foreign-earned income would lessen some of the complexity of the tax code.
Opponents of this option argue that U.S. citizens who live in other countries should not face the same tax treatment as U.S. residents because they do not receive the same services from the U.S. government. Opponents also maintain that excluding foreign-earned income promotes exports by U.S. multinational firms by making it cheaper for those companies to hire U.S. employees to live and work abroad.
|
Change in Revenues
|
+12.5
|
+25.5
|
+26.6
|
+31.6
|
+36.6
|
|
+132.8
|
|
+343.9
|
|
Under current law, roughly three-quarters of the total benefits paid by the Social Security and Railroad Retirement programs are not subject to income taxation. Recipients pay tax only if the sum of their adjusted gross income, their nontaxable interest income, and one-half of their Social Security and Tier I Railroad Retirement benefits exceeds a fixed threshold. If that total is more than $25,000 for a single taxpayer or $32,000 for a couple filing jointly, up to 50 percent of the benefits are taxed. Above a second set of thresholds—$34,000 for single filers and $44,000 for joint filers—as much as 85 percent of the benefits are taxed. Together, those levels constitute a three-tiered structure for taxing Social Security and Railroad Retirement benefits. However, most recipients fall in the first tier, so their benefits are not taxed.
Distributions from defined-benefit pension plans, by contrast, are taxable unless those payments represent the recovery of an employee's ”basis,” or after-tax contributions to the plan. Each year, a certain percentage of a recipient's distribution is deemed to be nontaxable basis recovery. That percentage (which is determined in the year that distributions begin) is based on the recipient's life expectancy and cumulative amount of after-tax contributions. Once the recipient has recovered his or her entire basis tax-free, all subsequent pension distributions are fully taxed. Until recently, distributions from defined-contribution plans and individual retirement accounts (IRAs) were taxed similarly to those from defined-benefit plans. Now, however, all workers have the opportunity to make after-tax contributions to so-called Roth plans; distributions from those plans are entirely tax-exempt—a more favorable treatment than the tax-free recovery of basis only.
This option would define a basis in Social Security and Railroad Retirement benefits and would tax only benefits in excess of that basis, in the same manner as with defined-benefit pensions. The basis would be the payroll taxes that employees pay out of their after-tax income to support those programs (as opposed to the equal amount that employers pay on their workers' behalf). For self-employed people, the basis would be determined using 100 percent of payroll taxes minus the half they can deduct on their income tax returns. Under such an approach, the percentage of benefits subject to income taxation would exceed 85 percent for the overwhelming majority of recipients. As a result, revenues would increase by $12.5 billion in 2008 and by $132.8 billion over the 2008–2012 period.
Taxing Social Security and Railroad Retirement benefits like defined-benefit pensions would make the tax system more equitable in at least two ways. First, it would eliminate the preferential treatment that the tax code now accords to Social Security benefits but not to pension benefits, which is slight in the case of higher-income taxpayers but much larger in the case of low- and middle-income taxpayers. Second, it would treat elderly taxpayers in the same way as nonelderly taxpayers with comparable income. In addition, the option would make preparing tax returns for elderly people much simpler.
At the same time, however, taxing Social Security and Railroad Retirement benefits like defined-benefit pensions would have several drawbacks. One is that more elderly people would have to file tax returns than is the case now. In addition, retirees might feel that raising taxes on Social Security and Railroad Retirement benefits would violate the implicit promises of those programs. Furthermore, calculating the percentage of each recipient's benefits that would be excluded from taxation would impose an additional burden on the Social Security Administration. Finally, this option would not provide the same tax benefits enjoyed by the increasingly popular defined-contribution plans and IRAs.
|
Change in Revenues
|
+0.4
|
+0.8
|
+0.8
|
+0.9
|
+1.0
|
|
+3.9
|
|
+9.9
|
|
Employee stock ownership plans (ESOPs) are a type of retirement plan designed to encourage a company and its shareholders to contribute or sell stock to the company's employees. ESOPs provide more tax advantages than other qualified retirement plans do. Corporations that sponsor ESOPs typically contribute their own stock rather than cash to the plan on their workers' behalf. Those contributions, like employers' contributions to other qualified retirement plans, can be deducted from the company's taxable income. But employers with ESOPs have an additional tax advantage: they can deduct the dividends paid on stock held in an ESOP, provided those dividends are paid directly to the plan's participants or are paid to the plan and either reinvested in additional company stock, used to repay loans with which the stock was originally purchased, or distributed to participants within 90 days of the end of the plan year.
Another advantage associated with ESOPs is that when shareholders sell the sponsoring company's stock to such a plan, they can defer paying taxes on capital gains from the sale, under certain circumstances. (Those conditions include that the company is a C corporation and thus subject to the corporate income tax, that the stock is not traded publicly, and that the proceeds of the sale are invested in the stock of another U.S. company.)
This option would eliminate the tax advantages that are now accorded to ESOPs, effectively rendering them indistinguishable from other qualified retirement plans. That change would increase revenues by $0.4 billion next year and by $3.9 billion over the next five years.
Several arguments can be made for not giving preferential tax treatment to ESOPs. First, the current treatment causes similar dividend payments to have different tax consequences for different companies. Second, it hinders the diversification of employees' retirement portfolios, because the assets of an ESOP, by design, consist primarily of shares of the employer's stock. If the price of that stock drops, employees may have much less wealth in retirement than they would have had if they had been allowed to diversify their investments, as participants in a typical 401(k) plan can. A third argument for eliminating ESOPs' preferential tax treatment is that the plans have occasionally been used for purposes for which they were not intended, such as to ward off hostile takeovers by placing large numbers of shares in friendly hands.
The main rationale for retaining the tax advantages of ESOPs is that having employees own stock directly links their financial interests to their productivity. That is, greater productivity translates into higher profits for the company and thereby increases the value of the employees' stock. To the extent that the incentive of stock ownership works as intended, ESOPs help promote increased productivity among workers. However, the efficacy of that incentive has not been clearly established.
|
Change in Revenuesa
|
*
|
+0.7
|
+0.7
|
+0.8
|
+0.7
|
|
+3.0
|
|
+7.0
|
|
The earned income tax credit (EITC)—a refundable credit designed to help low-income workers and their families—phases out as a taxpayer's earned income or adjusted gross income (AGI), whichever is larger, exceeds a certain threshold. Under the tax code, AGI does not include some income from government transfer programs, such as Social Security. Consequently, low-income families who receive sizable transfer payments may qualify for a larger EITC than otherwise comparable families with the same total income whose income stems entirely from sources included in AGI.
In the case of Social Security, the tax code requires single filers with income above $25,000 and joint filers with income above $32,000 to count up to 85 percent of their Social Security benefits in AGI. This option would extend that requirement by mandating that taxpayers who might be eligible for the EITC include all of their Social Security benefits in a modified AGI that would be used for phasing out the earned income tax credit. That change would increase federal revenues and decrease outlays for the EITC by a total of $3.0 billion over the 2008–2012 period.
The main rationale for counting all Social Security benefits when calculating the phaseout of the EITC would be to make the credit fairer with a minimum of administrative difficulty. Low-income taxpayers who receive Social Security benefits and those whose income is derived entirely from sources that are fully included in AGI would be treated the same way. Moreover, because the Internal Revenue Service already receives information about taxpayers' Social Security benefits, the option could be implemented with only minor procedural changes. (By comparison, a broader option that included income from other transfer programs in the modified AGI would be difficult to administer because not all of the necessary information is currently collected. Moreover, if all transfer payments were counted for phasing out the EITC, lawmakers would have to adjust other parameters of the credit if they wished to maintain the same level of subsidy for low-income workers.)
A drawback of this option is that counting Social Security benefits in phasing out the EITC would make claiming the credit more complex. Potential EITC claimants with Social Security income would have to compute a modified AGI in addition to their regular AGI, which would further complicate the already complex form that such taxpayers must fill out. That result would run counter to recent efforts to simplify the procedures for claiming the earned income tax credit.
|
Change in Revenues
|
+0.3
|
+0.6
|
+1.0
|
+1.3
|
+1.7
|
|
+4.9
|
|
+19.1
|
|
The tax code allows owners of state and local bonds to exclude the interest they earn on those bonds from their adjusted gross income (AGI) and thus from income taxation. As a result, state and local governments can pay lower rates of interest on such debt than would be paid on bonds of comparable risk whose interest was taxable. The revenue that the federal government forgoes because of that exclusion—more than $32 billion per year—effectively pays part of the costs that state and local governments incur when they borrow.
This option would replace the current exclusion for such interest income with a tax credit that—unlike most credits—would be included in taxpayers' AGI. Under the option, a bondholder would receive a taxable interest payment from the state or local government that issued the bond as well as a federal tax credit that would give the bondholder an after-tax return comparable to the return on a tax-exempt bond. That change would increase federal revenues by $0.3 billion next year and by $4.9 billion over the next five years. (The option would retain restrictions, such as those on arbitrage earnings, that now apply to the issuance of tax-exempt bonds by state and local governments.)
Creating a tax credit for the interest paid on state and local debt could have several advantages. First, it could lower states' and localities' borrowing costs to a similar extent as the current tax exclusion but with a smaller reduction in federal revenues. The drop in revenues would be smaller because switching to the credit in this option would prevent bondholders in higher tax brackets from receiving gains that exceeded the investment return necessary to induce them to buy the bonds. Second, the size of the tax credit could be varied to allow lawmakers to adjust the extent of the federal subsidy—on the basis of its perceived benefit to the public—for different categories of state and local government borrowing. (Even with a tax credit, however, the federal subsidy would remain akin to an entitlement; that is, it would not automatically be subject to annual Congressional scrutiny.)
Opponents of switching to a tax credit argue that it could raise the interest rate that state and local governments pay to borrow funds. For example, the credit would reduce the after-tax returns on state and local bonds for people who are subject to high marginal tax rates (the rate on the last dollar of income) and thus could lead them to buy fewer of those bonds. If the drop in demand from those taxpayers was not offset by increased demand from other investors, state and local governments' borrowing costs would be reduced by a smaller percentage than they are now, and interest rates on state and local debt would rise. Paying higher rates for borrowing could in turn cause states and localities to reduce their spending on schools, roads, and other capital facilities that are frequently financed by issuing bonds.
|
Change in Revenues
|
+0.6
|
+2.3
|
+2.3
|
+2.3
|
+2.1
|
|
+9.6
|
|
+19.8
|
|
In recent years, the ways in which the federal government supports postsecondary education through the tax system have grown more numerous and complex. In addition to the myriad tax-preferred savings vehicles, taxpayers currently benefit from several education-related credits and deductions:
To qualify for those credits and deductions, taxpayers and students must meet various conditions (in addition to those noted above). Moreover, each of the benefits phases out for taxpayers with income above a certain point.
This option would combine the benefits provided by the Hope and Lifetime Learning credits and the student loan interest deduction into a single tax credit for higher education. For students in their first two years of postsecondary school, the first $10,000 of tuition and fees would qualify for a 20 percent nonrefundable subsidy. For students more than two years into their postsecondary education or for those attending school less than half-time, the credit would have a 15 percent subsidy rate. Although the current deduction for interest on student loans would be eliminated, the first $2,500 of such interest would count as a qualifying tuition expense under the new credit. The credit could be claimed for each student in a household.
Under this option, the starting point of the phaseout range for the tax credit would rise slightly, to $50,000 for single filers and $100,000 for joint filers (amounts that would be indexed for inflation). Beyond that point, each additional dollar of modified adjusted gross income (AGI) would reduce the credit by 5 cents until the credit was completely phased out.2 Thus, a single filer who qualified for a $2,000 credit would see the credit fully phase out at an AGI of $90,000. With that structure, the new credit would raise revenues by $9.6 billion over the 2008–2012 period.
Creating a unified education credit would have two main advantages: It would simplify the tax code's preferences for higher education, and it would most likely provide higher average benefits to households with students than current law does.
Some taxpayers, however, would benefit less from the new credit than they do from the present system of education-related credits and deductions. Like the Lifetime Learning credit, the new credit would subsidize 20 percent of qualifying education expenses. But for a taxpayer whose marginal tax rate (the rate on the last dollar of income) was more than 20 percent, substituting the new credit for the deduction of interest on student loans could result in lower benefits. For example, someone with a marginal tax rate of 25 percent who paid $1,000 in student loan interest would receive a benefit of $150 under this option, compared with $250 under current law.
|
Change in Revenues
|
|
||||||||||
|
|
Eliminate the child tax credit
|
+9.2
|
+46.1
|
+46.0
|
+39.8
|
+14.9
|
|
+156.0
|
|
+223.3
|
|
|
|
Reduce the eligibility age to 13
|
+2.1
|
+10.6
|
+10.3
|
+8.8
|
+3.3
|
|
+35.1
|
|
+49.6
|
|
The child tax credit, enacted in the Taxpayer Relief Act of 1997, allows taxpayers to claim a partially refundable credit against their federal income tax liability for each eligible child. To qualify, a child must be 17 or younger at the close of the year and be able to be claimed as a dependent by the taxpayer. Since 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) and other laws have expanded the credit, raising it from $500 to $1,000 per child and making it refundable for taxpayers with one or two children. Just under 26 million taxpayers claimed the expanded credit in 2004 (the most recent year for which data are available). In 2011, the credit is scheduled to revert to its pre-EGTRRA form, with a credit amount of $500 that is refundable only to families with three or more children.
Under current law, the maximum child credit that taxpayers can receive as a refund is an amount equal to 15 percent of their earned income over an inflation-indexed threshold that depends on family size. The credit phases out for single filers with adjusted gross income of more than $75,000 or joint filers with income above $110,000 (thresholds that are not indexed for inflation).
This option would either eliminate the child tax credit or lower the age limit for eligible children from 17 to 13. The first approach would increase income tax revenues by a total of $156.0 billion from 2008 through 2012; the second would raise revenues by $35.1 billion over that five-year period.
Supporters of eliminating or curtailing the child tax credit argue that other features of the individual income tax—such as the standard deduction, personal exemptions, dependent care tax credit, and earned income tax credit—already provide significant tax preferences to families with children, particularly those whose income is near the poverty line. Moreover, the credit does not benefit many of the poorest families because they have no income tax liability, whereas households must have income of at least $11,300 to receive the refundable portion of the credit. Another argument for reducing the credit is that the choice to have children represents a family's decision about how to spend its income—a choice that could be considered analogous to other spending decisions.
Opponents of cutting the child tax credit argue that the other preferences in the tax code do not fully account for the costs of raising children. In that view, because those costs can be considered an investment in the future, people should receive an income tax credit for them.
|
|
|
|
|
|
|
|||||
|
Change in Revenues
|
+1.5
|
+3.0
|
+2.9
|
+2.9
|
+2.9
|
|
+13.2
|
|
+27.6
|
|
Under current law, C corporations (those subject to the corporate income tax) pay taxes according to a progressive schedule of four statutory rates. The first $50,000 of corporate taxable income is taxed at a rate of 15 percent; income from $50,000 to $75,000 is taxed at 25 percent; income from $75,000 to $10 million is taxed at 34 percent; and income over $10 million is subject to the top corporate tax rate, 35 percent.
This option would replace those multiple rates with a single statutory rate of 35 percent on all corporate taxable income. If that change took effect in 2008, it would raise revenues by $1.5 billion in that year and by a total of $13.2 billion over the first five years.
In addition to the statutory rates listed above, some amounts of corporate taxable income face other rates. Income between $100,000 and $335,000 is subject to a further tax of 5 percent, and an additional 3 percent tax is levied on income between $15 million and $18.3 million. Those additional taxes effectively phase out the benefit of the 15 percent, 25 percent, and 34 percent tax rates for corporations with income above certain amounts. For example, a firm with taxable income of at least $18.3 million pays an average tax rate of 35 percent, despite paying the lower rates on the first $10 million. This option would not alter the taxes that those firms pay. Nor would it affect firms that operate as S corporations or as limited liability companies. (Owners of such enterprises pay taxes on their total business income but at the rates of the individual income tax.)
The progressive rate schedule for the corporate income tax was designed in part to lessen the effect of “double taxation,“ in which the government taxes the earnings of C corporations once at the corporate level and again at the individual level if those earnings are distributed to shareholders. The current rate structure is intended to encourage entrepreneurship and provide some tax relief to businesses with small and moderate levels of profit. Of the roughly 1 million corporations that typically owe corporate income taxes each year, all but a few thousand benefit from the schedule's reduced rates. (Because the firms that benefit earn only about 10 percent to 15 percent of all corporate taxable income, however, the reduced rates have a limited effect on tax revenues.)
One argument for creating a flat corporate income tax is that many of the companies that benefit from the current rate structure are not small or medium-sized firms, which goes against the original rationale for the rates' progressivity. For example, under current law, large corporations can reduce their taxable income for certain years by sheltering some of it or by controlling when they earn income and incur expenses. The current system also allows individuals in a small corporation to shelter income by retaining earnings rather than paying them out as dividends. (That benefit does not apply to owners of personal-services corporations—such as physicians, attorneys, and consultants—whose firms are already taxed at a flat rate of 35 percent.) Finally, the lower tax rates on dividends and capital gains that were enacted in 2003 undercut part of the rationale for the existing corporate tax rate structure by alleviating much of the “double taxation“ of C corporations' profits.
A disadvantage of this option is that it might have some repercussions for the way in which companies finance their investments. Investment capital would be more costly for firms affected by the higher tax rates. Those firms would also be encouraged to increase their use of debt financing, the interest on which is tax-deductible, rather than issue stock. As a result, the higher level of debt could increase some companies' risk of bankruptcy.
|
Change in Revenues
|
-26.6
|
-6.0
|
-16.5
|
-34.7
|
-23.6
|
|
-107.4
|
|
-374.5
|
|
Income generated by corporations is taxed in varying ways depending on the type of corporation and the form in which the income is paid. Some corporate income is taxed twice: first as profits under the corporate income tax and second as dividends and capital gains on corporate stock under the individual income tax. Other corporate income—such as interest on corporate bonds and the profits of companies that are not subject to the corporate tax (so-called S corporations, which are generally small and have few shareholders)—is subject only to the individual income tax. Still other corporate earnings are subject to taxation primarily under the corporate income tax and effectively have little or no tax imposed under the individual income tax—because taxes on capital gains on stock can be deferred until the gains are realized (when the stock is sold). Since investors face different effective tax rates depending on the organizational form of the business in which they are investing, the corporate and individual income taxes are said to be nonintegrated.
That lack of integration reduces economic efficiency (the relationship between total resources used and the social benefits they generate) by distorting various choices that companies make, such as:
In addition, the current nonintegrated system raises the overall taxation of income from capital, which distorts the choice that people make between saving and consuming. The lack of integration impairs economic efficiency, at a cost that has been estimated to equal about 0.25 percent to 0.75 percent of the value of total household consumption.
The individual and corporate income taxes could be integrated in various ways. All corporate earnings could be subject to the individual income tax (as the earnings of S corporations are); stock dividends and capital gains could be excluded from individual taxation; companies could be allowed to deduct dividends from corporate taxable income; or all business income could be subject to a tax at the corporate level, with no tax imposed on that income at the individual level.3 Another approach, however—simply eliminating the corporate income tax without making other changes to the tax system—would continue to result in significant efficiency costs because stockholders would defer (or in some cases avoid altogether) paying taxes on corporate earnings that were not distributed as dividends.
This option would integrate the two income tax systems by changing the treatment of some dividends and capital gains. Specifically, individual taxpayers could exclude from their taxable income any dividends or capital gains that had already been taxed as profits at the corporate level—provided those dividends or gains resulted from earnings that the corporation received after this option took effect. (That change is identical to a proposal that was included in the President's budget for 2004.) In addition, the statutory tax rates on those dividends and capital gains that had not been taxed at the corporate level would immediately return to the rates that prevailed before they were lowered by the Jobs and Growth Tax Relief Reconciliation Act of 2003, or JGTRRA. (The current lower rates are scheduled to expire at the end of 2010.)
Together, the changes envisioned in this option would reduce revenues by a total of $107.4 billion over five years. Those changes would be permanent, unlike the current temporary rates on dividends and capital gains that they would replace. (The reduction in revenues from this option would be different if those lower rates were assumed to be permanent.)
The principal advantage of this option is that it would improve the integration of the corporate and individual income taxes. Under the current reduced tax rates on dividends and capital gains, some corporate profits are still subjected to additional taxation under the individual income tax. In addition, those tax rates apply regardless of whether profits distributed as dividends or realized as capital gains are taxed at the corporate level. Because of special provisions of tax law, not all corporate profits are taxed at the corporate level. Moreover, the reduced capital gains rates that were enacted in JGTRRA apply to gains not only on corporate stock but also on other assets. The effect of that broad scope is to worsen other distortions in the tax code—a situation that would not occur under this option. Furthermore, because JGTRRA's rate reductions are scheduled to expire after 2010, much of the potential gain in efficiency that integration could bring by reallocating capital might not be realized under current law.
The main disadvantages of this option are its complexity and administrative cost. To limit the amount of forgone revenue and to target the incentives of lower tax rates toward new investment, this option would not make all dividends and gains eligible for the exclusion, only those that resulted from earnings after the option was enacted. That restriction would require firms to maintain accounts and inform shareholders of the amounts of dividends and gains that they could exclude from their income—bookkeeping responsibilities that could prove burdensome. Moreover, although the lower rates enacted in JGTRRA did not represent a complete integration of the individual and corporate income taxes, they substantially reduced the differences that give rise to the distortions associated with the two taxes' lack of integration. Hence, simply making those lower rates permanent would achieve many of the same efficiency gains as full integration but with much less complexity. (See Revenue Option 3 for the costs of that approach.)
|
Change in Revenues
|
+0.6
|
+1.3
|
+1.3
|
+1.3
|
+0.9
|
|
+5.4
|
|
+6.5
|
|
Businesses that use the first-in, first-out approach to identify inventory receive a tax advantage under current law because they can employ the "lower of cost or market" (LCM) method of inventory valuation. That method allows firms to deduct from their taxable income unrealized year-end losses on items in their inventory that have declined in value. (The losses are unrealized because the items have not actually been sold.) For items that have increased in value, companies can defer taxes on unrealized gains until the year in which the items are sold. Similarly, goods in a firm's inventory that cannot be sold at normal prices because of damage, imperfections, or other problems qualify for the "subnormal goods" method of inventory valuation. That approach allows the company to immediately deduct the loss in value, even if it later sells those goods and realizes a profit on them.
This option would repeal the LCM and subnormal-goods methods of inventory valuation over a three-year period and require all firms to value their inventory according to its cost. (Under the cost method of inventory valuation, companies generally must include in taxable income both the gains and losses from any changes in the value of their inventory when the goods are sold.) Those changes would increase revenues by $0.6 billion in 2008 and by a total of $5.4 billion over the 2008–2012 period.
Inventory valuation is an integral part of determining a firm's taxable profits, which (in accounting terms) are the difference between the firm's receipts and the cost of the goods it has sold. Most businesses with an inventory are required to use the accrual method of accounting. Under that approach, a firm calculates the cost of the goods it has sold by adding the value of its inventory at the beginning of the year to the cost of goods it purchased or produced during the year and then subtracting from that total the value of its inventory at the end of the year. In valuing an inventory, companies may now use either the LCM method or the cost method; they can also use the subnormal-goods method for imperfect items that cannot be sold at regular prices, regardless of which inventory-valuation approach they choose.
The rationale for replacing LCM valuation with cost valuation is to eliminate the tax advantages that the LCM method provides. Under the LCM approach, a business compares the market value of each item in its inventory with the item's cost and then uses the lower of the two amounts as the item's value. A firm's inventory will have a lower total value under the LCM method than under the cost method if the market value of any item in the inventory is less than its cost. The reverse is not true, however, because under the LCM approach, inventory items that have appreciated in value during the year are pegged at their original cost. Thus, for a business that experiences both gains and losses from its inventory, the LCM method provides a tax advantage over the cost method by treating gains and losses asymmetrically (firms can recognize losses without counting comparable gains). As a result, a company may claim a deduction for certain losses in the value of its inventory even if, overall, the inventory's value has risen. In that way, the LCM method can increase the portion of the firm's costs that are tax-deductible in a given year and thus lower the firm's taxable profits.
The LCM method has two other features that may offer unwarranted tax advantages to the businesses that use it. First, once a company has reduced the value of its inventory, it is not required under current law to record an increase if the market value later rises. Second, market values under the LCM method are based on the replacement cost of inventory items, not on their resale value. Thus, that method allows a firm to reduce the value of items in its inventory if the items' replacement cost has declined—even though the firm may still be able to sell the items at a profit.
Companies that incur losses in the value of their inventory without offsetting gains would see a disadvantage in repealing the LCM method of inventory valuation. For those businesses, the method provides a "cushion" during economic downturns or periods of uncertainty created by shifts in markets. A firm whose inventory has declined in value has incurred an economic loss. If that loss is deferred (not accounted for) until the inventory is subsequently sold, the company may be overtaxed.
|
Change in Revenues
|
+1.2
|
+1.8
|
+1.9
|
+2.0
|
+2.1
|
|
+9.0
|
|
+21.1
|
|
Credit unions are nonprofit institutions that provide their members with financial services, such as accepting deposits and making loans. Originally, credit unions were designed to be cooperatives whose members shared a common bond (in most cases, the same employer or the same occupation). Partly as a result of that distinction, federal income tax law treats credit unions more favorably than competing thrift institutions—such as savings and loans and mutual savings banks—by not taxing their retained earnings (the portion of net income that they keep rather than paying out in dividends).
This option would tax the retained earnings of large credit unions—those with more than $10 million in assets—in the same way that the retained earnings of other thrift institutions are taxed. Credit unions with less than $10 million in assets, however, would continue to be tax-exempt. The change in the tax treatment of large credit unions would increase revenues by $1.2 billion in 2008 and by a total of $9.0 billion over five years.
Originally, the retained earnings of credit unions, savings and loans, and mutual savings banks were all exempt from taxation. In 1951, however, lawmakers eliminated the exemptions for savings and loans and mutual savings banks on the grounds that those institutions were similar to profit-seeking corporations. Since then, large credit unions have come to resemble other thrift institutions. Beginning in 1982, regulators have allowed credit unions to extend their services (with some limits) to members of organizations other than the ones for which they were founded. In addition, most credit unions permit members and their families to participate even after a member has left the sponsoring organization.
In part because of that relaxation of restrictions, total membership in credit unions has soared from about 5 million in 1950 to more than 85 million today. Large credit unions, like taxable thrift institutions, now serve the general public and provide many of the services offered by savings and loans and mutual savings banks—including mortgages and car loans, access to automatic tellers, credit cards, individual retirement accounts, and discount brokerage services. They also resemble thrift institutions in that they retain some of their earnings.
One argument for taxing the retained earnings of large credit unions like the earnings of other large thrift institutions is to improve economic efficiency. Taxing similar entities in a similar manner promotes competition and encourages them to provide services at the lowest cost. With their current tax advantage, credit unions can use their retained earnings to expand and thus displace the services of other thrift institutions, even though the latter may provide those services more efficiently.
Many credit unions, however, are more like cooperatives than like their larger counterparts, which suggests that their retained earnings should be treated similarly to those of other cooperatives. Like those entities, most small credit unions have members with a single common bond or association. And in some cases, their organizations are rudimentary: volunteers from the membership manage and staff the credit union, and the level of service is not comparable with that of other thrift institutions.
Allowing small credit unions to keep their tax exemption for retained earnings would affect about 3 percent of total assets in the credit union industry and about half of all credit unions. However, a problem with taxing the assets of large credit unions while allowing the assets of small ones to remain tax-exempt is that the $10 million threshold for determining a "large" credit union could be seen as arbitrary.
|
Change in Revenues
|
+5.4
|
+7.2
|
+5.4
|
+3.7
|
+1.8
|
|
+23.5
|
|
+25.5
|
|
Through various tax incentives, the current tax system treats extractive industries—producers of oil, natural gas, and minerals—more favorably than most other industries. One incentive designed to encourage firms to explore for and develop certain types of oil, gas, and hard minerals allows producers to "expense" some of their exploration and development costs rather than capitalize them. In other words, companies are allowed to fully deduct those costs from taxable income when they are incurred rather than deduct them over time as the resulting income is generated.
In other industries, by contrast, costs must be deducted more slowly according to prescribed rates of depreciation or depletion. The Tax Reform Act of 1986 established uniform capitalization rules that require certain direct and indirect costs related to property to be either deducted when the property is sold or recovered over several years as depreciation (in either case, postponing those costs' deduction from taxable income). However, so-called intangible costs related to drilling and development (such as the maintaining of a working-capital fund) and costs for mine development and exploration are exempt from those rules. The ability to expense such costs gives extractive industries a tax advantage that other industries do not have.
This option would replace the expensing of exploration and development costs for oil, gas, and minerals with the standard capitalization approach. That change would increase revenues by $5.4 billion next year and by a total of $23.5 billion over five years. (Those amounts reflect the assumption that firms could still expense some of their costs, such as from unproductive wells and mines.)
The exploration and development costs that extractive companies can expense include costs for excavating mines, drilling wells, and prospecting for hard minerals—but not in the case of oil and natural gas. Current law allows independent oil and gas producers and noncorporate mineral producers to fully expense their costs. However, for "integrated" oil and gas producers (companies involved in substantial retailing or refining activities) and for corporate mineral producers, expensing is limited to 70 percent of costs. Those firms must deduct the remaining 30 percent of their costs over 60 months.
The primary rationale for this option is that expensing distorts how society's resources are allocated in several ways. First, it causes resources to be used for drilling and mining that might be employed more productively elsewhere in the economy. Second, it may influence the way in which resources are allocated within the extractive industries. Firms may decide what to produce not on the basis of factors related to economic productivity but on the basis of the size of the advantage that expensing provides (for example, the difference between the immediate deduction and the deduction over time, which reflects the true useful life of the capital involved.) Such decisions may also rest on whether the producer must pay the alternative minimum tax, under which expensing is limited. Third, expensing encourages producers to extract more resources now—which, in the short run, could make the United States less dependent on imported oil but, in the long run, could mean that the nation would have less oil available to extract and thus might have to rely more on foreign producers.
The rationale for expensing the costs of exploration and development has shifted over time. When the current incentive was put in place, its advocates argued that those costs were ordinary operating expenses. Today, they also argue that oil and natural gas are strategic resources that are essential to the nation's energy security.
|
Change in Revenues
|
+0.5
|
+0.8
|
+0.8
|
+0.8
|
+0.9
|
|
+3.8
|
|
+8.6
|
|
In the United States, some electricity is provided by privately owned companies and some by public utilities owned by local governments. The income that those governments earn from any public utility, including electric power facilities, is exempt from federal income taxes. By contrast, the income of investor-owned utilities is taxable.
This option would tax the income of public facilities that generate, transmit, or distribute electricity. That change would increase federal revenues by $0.5 billion in 2008 and by a total of $3.8 billion through 2012.
In the past, local monopolies provided electricity, in part to take advantage of cost-saving economies of scale. Some of those utilities were public facilities, which had developed for various reasons. For example, public utilities offered a feasible alternative in places where low population density made the cost of power per customer high and private producers were reluctant to enter the market because the potential for profit appeared inadequate. Public utilities also developed in areas where residents—worrying that a private provider might exploit its position as a monopoly—wanted to ensure that electricity would be available to all households at a reasonable cost. Now, however, states are in varying stages of deregulating electricity generation, partly because improved technologies have lessened the importance of economies of scale and partly because electricity service is almost universal in the United States, even in areas with few people.
The major argument for taxing the income earned by public electric utilities is that the recent changes in the electricity market cast doubt on the benefits that society receives from the public sector's involvement in providing electricity. The private sector already supplies about three-quarters of the nation's electric power. Advocates of this option argue that the competition that is resulting from the industry's restructuring will protect consumers from monopolistic pricing by private firms. (California's experience in 2000 and 2001, however, suggests that some degree of government oversight of the market may still be needed.) Other rationales for ending the favorable tax treatment of publicly owned power facilities might be to further boost competition, to encourage the consumption of an economically efficient amount of publicly provided electricity, and to preserve the corporate tax base.
One argument against this option is that exempting the income of public utilities from taxation keeps the price of power low and thus reduces the amount that lower-income people pay for electricity. In addition, taxing the income of public electric utilities might adversely affect residents of some communities that rely on such facilities for their power. Taxation would cause the price of publicly provided electricity to rise, and public utilities that found themselves uncompetitive might have to shut down facilities that were inefficient. If those facilities were being financed with debt that had not yet been retired, state and local taxpayers could be left with significant costs. Another complication associated with this option is that numerous legal and practical issues would have to be resolved if the federal government taxed income earned from what might be termed business enterprises of state and local governments.
|
Change in Revenues
|
*
|
*
|
*
|
*
|
+0.1
|
|
+0.1
|
|
+2.2
|
|
Businesses can be structured in various ways, each of which has different implications for the tax liability of the entity and its owners and for the owners' legal liability. For tax purposes, the main forms of business enterprise are C corporations, S corporations, partnerships, and sole proprietorships. Companies whose stock trades publicly are usually C corporations, although many small, privately owned businesses are also structured in that way. The income of a C corporation faces a two-tiered tax: The firm's net income and capital gains are taxed at the corporate level, and when the firm distributes its after-tax profits to hareholders as dividends, those dividends are subject to the individual income tax. The owners of a C corporation are not legally liable for the actions of the corporation.
By contrast, businesses such as partnerships, sole proprietorships, and S corporations are set up in a "flow-through" structure. Income and expenses pass through the business to the shareholders (in the case of an S corporation) or to the partners or proprietors (in the case of partnerships and sole proprietorships), and the income is generally free from corporate income taxes. But shareholders, partners, and proprietors pay tax on that income under the individual income tax, even if the income is reinvested in the business.
S corporations differ from the other two kinds of flow-through firms in part by legal liability. Owners of S corporations—unlike sole proprietors or partners in limited or general partnerships—have limited liability. They face many restrictions, however: for example, S corporations may have no more than 100 owners, and they may not have C corporations as shareholders. Until recently, S corporations were the only type of business that offered owners both limited liability and a form of tax treatment that placed business income and losses under the individual income tax. In 1988, the Internal Revenue Service ruled that limited liability companies, or LLCs, which are defined under state law, could be treated as partnerships for federal tax purposes (though with some restrictions). Over time, the distinction between S corporations and partnerships has blurred.
Under current law, a C corporation can reduce tax liability on some of its income by converting to an S corporation or a partnership. Between those alternatives, the tax code provides an incentive to choose the S corporate structure because converting to an S corporation is tax-free in many circumstances. Converting to a partnership, by contrast, is taxable; it requires the corporation to "recognize" (include in its taxable income) any built-in gain on its assets and requires the company's shareholders to recognize any such gain in their corporate stock. Under section 1374 of the Internal Revenue Code, if a C corporation converts to an S corporation, the appreciation of the firm's assets while it was a C corporation is not subject to corporate income taxes, unless the assets are sold within 10 years of the conversion. Thus, current law allows a C corporation to avoid two-tiered taxation by converting tax-free to an S corporation.
This option would repeal such tax-free conversions for C corporations whose value was greater than $5 million at the time of the conversion. That is, when a C corporation with a value of more than $5 million converted to an S corporation, the company and its shareholders would immediately recognize the gain on their appreciated assets. Taxing such conversions would increase income tax revenues by a total of $0.1 billion over five years but by $2.2 billion through 2017.
A major advantage of this option is that repealing tax-free conversions by C corporations would treat economically similar conversions—from two-tiered corporate tax systems to single-tiered systems—in the same way. Equalizing that tax treatment would, in turn, allow society's resources to be allocated more efficiently by making tax considerations less important in decisions about what legal form a business should take.
An argument against changing the current differential tax treatment is that, in some people's eyes, S corporations resemble C corporations more closely than they do partnerships. In that view, current law merely allows a C corporation (if it meets the legal requirements) to choose a different corporate form—that of an S corporation—and change its filing status without having to pay tax.
|
Change in Revenues
|
+0.1
|
+0.4
|
+0.9
|
+1.5
|
+2.1
|
|
+5.0
|
|
+26.1
|
|
The low-income housing credit (LIHC) subsidizes the construction, substantial rehabilitation, or purchase of buildings that are used to provide rental housing to people with low income. Corporations and individuals that qualify for the LIHC receive tax credits over a 10-year period that can be worth as much as 70 percent of a building's construction or rehabilitation costs or 30 percent of its purchase price. The majority of qualifying projects are new construction.
To qualify for the LIHC, the owners of a project must fulfill several requirements. They must set aside at least 20 percent of a building's rental units for families whose income is below 50 percent of the median income in the area or 40 percent of the units for families whose income is below 60 percent of the median. In addition, rents for those units are restricted. The set-aside requirements and the limits on rents apply for at least 30 years. Unlike most tax provisions, however, the LIHC is not necessarily available once its requirements have been met. The credit is limited by statute and allocated by state housing authorities, which are authorized to issue a fixed number of credits depending on the state's population.
This option would repeal the LIHC for new projects to build, renovate, or purchase low-income housing. (The credit would continue for previously approved projects that had time remaining on their 10-year periods.) That change would increase revenues by $0.1 billion in 2008 and by $5.0 billion through 2012.
An argument for eliminating the credit is that, in most places, federal housing vouchers could assist the same number of people at a lower cost. Low-income tenants can use such vouchers to pay all or part of the rent for the housing of their choice (as long as the dwelling meets minimum standards for habitability). In most cases, housing vouchers are more likely than tax credits to help low-income people obtain rental housing, because the existing stock of buildings can usually provide adequate housing more affordably than either new construction or buildings that have been substantially rehabilitated. Extra overhead costs (such as for additional paperwork and approvals) also make some housing that is subsidized by the LIHC more expensive to produce and rent.
Another rationale for repealing the credit is that it does not, by itself, always fulfill the purpose that it was designed to serve. In general, households with the lowest income do not rent units whose construction or rehabilitation has been supported by the LIHC unless they or the project receive additional subsidies. Rather, the credit tends to benefit lower-middle-income people whose income typically is too high to allow them to qualify for voucher and public housing programs.
An argument for retaining the credit is that, in some neighborhoods, existing housing that meets minimum standards for habitability at affordable rents is scarce. Furthermore, the money spent to build new housing and rehabilitate existing dwellings may help revitalize neighborhoods. In contrast, similar spending on housing vouchers is unlikely to have a noticeable impact on a neighborhood, because the vouchers' effect is more likely to be diluted among a number of neighborhoods.
|
Change in Revenues
|
+4.2
|
+12.9
|
+19.5
|
+22.2
|
+24.6
|
|
+83.4
|
|
+192.5
|
|
When a company calculates its taxable income, it is allowed to deduct many of the expenses that it incurs to produce the goods and services it sells. One of those deductible expenses is depreciation (the drop in the value of productive assets over time). For taxable income to be calculated accurately, deductions for depreciation should reflect an asset's actual economic decline—that is, economic depreciation, which takes into account inflation over the lifetime of the asset. However, rates of depreciation are set by the tax code, and depreciation deductions are not indexed for inflation. As a result, the real (inflation-adjusted) value of the depreciation allowed by tax law depends on the rate of inflation.
The Tax Reform Act of 1986 is the major source of the current rates of depreciation for tax purposes, which were set to approximate economic depreciation with inflation of 5 percent. Yet, in the Congressional Budget Office's estimation, the inflation that will apply to economic depreciation over the coming decade will average about 2 percent. That estimated difference of 3 percentage points means that tax depreciation is more valuable than economic depreciation, resulting in the understatement of firms' taxable income.
Two of the main types of tangible capital for which firms take depreciation deductions are equipment and structures. Depreciation deductions for equipment tend to contribute more to the understatement of taxable income than deductions for structures do. The reason is that equipment has a shorter service life (the time over which depreciation deductions can be taken); thus, changes in inflation affect deductions for equipment more strongly than deductions for structures. In addition, since 1986, policymakers have extended the useful lifetimes of some kinds of structures for calculating depreciation.
This option would lengthen the lifetime of equipment for tax depreciation purposes. Specifically, property that currently has a lifetime of 3, 5, 7, 10, 15, or 20 years under the tax code would shift to a lifetime of 4, 8, 11, 20, 30, or 39 years, respectively. Those changes would increase revenues by $4.2 billion in 2008 and by a total of $83.4 billion over five years.
One advantage of this option is that it would equalize effective tax rates on different types of investment. Under the assumptions of 2 percent inflation and a 7 percent real discount rate (to adjust for the change in the worth of a dollar over time), the average effective tax rate on equipment for all firms would be about 32.9 percent, and the rate on structures would be 33 percent. That near parity would lessen the tax code's current incentive for companies to invest more in equipment and less in structures than they would if investment decisions were based on economic returns. Such a tax incentive distorts firms' choices between investing in equipment and investing in structures, thus reducing the efficiency of the economy.
Those average tax rates would differ with different inflation rates, however. If inflation was half a percentage point lower, the rates would be 32 percent for equipment and about 32.5 percent for structures. Conversely, if inflation was half a percentage point higher, the effective tax rates on equipment and structures would be 33.8 percent and 33.5 percent, respectively. Therefore, if inflation differed from CBO's expectations, new distortions would emerge over the long run between investment in equipment and structures.
Some opponents of this option argue that low tax rates on capital are important for maintaining a strong economy. Others favor equalizing the current tax treatment by easing the taxation on all forms of capital rather than by raising the effective tax rate on a type of capital that is now favored. In addition, under this option, there would continue to be substantial variation in the effective tax rates on different types of equipment.
|
Change in Revenues |
|
||||||||||
|
|
Eliminate tax exemption for new bonds |
+0.1 |
+0.5 |
+1.1 |
+1.7 |
+2.3 |
|
+5.7 |
|
+25.6 |
|
|
|
Eliminate indexation of the volume cap |
* |
* |
* |
* |
+0.1 |
|
+0.2 |
|
+1.7 |
|
Federal tax law permits state and local governments to issue bonds whose interest income is exempt from federal taxation. As a result, those bonds bear lower rates of interest than they would if the interest income were taxable. (The bondholder is compensated for the lower interest rate by not having to paying federal tax on the interest income.) For the most part, proceeds from those tax-exempt bonds finance public projects, such as schools, highways, and water and sewer systems. But state and local governments also issue tax-exempt securities—known as private-activity bonds—whose proceeds are used by nongovernmental entities to finance various quasipublic facilities and private-sector projects: mortgages for rental housing and single-family homes; infrastructure facilities such as airports, docks, wharves, mass transit, and solid-waste disposal plants; small manufacturing plants and agricultural land and property for first-time farmers; student loans; and facilities for nonprofit institutions, such as hospitals and universities.
The Tax Reform Act of 1986 limits the annual volume of new bonds that state and local governments can issue for eligible facilities, small manufacturing plants, student loans, and housing and redevelopment projects. Some private-activity bonds are exempt from the volume cap, including those for airports, ports, and solid-waste disposal facilities that meet requirements for government ownership, as well as certain bonds for nonprofit organizations (primarily hospitals and educational institutions). Initially, the cap was not indexed for inflation, so the volume of private-activity bonds issued each year would decline over time and eventually disappear. However, the volume cap has since been raised periodically, and it was indexed for inflation beginning in 2002. (At that time, the annual volume of new bonds allowed was $225 million or $75 per resident, whichever was greater.)
This option would curtail the issuance of private-activity bonds either by eliminating the tax exemption for all new issues or by allowing tax exemption but no longer indexing the volume cap for inflation. The first approach would have an immediate impact on the volume of such bonds and would increase revenues by a total of $5.7 billion over the 2008–2012 period. The second approach would work more slowly, boosting revenues by only $0.2 billion over those five years. (Lawmakers could also limit the outstanding stock of private-activity bonds for certain uses, such as nonprofit organizations' facilities. That change is discussed in the next option.)
An advantage of this option is that eliminating or limiting the tax exemption for new private-activity bonds would improve economic efficiency. Investments that can be financed at below-market interest rates require a lower return and thus contribute less to national income than do investments that are not preferentially taxed. Altering those projects' financing by removing the tax exemption or curbing the volume cap would redirect savings to more valuable uses and allocate resources more efficiently.
A disadvantage of this option is that state and local governments and other entities that rely on private-activity bonds would face higher costs to finance projects that benefit their communities. (If the federal government wished to help such projects, however, it could do so more efficiently through a direct subsidy. Unlike tax-exempt financing, such a subsidy would not reduce federal revenues by more than the drop in borrowers' interest costs. In addition, access to a direct subsidy would not be open ended, and the subsidy amount could receive regular scrutiny from lawmakers in the annual appropriation process.)
|
Change in Revenues
|
*
|
*
|
*
|
+0.1
|
+0.2
|
|
+0.5
|
|
+2.7
|
|
Under current law, the interest income that investors earn on bonds issued by state and local governments is exempt from federal taxation. That tax exemption means that such bonds can pay below-market interest rates and still attract investors. In general, the proceeds that state and local governments receive from issuing tax-exempt bonds are used to finance schools, highways, and other public infrastructure projects. But states and localities can also issue tax-exempt "private-activity" bonds, whose proceeds are used to finance a wide range of quasipublic or private-sector projects, including facilities for nonprofit institutions such as hospitals and universities.
The Tax Reform Act of 1986 limited the annual volume of new tax-exempt bonds that could be issued for many, though not all, private activities. Nonprofit institutions were not included in that annual cap, but a $150 million ceiling was imposed on each institution's outstanding stock of tax-exempt bonds (excluding those of hospitals). That $150 million ceiling was eliminated in 1997.
This option would reestablish the $150 million cap on the outstanding stock of tax-exempt bonds that a nonprofit organization—including a nonprofit hospital—could use for financing. That cap would increase federal tax revenues by a total of $0.5 billion through 2012. (A related approach, ending or reducing the tax exemption for new issues of private-activity bonds, is discussed in the previous option.)
An advantage of limiting nonprofit organizations' tax-exempt bond financing is that it would curtail what might be characterized as arbitrage profits that such organizations can earn indirectly under the current system. Many nonprofit universities, hospitals, and other institutions use tax-exempt debt to pay for buildings and equipment that they could have financed by selling their own investment assets. Their decision to fund new operating assets with tax-exempt bonds is influenced by their ability to earn an untaxed return from their investment assets that is much higher than the interest cost they must pay on the bonds—in other words, arbitrage profits. Imposing a ceiling on such organizations' outstanding stock of tax-exempt bonds would curtail that tax arbitrage. Investment might be redirected to more valuable uses because projects that would otherwise be financed with tax-exempt debt would be forced to compete for funding at the higher interest rate prevailing in private markets.
A drawback of such a ceiling is that some of the nonprofit activities that would face higher financing costs under this option might be activities that provide enough public benefits to justify a tax subsidy.
|
Change in Revenues
|
+3.2
|
+7.5
|
+9.6
|
+11.8
|
+12.6
|
|
+44.7
|
|
+119.8
|
|
Under the American Jobs Creation Act of 2004, businesses can deduct from taxable income a percentage of what they earn from qualified domestic production activities. The deductible percentage was set at 3 percent for taxable years beginning in calendar years 2005 and 2006; it rises to 6 percent for taxable years beginning in 2007 through 2009, and to 9 percent thereafter. Various activities qualify for the deduction, including:
Qualified activities specifically exclude the sale of food or beverages prepared at retail establishments; the transmission or distribution of electricity, natural gas, or potable water; and many activities that would otherwise qualify except that the proceeds come from sales to a related business.
The deduction for domestic production activities was created in part to replace the tax code's extraterritorial income exclusion—which, according to the World Trade Organization (WTO), violated WTO agreements by subsidizing exports. The deduction was intended to reduce the taxes on income from domestic production without violating the WTO's rules.
This option would repeal the deduction for domestic production activities. Doing so would raise revenues by $3.2 billion in 2008 and by a total of $44.7 billion over the 2008–2012 period.
One rationale for eliminating the deduction is that it creates economic distortions. Although it is targeted toward investments in domestic production activities, it does not apply to all domestic production. Whether a business activity qualifies for the deduction is unrelated to the economic merits of the activity. Thus, the deduction gives businesses an incentive to invest in a particular set of domestic production activities and to forgo other, perhaps more economically beneficial investments in domestic production activities that do not qualify.
In addition, to comply with the law, businesses must satisfy a complex and evolving set of statutory and regulatory rules about how to allocate gross receipts and business expenses to the qualified activities. The complexity of those rules and the costly planning that companies will have to engage in to take full advantage of the deduction are likely to cause controversies between businesses and the Internal Revenue Service. Yet more rules will be needed to address those controversies.
An argument against this option is that simply repealing the deduction for domestic production activities would increase the cost of domestic business investment. Alternatively, the deduction could be replaced with a revenue-neutral cut in the top corporate tax rate (a cut that would reduce revenues by the same amount that eliminating the deduction would increase them). That alternative would end the current distortions between activities that qualify for the deduction and those that do not. It would also reduce biases in the corporate tax that favor noncorporate investments over investments in the corporate sector and foreign business activities over domestic ones.
|
Change in Revenues
|
-2.6
|
-4.9
|
-6.1
|
-7.4
|
-8.7
|
|
-29.7
|
|
-84.9
|
|
Current law allows businesses to take a nonrefundable research and experimentation (R&E) tax credit equal to 20 percent of their qualified research expenses above a base amount. That base amount is generally determined by multiplying a company's average annual gross receipts in the previous four years by its ratio of research expenses to gross receipts during the 1984–1988 period. Companies that did not exist at that time are assigned a fixed ratio (research expenses to gross receipts) of 3 percent. As an alternative, businesses can choose to apply a much lower credit rate (ranging from 2.65 percent to 3.75 percent) to qualified research expenses in excess of a lower base amount (ranging from 1 percent to 2 percent of average gross receipts).
The R&E tax credit was first enacted as a temporary provision in the Economic Recovery Tax Act of 1981. It has been extended, with modifications, 10 times since then. Each extension has been fully retroactive to the previous date of expiration (except for one year between June 30, 1995, and July 1, 1996). Most recently, the credit expired on December 31, 2005, and was later retroactively extended until January 1, 2008.
This option would make the research and experimentation tax credit permanent. That change would reduce revenues by $2.6 billion in 2008 and by a total of $29.7 billion over five years.
Supporters of the R&E credit argue that the tax provision produces a net benefit for society by making it cheaper for companies to engage in types of research that create general knowledge or other social benefits beyond those that accrue to the firms themselves. In that view, encouraging such research can make the economy as a whole more productive than it would be otherwise.
According to supporters, those benefits would probably increase if the credit was no longer allowed to expire every few years. A temporary tax credit creates uncertainty about whether and when it will be extended and with what modifications. Such uncertainty is not likely to matter much in the case of qualified research projects that take only a short time to complete. But making the tax credit permanent might encourage longer-term research projects by decreasing businesses' uncertainty about the costs of undertaking those projects. Because a permanent extension would probably shift the incentives toward such longer-term projects, it would shift the incentives toward research for which the effect of the credit is most likely to produce a net social gain.
An argument against permanently reinstating the R&E tax credit is that the credit could make the economy less productive by encouraging firms to pursue some research that does not provide social benefits in addition to private benefits. In cases in which there are no additional social benefits, the tax credit merely gives companies an incentive to undertake research projects that qualify for the credit rather than make alternative investments that would otherwise earn a higher return. Whether the R&E tax credit produces a net benefit to the economy depends on the extent to which it encourages research that imparts general knowledge or other social benefits. The evidence on that question is inconclusive.
|
Change in Revenues
|
+0.7
|
+1.1
|
+1.2
|
+1.2
|
+1.5
|
|
+5.7
|
|
+15.1
|
|
The Federal Home Loan Bank (FHLB) System is a government-sponsored enterprise (GSE) that was created in 1932 to provide low-cost loans (called advances) to thrift institutions to bolster their lending for home mortgages. The system consists of 12 banks that are cooperatively owned by their members, mainly commercial banks and thrifts. The FHLBs raise money in the capital markets through borrowing to fund the advances made to members. Because investors perceive an implied guarantee of the FHLBs' debt by the federal government, the banks are able to borrow at rates below those available to private entities. In recent years, the FHLBs have also started purchasing mortgages from their members, which puts them in direct but limited competition with Fannie Mae and Freddie Mac, the other housing GSEs.
In contrast to the other GSEs that finance home mortgages, the FHLBs pay no federal corporate income taxes. The federal government requires them to make other payments, however. They must devote 10 percent of their previous year's net income to affordable-housing programs, which offer subsidized and other low-cost funding to targeted borrowers. In 2005, the FHLBs' payments for affordable housing totaled $280 million. The programs subsidized the rental or purchase of over 430,000 housing units for low- and moderate-income borrowers from 1990 to 2004. The FHLBs are also required to transfer 20 percent of their net income to the Resolution Funding Corporation (REFCORP), a federal corporation created to borrow money to help finance the Federal Savings and Loan Insurance Corporation's obligations for insured deposits of insolvent thrifts. The banks' payments totaled $498 million in 2005. The FHLBs are projected to make their last contributions to REFCORP for its debt service in 2011. (Their total contributions to REFCORP are capped by law.) Both types of required payments are included as revenues in the federal budget.
This option would impose federal corporate income taxes on the FHLBs. Taxing the FHLBs would generate revenues of $0.7 billion in 2008 and $5.7 billion over five years. Those estimates assume that the FHLBs' payments for affordable housing and REFCORP would be deductible expenses for the purpose of calculating federal income taxes. (Revenues would be significantly lower if tax credits were granted for either or both types of required payments.)
An advantage of this option is that it would eliminate a special privilege—tax-free status—not provided to other entities (including Fannie Mae and Freddie Mac) and not wholly benefiting mortgage borrowers. Studies by the Congressional Budget Office and others have concluded that the FHLB system's status as a government-sponsored enterprise confers substantial implicit federal subsidies beyond the tax benefits, which are not fully passed on to mortgage borrowers.
A disadvantage of the option is that it might cause member banks to pay somewhat higher costs for their advances, which could result in higher costs to borrowers. Another disadvantage is that taxing the FHLBs while also requiring payments to affordable-housing programs and REFCORP could create a greater burden than is imposed on their competitors. If so, the banks might be less able compete with Fannie Mae and Freddie Mac.
|
Change in Revenues
|
+0.6
|
+0.7
|
+0.6
|
+0.5
|
+0.3
|
|
+2.7
|
|
+3.3
|
|
Unlike nearly all private-sector workers and federal employees, certain workers employed by state or local governments do not pay the Medicare payroll tax. That tax is currently 2.9 percent of earnings, half of which is deducted from employees' paychecks and half of which is paid by employers. The Consolidated Omnibus Budget Reconciliation Act of 1985 mandated that employees who began working for a state or local government after March 31, 1986, pay the Medicare tax, but it did not make the tax mandatory for workers hired before that date. Under the Omnibus Budget Reconciliation Act of 1990, the tax's reach was broadened to include all state and local government workers who were not covered by a retirement plan through their current employer.
This option would impose the Medicare tax on all state and local government employees who do not now pay it, increasing revenues by $0.6 billion in 2008 and by a total of $2.7 billion over the 2008–2012 period. The annual gain in revenues from that change would decline over time as employees who were hired before April 1986 gradually retired or otherwise left the payrolls of state and local governments.
Paying the Medicare payroll tax for 10 years generally qualifies workers (and their spouses) to receive Medicare benefits when they reach age 65 or become disabled. Thus, extending the tax to more employees would eventually increase the number of Medicare beneficiaries. That addition would have a relatively small impact on Medicare spending, however. (The estimates shown here do not reflect those additional outlays.)
A rationale for requiring all state and local government employees to pay the Medicare payroll tax is fairness. Only about 10 percent of state or local workers do not currently pay the tax through their employers; nevertheless, most of those workers will receive Medicare benefits under current law because they either had other, covered jobs in the past or are covered through their spouse's employment. The broader coverage created by this option would lessen the inequity of those employees' receiving high levels of benefits in relation to the payroll taxes they paid.
One drawback of expanding Medicare coverage to all state and local government employees is that the federal government's obligation for future benefits under the program would increase. In addition, that change could affect the finances of some state and local governments that have large numbers of workers who are not currently covered by Medicare.
|
Change in Revenues |
|
||||||||||
|
|
Tax 92 percent of earnings |
+18.8 |
+62.5 |
+65.6 |
+67.8 |
+70.0 |
|
+284.7 |
|
+682.7 |
|
|
|
Tax 91 percent of earnings |
+17.9 |
+55.5 |
+58.2 |
+60.0 |
+61.9 |
|
+253.5 |
|
+604.3 |
|
|
|
Tax 90 percent of earnings |
+16.5 |
+48.3 |
+50.5 |
+52.1 |
+53.7 |
|
+221.1 |
|
+524.4 |
|
Social Security—which is composed of the Old-Age, Survivors, and Disability Insurance (OASDI) programs—is financed by a payroll tax on employees, employers, and self-employed people. Only earnings up to a specified maximum are subject to the tax. That maximum, which is $97,500 in 2007, automatically increases each year by the growth rate of average wages in the economy.
When Social Security began in 1937, about 92 percent of the total earnings from jobs covered by the program were below the maximum taxable amount. That percentage gradually declined over time because the maximum was raised only occasionally, when lawmakers enacted specific increases to it. The 1977 amendments to the Social Security Act boosted the percentage of covered earnings subject to the tax to 90 percent by 1982; that law also provided for the taxable maximum to rise automatically each year with the growth in average wages. Despite that indexing, the overall fraction of earnings that is taxable has slipped in the past decade because earnings for the highest-paid workers have grown faster than the average. Thus, in 2005, approximately 85 percent of earnings from employment covered by OASDI fell below the maximum taxable amount.
This option would increase the share of total earnings subject to the Social Security payroll tax to 92 percent, 91 percent, or 90 percent by raising the maximum taxable amount to $250,000, $214,000, or $186,000, respectively. After that increase, the maximum amount would continue to be indexed as it is now.
The first alternative, 92 percent coverage, would generate an additional $284.7 billion in revenues over the 2008–2012 period; the second, 91 percent coverage, would increase revenues by $253.5 billion in that period; and the third, 90 percent coverage, would add $221.1 billion to revenues over those five years. However, because the Social Security benefits that retirees receive are tied to the amount of taxes they pay, some of the increase in revenues from this option would be offset by the additional retirement benefits that Social Security would pay to people with income above the current maximum taxable amount. The revenue estimates shown here do not reflect those additional outlays (although they include the effects on individual income tax revenues that result from assumed changes in the taxable and nontaxable components of labor compensation).
Besides improving the Social Security system's long-term financial outlook, this option would make the payroll tax less regressive. Because people who have income above the ceiling do not pay the tax on all of their earnings, they pay a smaller fraction of their total income in payroll taxes than do people whose total earnings are less than the maximum amount. Making more earnings taxable would increase payroll taxes for those high-income earners and move the Social Security tax toward proportionality. (Although that change could also lead to higher benefit payments for people with earnings above the prior maximum, the additional benefits would be modest relative to the additional taxes those earners would have to pay.)
A drawback of this option is that raising the earnings cap could weaken the link between the taxes that workers pay into the system and the benefits they receive, which has been an important aspect of the Social Security system since its inception. Moreover, this option would reduce the rewards of working for people with earnings above the current maximum by subjecting those earnings to the Social Security tax, which would raise their average tax rate. As a result, such earners would have an incentive to work less or to take more compensation in the form of fringe benefits that would not be subject to payroll taxes.
|
Change in Revenues
|
|
||||||||||
|
|
On-budget
|
+0.2
|
+0.3
|
+0.3
|
+0.3
|
+0.3
|
|
+1.4
|
|
+2.9
|
|
|
|
Off-budget
|
+0.1
|
+0.1
|
+0.2
|
+0.2
|
+0.2
|
|
+0.8
|
|
+1.6
|
|
Social Security and Medicare taxes come in two forms: the Federal Insurance Contribution Act (FICA) tax paid on wages, and the Self-Employment Contribution Act (SECA) tax paid on income from self-employment. Under FICA, employees and employers each pay a Social Security tax of 6.2 percent on wages up to a maximum taxable amount ($97,500 in 2007) as well as a Medicare tax of 1.45 percent on all wages. Until 1983, the tax rate levied on income from self-employment (the SECA rate) was lower than the combined employer and employee rate under FICA. As part of the Social Security Amendments of 1983, however, lawmakers increased the effective tax rate under SECA. The report of the conference committee for that law said the change was "designed to achieve parity between employees and the self-employed" beginning in 1990.
In fact, the current method for calculating SECA taxes allows a self-employed person to pay less tax than a worker with the same nominal income who is not self-employed, in two ways. First, under current law, self-employed people calculate their tax on an income base that comprises their total compensation minus 7.65 percent; for other workers, tax is calculated on total compensation without a percentage deduction. For example, an employee who earns $50,000 pays $3,825 in FICA taxes, which are calculated on a taxable base of $50,000; his or her employer also pays $3,825 in FICA taxes. Because the employer's contribution amounts to additional compensation, the employee is implicitly earning $53,825 ($50,000 plus the employer's share of FICA taxes) and paying $7,650 in employment taxes.4 An otherwise identical worker who is self-employed and earning the same $53,825 pays $7,605 in SECA taxes ($53,825 minus 7.65 percent, times the SECA rate), or $45 less. The difference arises because comparability would require that the 7.65 percent tax rate be applied to a base of $50,000 for self-employed people, not $49,707.
Second, among people with earnings above Social Security's taxable maximum, those who are self-employed pay the same amount of Social Security tax as employees—the tax on $97,500—but pay less Medicare tax. For example, an employee who earns $100,000 and his or her employer each pay the maximum amount of Social Security tax ($6,045) as well as $1,450 in Medicare tax. The employee's total compensation is thus $107,495, and the total FICA tax is $14,990. That person's self-employed counterpart who earns $107,495, however, has a taxable base of $99,272 (total compensation of $107,495 minus 7.65 percent). Consequently, the self-employed worker pays the same maximum Social Security tax but $21 less in Medicare tax. Indeed, high-income self-employed taxpayers may pay as much as 6.3 percent less in Medicare tax under SECA than employees with similar total compensation pay under FICA. That difference has existed since 1991, when lawmakers first set a taxable maximum for Medicare that was higher than the taxable maximum for Social Security. (The cap on taxable earnings for the Medicare tax ended in 1994.)
This option would eliminate the difference between the way wages subject to payroll taxes are calculated for self-employed people and the way they are determined for employees. Changing the calculation of taxable wages for SECA taxes would increase on-budget revenues by a total of $1.4 billion over the 2008–2012 period. (That estimate includes reductions in individual income tax revenues because a portion of the additional SECA taxes are tax-deductible.) Off-budget SECA receipts, which are credited to the Social Security trust funds, would increase by $0.8 billion over that five-year period. (The option would require a slight change in Schedule SE, the income tax form for reporting self-employment income.)
The main rationale for calculating taxable wages in the same way regardless of employer would be to make the tax system more equitable. That change would ensure that people with the same total compensation paid the same amount of payroll tax.
One drawback to this option, however, would be the complexity that it would introduce into the structure of FICA taxes. The Social Security tax would need different taxable maximums for employees and self-employed people, and different methods of calculation would have to be used to determine tax liabilities for the two groups of workers.
|
Change in Revenues
|
+0.3
|
+0.6
|
+0.9
|
+0.9
|
+1.0
|
|
+3.7
|
|
+9.0
|
|
Most workers covered by the Civil Service Retirement System (CSRS)—the older of the two major retirement plans for civilian employees of the federal government—are required to contribute 7 percent of their salary to their retirement fund in exchange for a defined-benefit pension. (In a defined-benefit plan, the level of benefits is set by formula and is not affected by the amount an employee contributes.) CSRS workers do not pay Social Security payroll taxes, however. Employees covered by the other main plan for federal civilian workers, the Federal Employees Retirement System (FERS), must generally contribute at least 0.8 percent of their salary toward a defined-benefit plan and pay 6.2 percent in Social Security taxes. Both CSRS and FERS employees are also allowed to make voluntary contributions (up to the Internal Revenue Service's limit of $15,500 in 2007) to the Thrift Savings Plan, the government's counterpart to a defined-contribution 401(k) plan.
This option would raise the contributions that most federal civilian workers would have to make to their defined-benefit retirement plan by 0.5 percentage points relative to current levels. The increase would be phased in over several years, starting at 0.25 percentage points in calendar year 2008, growing to 0.4 percentage points in 2009, and finally reaching 0.5 percentage points in 2010. (Those increases match the ones that the Balanced Budget Act of 1997 imposed through 2002.) Adopting those changes for federal civilian employees would boost revenues by $0.3 billion in fiscal year 2008 and by a total of $3.7 billion through 2012 (assuming that the retirement contributions that agencies made on behalf of their employees were unchanged, as was the case under the Balanced Budget Act).
The main rationale for requiring federal workers to pay more for their retirement plans is to make the government's costs for civilian pension benefits more like those of private-sector employers, without reducing the level of salary replacement that workers receive once they retire. Raising the contributions of current employees would arguably be better than cutting the benefits paid to current retirees (the approach in Option 600-3), because workers could accommodate the effective pay cut by making smaller adjustments to their spending over a larger number of years. (Some employees could choose to maintain their previous take-home pay by reducing their contributions to the Thrift Savings Plan.)
An argument against raising employees' retirement contributions is that the increases would be roughly equivalent to a 0.5 percent pay cut for most federal civilian workers and thus would diminish the government's compensation package relative to that of the private sector. (The large private firms that still offer defined-benefit plans seldom require employees to contribute to them.) Those factors could weaken the government's ability to attract new personnel and might cause it to have to increase cash compensation for its employees or settle for having a less skilled workforce.
|
Change in Revenues
|
|
||||||||||
|
|
Alternative 1
|
0
|
0
|
-0.8
|
-23.8
|
-50.2
|
|
-74.8
|
|
-400.9
|
|
|
|
Alternative 2
|
0
|
0
|
-0.7
|
-19.4
|
-45.8
|
|
-65.9
|
|
-366.6
|
|
|
|
Alternative 3
|
0
|
0
|
-0.2
|
-1.0
|
-28.8
|
|
-30.0
|
|
-231.9
|
|
|
|
Alternative 4
|
-2.1
|
-1.4
|
-3.1
|
-36.0
|
-59.8
|
|
-102.4
|
|
-498.8
|
|
When someone dies, an estate tax is imposed on the value of his or her assets that are transferred at death, and a gift tax is paid on the value of taxable gifts that were made during the decedent's lifetime. Only the portion of an estate that exceeds a certain amount (currently $2 million) is subject to the estate tax. Likewise, only taxable gifts that exceed the lifetime exemption amount ($1 million) are subject to the gift tax. (Those two exemptions are not cumulative; the exemption amount under the estate tax is reduced by any exemption used under the gift tax.) Gifts and bequests between spouses and bequests to charities are not subject to taxation.
Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was enacted, the estate and gift taxes were a single unified levy, with a common exemption amount and rate schedule that applied to the cumulative taxable transfers made by a taxpayer during life and at death. EGTRRA created different exemption amounts for the two taxes. Moreover, under the law's provisions, the estate tax is gradually being phased out until it is repealed in 2010, whereas the gift tax is being retained. (EGTRRA also phases out and then repeals generation-skipping transfer taxes. Those taxes were designed to prevent people from being able to avoid some estate taxation by transferring assets, either as gifts during their lifetime or as bequests, to individuals more than one generation younger than the transferor.)
EGTRRA phases out the estate tax primarily by increasing the amount of an estate that is exempt from taxation and by reducing the top marginal tax rate (the rate that applies to the last dollar of an estate). Under the law, the exemption amount is scheduled to rise from $2 million in 2007 and 2008 to $3.5 million in 2009, while the top marginal rate has fallen from 46 percent in 2006 to 45 percent for 2007 through 2009. In 2010, the estate tax is repealed entirely (as are generation-skipping transfer taxes).
In repealing the estate tax, EGTRRA also temporarily changes the way in which basis is calculated for assets transferred from a decedent. Basis comes into play when inherited assets are eventually sold and capital gains (or losses)—and any applicable taxes—are calculated. A capital gain or loss is measured as the proceeds received from the sale of an asset minus the taxpayer's basis in the asset (which represents his or her original cost for it). Through 2009, "stepped-up basis" will continue to apply to assets transferred from a decedent. In that treatment, basis is generally measured as an asset's fair market value on the date of the decedent's death or on an alternate valuation date, as specified by law. However, EGTRRA specifies that in 2010, a modified "carryover basis" be used for inherited assets whose increase in basis exceeds $1.3 million (or $4.3 million if a spouse inherits the assets). Under modified carryover basis, the basis of those assets in the hands of the heir is generally the same as it was in the hands of the decedent.
For the gift tax, EGTRRA set the exemption amount at $1 million beginning in 2002. That tax's top marginal rate is due to decline in 2010 from 45 percent to a rate equal to the highest rate of the individual income tax, which is currently scheduled to be 35 percent in that year.
All of those provisions of EGTRRA are set to expire on December 31, 2010. Thus, under current law, the estate tax is due to return in 2011 in its pre-EGTRRA form: unified with the gift tax, having a top marginal rate of 55 percent and a combined exemption amount of $1 million, and using stepped-up basis. (An additional 5 percent surcharge will apply to estates worth between $10 million and $17 million.)
EGTRRA's provisions also address state death taxes. Previously, estates could use a credit to lower their federal estate tax liability by the amount of state death taxes they paid (up to a certain level). EGTRRA gradually repealed that credit and, in 2005, replaced it with a deduction that reduces a taxable estate by the amount of such taxes paid to any state or the District of Columbia. In 2011, when EGTRRA expires, that deduction will again be replaced by a credit.
Because of the various changes included in EGTRRA, far fewer estates are subject to the estate tax than would have been the case otherwise. For example, without EGTRRA, about 30,400 estates would have faced the tax in 2005; instead, about 20,000 estates faced it in that year. Similarly, about 38,100 estates would have been subject to the tax in 2010 under prior law, compared with none under EGTRRA.
EGTRRA has made estate planning significantly more complicated, however. People now face not only uncertainty about when they will die and how big their estate will be but also the complexity of legislated phaseouts and repeals and the ultimate reinstatement of the estate and gift tax. EGTRRA has also complicated the process of transferring wealth to heirs before death through the strategic use of gifts (called inter vivos giving), which is a significant part of estate planning for many taxpayers.
This option would modify the scheduled phaseouts and eventual repeal of the estate tax (and generation-skipping transfer taxes) in four alternative ways. The first three approaches would retain and reunify the estate and gift taxes, beginning in 2010; the fourth approach would make EGTRRA's repeal of the estate tax permanent.
In each of those alternatives, the exemption amount for generation-skipping transfer taxes would mirror that of the estate tax.
An advantage of all of the alternatives is that they would provide more certainty about future estate and gift tax law, which would simplify estate planning. Another potential benefit is that they would exempt smaller estates (or, in the case of Alternative 4, all estates) from filing estate tax returns, which would reduce the filing burden for some taxpayers and their heirs. In addition, smaller estates would be less likely to incur estate tax liability—which, some proponents argue, would reduce the chance that a small business would have to be liquidated after the owner's death to pay estate taxes. Nevertheless, because the first three alternatives would retain the estate and gift tax, returns would still have to be filed for some estates, and some of them would have to pay estate taxes.
Opponents of reducing or repealing estate and gift taxes argue that the progressive nature of those taxes lessens the concentration of wealth in the United States. Another drawback of repealing the estate tax—besides the large loss in revenues—is that charitable giving could decline because taxpayers would no longer have a deduction for leaving bequests to charities. Other opponents of repeal argue that if the estate tax has a negative impact on small estates and closely held businesses (such as family-owned firms), it could be largely avoided by increasing the exemption amount rather than repealing the tax. Moreover, they maintain that even before EGTRRA, very few businesses were forced to liquidate to pay estate taxes. Another consideration is that repealing the federal estate tax would not eliminate the filing burden because many estates would still have to file returns—and pay estate taxes—at the state level.
Analysts hold a variety of views about how estate and gift taxes affect saving, the accumulation of capital, and economic growth. Research in those areas is inconclusive.
|
Change in Revenues
|
+2.1
|
+5.2
|
+5.3
|
+5.4
|
+5.5
|
|
+23.5
|
|
+52.5
|
|
U.S. multinational corporations generally pay U.S. taxes on their worldwide income, including income they earn from the operations of branches or subsidiaries in other countries. Foreign nations also tax the income from those operations, and the U.S. tax code allows a multinational firm to take a limited credit for the foreign income taxes it pays. The credit is subtracted from the U.S. tax that the firm owes on that income, but the credit cannot exceed what the firm would have owed if the income had been earned in the United States. If a corporation pays more foreign tax on its foreign income than it would have paid on otherwise identical domestic income, it accrues what the tax code calls excess foreign tax credits.
Unlike income from companies' operations abroad, income from products that are produced domestically but sold abroad results almost entirely from value created or added in the United States. Hence, the income that U.S. corporations receive from exports typically is not taxed by foreign nations. However, the U.S. tax code's "title-passage" rule specifies that the source of a gain on the sale of a firm's inventory is the place to which the legal title to the inventory "passes." If a firm sells its inventory abroad as exports, the title-passage rule treats the income from those sales in a way that, in effect, allocates half of it to the jurisdiction in which the sale takes place and half to the place of manufacture. In practice, that means that if the firm's inventory is produced in the United States and sold elsewhere, half of the income from the sale is still treated as though it originated from a foreign source, even though the company may have no branch or subsidiary located in the place of sale and the foreign jurisdiction does not tax the income.
The upshot of the title-passage rule is that a firm can classify more of its income from exports as foreign in source than could be justified solely on the basis of where the underlying economic activity occurred. A multinational corporation with excess foreign tax credits can then use the credits to offset U.S. taxes on that income. As a result, about half of the export income that companies with such excess credits receive is effectively exempted from U.S. taxation, and the income-allocation rules essentially give those companies an incentive to produce goods domestically for sale by their overseas subsidiaries.
This option would eliminate the title-passage rule; doing so would require taxpayers to allocate income for the purpose of taxation on the basis of where a firm's economic activity actually occurred. That change would increase revenues by $2.1 billion in 2008 and by $23.5 billion over the 2008–2012 period.
One rationale for eliminating the title-passage rule is that export incentives, such as those embodied in the rule, do not boost overall levels of domestic investment and employment or affect the trade balance. They do increase profits—and thus investment and employment—in industries that sell substantial amounts of their products abroad. But the U.S. dollar appreciates as a consequence, making foreign goods cheaper and thereby reducing profits, investment, and employment for U.S. firms that compete with imports. Thus, export incentives distort the allocation of resources by misaligning the prices of goods relative to their production costs, regardless of where those goods were produced.
Another advantage of this option is that it would end an undesirable feature of the way in which foreign tax credits are granted under U.S. tax law. Those credits were intended to prevent the income of U.S. businesses from being taxed both domestically and abroad. But the title-passage rule allows domestic export income that is not usually subject to foreign taxes to be exempted from U.S. taxes as well, which means that the income escapes corporate taxation altogether.
Opponents of eliminating the title-passage rule argue that the rule is necessary to give U.S. corporations an advantage over foreign companies that operate in the same markets. (However, companies that lack excess foreign tax credits—such as U.S. exporters that carry out all of their production domestically and some U.S. multinational corporations—receive no such advantage.) Some opponents of this option also argue that allocating income is less complex under the title-passage rule than under the normal rules for income allocation.
|
Change in Revenues
|
+1.7
|
+3.5
|
+3.6
|
+3.7
|
+3.9
|
|
+16.4
|
|
+39.1
|
|
U.S. corporations are subject to U.S. taxes on their worldwide income, regardless of where it is earned. In the case of income earned abroad, the same income may face both foreign and U.S. taxes. To prevent such "double taxation," U.S. companies are allowed to claim the foreign tax credit, which reduces their U.S. taxes by the amount of any income and withholding taxes they have paid to foreign governments. The foreign tax credit is subject to limits that are designed to ensure that the amount of credits taken does not exceed the amount of U.S. tax that would otherwise have been due. Those limits are also intended to prevent corporations from using foreign tax credits as a way to reduce taxes on income earned in the United States. For computing those limits, overhead expenses (such as interest costs) of a U.S. parent company's domestic operations must be allocated between domestic and foreign activities. Most income earned by the foreign subsidiaries of U.S. corporations is not subject to U.S. taxation until it is repatriated in the form of dividends paid to the parent corporation.
Under this option, all income earned by the foreign subsidiaries of U.S. companies would be subject to U.S. taxes as it was earned, regardless of when it was repatriated. To prevent double taxation, foreign tax credits would still be allowed. For determining the limit on those credits, however, the U.S. parent corporation's overhead expenses would no longer be allocated between domestic and foreign activities. Together, those changes would increase revenues by $1.7 billion in 2008 and by $16.4 billion over the 2008–2012 period.
Proponents of this option argue that by not taxing income until it is repatriated as dividends, the current system reduces the cost of foreign investment relative to the cost of domestic investment. In that view, this option would eliminate the bias toward foreign investment and thus increase the amount of domestic investment, which in turn would make U.S. workers more productive and boost their earnings.
Other arguments for this option focus on the benefits of simplifying the tax system. Eliminating the rules for allocating overhead expenses and the provisions that distinguish between active foreign income (which is not taxed until it is repatriated) and passive foreign income (which is generally taxed as it is earned) would make international tax rules less complex. In addition, the costs of tax planning would decline for U.S. multinational corporations because they would no longer have to plan when to repatriate dividends from their foreign subsidiaries. Likewise, the costs of enforcing tax rules would be lower because U.S. companies would not be able to reduce their worldwide taxes by disguising U.S. income as foreign income.
Opponents of this approach argue that it would put U.S. multinational corporations at a competitive disadvantage compared with foreign multinationals: The cost of foreign investments by U.S. multinationals would rise, whereas the cost of foreign investments by foreign multinationals would not change. Opponents maintain that such a competitive disadvantage would shift market share and production toward businesses controlled by foreign multinational corporations.
Concerns of both proponents and opponents of this option could be addressed by reducing U.S. corporate tax rates at the same time. Alternatively, the average U.S. tax burden on U.S. multinational corporations could be held constant by combining this option with a reduction in the top U.S. corporate tax rate.
|
Change in Revenues
|
+2.8
|
+5.7
|
+5.9
|
+6.1
|
+6.3
|
|
+26.8
|
|
+61.3
|
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The United States taxes the income of U.S. businesses regardless of whether it is earned at home or abroad. However, to prevent income earned abroad from being subject to both foreign and U.S. taxation, the tax code allows U.S. corporations to take a tax credit that lowers their U.S. tax liability by the amount of income and withholding taxes they have paid to foreign governments. (The rules governing that foreign tax credit are designed to prevent the credit from exceeding the amount of U.S. tax that would otherwise be owed and to keep companies from using the credit as a way to reduce their taxes on income earned in the United States.) Most of the income that U.S. corporations earn from the business activities of their foreign subsidiaries is not subject to U.S. taxes until it is repatriated in the form of dividends paid to the parent company by its subsidiaries.
This option would exempt from U.S. taxation any dividends that U.S. corporations earned from the business operations of their foreign subsidiaries or foreign branches. Any overhead costs (such as interest expenses) of a U.S. parent company would be allocated between the company's U.S. and foreign activities in the same way that they are now. Unlike in current law, however, overhead expenses allocated to foreign income would not be deductible from U.S. income. All other foreign income would be taxed in the current manner: as it is earned. Foreign tax credits would be allowed so that companies could offset any foreign income taxes or withholding taxes paid on foreign income that would still be subject to U.S. taxation.
Those changes would increase revenues by a total of $26.8 billion through 2012. The revenue lost by exempting dividends from U.S. taxation would be more than offset by increases in taxes on other sources of income. Specifically, taxes on U.S. income would rise because overhead expenses allocated to exempt foreign income could no longer be deducted from U.S. income. In addition, companies that paid high foreign income taxes would no longer be able to use the foreign tax credits associated with repatriated dividends to shield other low-tax foreign income (such as royalties and export income) from U.S. taxes.
Advocates of exempting active foreign dividends argue that such a change would reduce the complexity of the tax system. Under the present rules, U.S. multinational corporations can reduce their worldwide taxes by carefully planning how and when they will repatriate dividend income from each of their foreign subsidiaries. Researchers have estimated the total costs of such planning at more than $1 billion per year. Proponents argue that this option would eliminate those planning costs without affecting the balance between the incentives that companies have to invest in the United States and their incentives to invest abroad. Proponents also argue that this option would allow foreign tax credit rules to be simplified because many of those rules would no longer apply to active dividend income.
Opponents of such a dividend exemption argue that both this option and the current tax system cause U.S. corporations to favor foreign investments over U.S. investments, thus reducing the amount of capital available for production in the United States. That bias could be eliminated by retaining the current system of foreign tax credits but taxing the income of foreign subsidiaries as it was earned (an approach discussed in the previous option) rather than waiting until it was repatriated as dividends.
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Change in Revenues
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+4.3
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+5.6
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+5.6
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+5.5
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+5.5
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+26.6
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+53.2
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Tobacco is taxed by both the federal government and the states. Currently, the federal excise tax on cigarettes is 39 cents per pack; other tobacco products are subject to similar levies. In 2005, federal tobacco taxes raised a total of $8.7 billion, or about 0.4 percent of federal revenues. At the state level, excise taxes on cigarettes have more than doubled in the past seven years, from an average of 42 cents per pack to 92 cents. In addition, settlements reached with states' attorneys general require major tobacco manufacturers to pay fees that are equal to an excise tax of about 50 cents per pack. Together, those federal and state taxes and fees boost the price of a pack of cigarettes by $1.81.
This option would raise the federal excise tax on cigarettes by 50 cents per pack. That increase would generate $4.3 billion in additional revenues in 2008 and a total of $26.6 billion through 2012. Because excise taxes reduce the tax base of income and payroll taxes, higher excise taxes would lead to reductions in income and payroll tax revenues. The estimates shown here reflect those reductions, as well as projected declines in cigarette purchases because of higher after-tax prices. Researchers estimate that each 10 percent increase in the price of cigarettes is likely to cause consumption to fall by 2.5 percent to 5 percent (probably more in the case of teenagers).
In general, the fact that taxing an item can cause consumers to buy less of it than they might otherwise can result in a less-efficient allocation of society's resources—unless some of the costs associated with the taxed item are not reflected in its price. Cigarette use creates "external costs" for society that are not covered in pretax prices, such as higher costs for health insurance (to cover the medical expenses linked to smoking) and the damaging effects of cigarette smoke on the health of nonsmokers. Another problem with tobacco is that consumers may underestimate the harm they do to themselves by smoking or the addictive power of nicotine. Teenagers in particular may not be capable of evaluating the long-term effects of beginning to smoke. Thus, an argument in favor of this option is that raising tobacco taxes would reduce tobacco consumption—and thus its associated costs—by causing cigarette prices to reflect more of the total, long-term costs of smoking that would otherwise be borne by society as a whole and not considered fully by individual smokers.
No consensus exists about the size of smoking's external costs, which makes it difficult to determine the appropriate level of tobacco taxes. Some analysts estimate that those costs are significantly lower than the taxes and settlement fees now levied on tobacco. Others maintain that the external costs are greater and that taxes should be raised even more. Technical issues cloud the debate; for example, the effect of secondhand smoke on people's health is uncertain. Much of the controversy centers on what to include in calculating external costs—such as whether to consider tobacco's effects on the health of smokers' families or the savings in spending on health care and pensions that result from smokers' shorter lives.
One argument against raising cigarette taxes is their regressivity. Such taxes take up a larger percentage of the earnings of low-income families than of middle- and upper-income families, for two reasons. First, lower-income people are more likely to smoke than are people from other income groups. And second, the amount that smokers spend on cigarettes does not rise appreciably with income.
Some opponents of higher cigarette taxes note that the market has mechanisms that already make individual smokers, rather than society, bear many of the costs of smoking—for example, higher insurance premiums for smokers than for nonsmokers and the voluntary establishment of separate smoking areas in restaurants. In that view, such mechanisms and the penalty they exact for smoking eliminate the need to raise taxes in order to reduce costs to society.
Other opponents object to a tax that is intended to protect consumers from a supposed lack of foresight about the harmful effects of smoking. They argue that consumer protection is a specious justification for focusing on cigarette taxes when many other choices that people make—to use alcohol, consume some types of food, engage in risky sports, or work long hours at the office—can also cause unforeseen health or social problems.
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Change in Revenues
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+4.7
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+5.7
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+5.8
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+5.9
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+6.0
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+28.0
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+59.5
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The federal government collects roughly $9 billion a year from excise taxes on distilled spirits, beer, and wine. The way in which those taxes are levied treats different alcoholic beverages in different ways: Taxes are much lower on the alcohol content of beer and wine than on the alcohol content of distilled spirits because the taxes are figured on different liquid measures. Distilled spirits are measured in proof gallons (a standard unit for the alcohol content of a liquid). The current excise tax rate on those spirits, $13.50 per proof gallon, translates to about 21 cents per ounce of alcohol. Beer, in contrast, is measured by the barrel, and the current tax rate of $18 per barrel translates to about 10 cents per ounce of alcohol (assuming an average alcohol content of 4.5 percent for beer). The current levy on wine is $1.07 per gallon, or about 8 cents per ounce of alcohol (assuming an average alcohol content of 11 percent).
This option would standardize the base on which the federal excise tax is levied by using the proof gallon as the measure for all alcoholic beverages. The tax rate would be raised to $16 per proof gallon, thus increasing revenues by about $4.7 billion in 2008 and by a total of $28.0 billion over the 2008–2012 period. (Because excise taxes reduce the tax base of income and payroll taxes, higher excise taxes would lead to reductions in income and payroll tax revenues. The estimates shown here reflect those reductions.)
A tax of $16 per proof gallon would equal about 25 cents per ounce of ethyl alcohol. Under this option, the federal excise tax on a 750-milliliter bottle of distilled spirits would rise from about $2.14 to $2.54. The tax on a six-pack of beer would jump from about 33 cents to 81 cents, and the tax on a 750-milliliter bottle of table wine would increase by a similar amount, from about 21 cents to 70 cents.
The consumption of alcohol creates costs for society that are not reflected in the pretax price of alcoholic beverages. Examples of those "external costs" include alcohol-related spending on health care that is covered by the public, losses in productivity because of alcohol consumption that are borne by others besides the consumer, and the loss of lives and property in alcohol-related accidents and crimes. Calculating such costs is difficult. However, a study done for the National Institute on Alcohol Abuse and Alcoholism estimated that the external economic costs of alcohol abuse exceeded $100 billion in 1998—an amount far greater than the revenues from the current taxes on alcoholic beverages.
Two advantages of raising those taxes would be to reduce alcohol use—and thus the external costs of that use—and to make consumers of alcoholic beverages pay a larger share of such costs. Research has consistently shown that higher prices lead to less alcohol consumption and abuse, even among heavy drinkers. Moreover, raising excise taxes to reduce consumption may be desirable, regardless of the effect on external costs, if lawmakers believe that consumers underestimate the extent of the harm they do to themselves by drinking. Finally, this option would treat different kinds of alcoholic beverages similarly. Such evenhanded treatment is seen by some analysts as beneficial because it avoids distorting consumers' choices among those various beverages.
An increase in taxes on alcoholic beverages would have disadvantages as well. It would make a tax that is already regressive—that takes up a greater percentage of income for low-income families than for middle- and upper-income families—even more regressive. In addition, it would affect not only problem drinkers but also drinkers who impose no costs on society and who thus would be unduly penalized. Furthermore, higher taxes would reduce consumption by some light drinkers whose intake of alcohol has health benefits. Finally, with regard to the argument that drinkers underestimate the costs of alcohol consumption to themselves, some opponents of raising alcohol taxes argue that the government should not try to modify private consumer behavior for reasons other than major external costs to society.
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Change in Revenues
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+49.3
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+68.6
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+67.4
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+67.3
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+68.2
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+320.8
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+685.3
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Revenues from federal taxes on motor fuels are credited to the Highway Trust Fund, which is used to finance highway construction and maintenance. Those taxes are currently levied at rates of 18.4 cents on each gallon of gasoline produced and 24.4 cents on each gallon of diesel fuel. (With state and local excise taxes included, total average tax rates nationwide are 40 cents per gallon for gasoline and 46.5 cents per gallon for diesel fuel.)
This option would raise those federal taxes by 50 cents per gallon, to 68.4 cents for gasoline and 74.4 cents for diesel fuel. That change would increase federal revenues by $49.3 billion in 2008 and by a total of $320.8 billion over five years. (Because excise taxes reduce the tax base of income and payroll taxes, higher excise taxes would lead to reductions in income and payroll tax revenues. The estimates shown here reflect those reductions.)
The primary rationale for this option is economic efficiency (allocating society's resources to their most valued uses). Raising taxes on motor fuels would improve efficiency if it caused the price of motor fuel to more accurately reflect "external costs—costs that fuel use imposes on society that are not reflected in the pretax price of fuel paid by individual consumers. For example, if motor fuels were more expensive, people would have an incentive to drive less or to purchase more-fuel-efficient vehicles, which would lessen the external costs of congestion, accidents, and smog. Lower fuel consumption would also reduce emissions of carbon dioxide and thus could help moderate the effects of human activity on the global climate.
This option envisions a 50 cent rise in tax rates because that increase would bring average nationwide rates on gasoline and diesel fuel to roughly $1 per gallon (including state and local excise taxes). Various studies and public statements by economists have suggested that $1 is the "optimal" excise tax rate on motor fuels. That level is intended to account for several external costs imposed by the overconsumption of motor fuel, including costs associated with pollution, the risk of accidents, and road congestion.
Judging from estimates by analysts at the research organization Resources for the Future, road congestion is the single biggest contributor to the external costs associated with driving. An argument against raising the tax on gasoline is that congestion would be better addressed through other measures, such as tolls or congestion prices (which impose a fee for driving at certain times in certain areas). The President's budget for 2008 proposes policies related to congestion pricing. In the absence of such measures, however, a 50 cent increase in tax rates could partially address those problems.
Other arguments against raising tax rates on motor fuels involve issues of fairness. If the higher fuel prices paid by the trucking industry were passed on to consumers in the form of higher prices for transported retail goods, those higher prices would impose a disproportionate cost on rural households, although the benefits associated with reducing vehicle emissions and congestion are greatest in densely populated, mostly urban areas. Moreover, some analysts argue that taxes on gasoline and other petroleum products are regressive (that is, they take up a greater percentage of the income of lower-income households than of middle- and upper-income households.) Other researchers, however, conclude that the effects of such taxes are proportionate.