JCT Description of Tax Provisions in President's FY2001 Budget (Part 1 of 4)

PREPARED BY THE STAFF

[1] This pamphlet, prepared by the staff of the Joint Committee on Taxation ("Joint ¹ Committee staff"), provides a description and analysis of the revenue provisions and other provisions requiring amendment of the Internal Revenue Code (the "Code") that are contained in the President's Fiscal Year 2001 Budget Proposal, as submitted to the Congress on February 7, 2000. The pamphlet generally follows the order of the proposals as included in the Department ² of the Treasury's explanation. For these provisions, there is a description of present law and the ³ proposal (including effective date), an analysis of issues related to the proposal, and a reference to any recent prior legislative action or budget proposal submission.

I. PROVISIONS REDUCING REVENUES

A. Education Provisions

1. College opportunity tax cut

Present Law

General tax treatment of education expenses

[2] Individual taxpayers generally may not deduct their education and training expenses. However, a deduction for education expenses generally is allowed under section 162 if the education or training (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's employer, or requirements of applicable law or regulations, imposed as a condition of continued employment (Treas. Reg. sec. 1.162-5). Education expenses are not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In the case of an employee, education expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if such expenses meet the above-described criteria for deductibility under section 162 and only to the extent that the expenses, along with other miscellaneous deductions, exceed two percent of the taxpayer's adjusted gross income ("AGI").

HOPE credit

[3] Individual taxpayers are allowed to claim a nonrefundable credit, the "HOPE" credit, against Federal income taxes up to $1,500 per student per year for qualified tuition and related expenses paid for the first two years of the student's post-secondary education in a degree or certificate program. The HOPE credit rate is 100 percent on the first $1,000 of qualified tuition ⁴ and related expenses, and 50 percent on the next $1,000 of qualified tuition and related expenses. The qualified tuition and related expenses must be incurred on behalf of the taxpayer, ⁵ the taxpayer's spouse, or a dependent of the taxpayer. The HOPE credit is available with respect to an individual student for two taxable years, provided that the student has not completed the first two years of post-secondary education before the beginning of the second taxable year. The HOPE credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $40,000 and $50,000 ($ 80,000 and $100,000 for joint returns). For taxable years beginning after 2001, the $1,500 maximum HOPE credit amount and the AGI phase-out range will be indexed for inflation. The HOPE credit is not available for a year if an exclusion is allowed for distributions from an Education IRA for that year.

[4] The HOPE credit is available in the taxable year the expenses are paid, for academic periods beginning during that year or the first three months of the next year. Qualified tuition and related expenses paid with the proceeds of a loan generally are eligible for the HOPE credit. The repayment of a loan itself is not a qualified tuition or related expense.

[5] A taxpayer may claim the HOPE credit with respect to an eligible student who is not the taxpayer or the taxpayer's spouse (e.g., in cases in which the student is the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year for which the credit is claimed. If a student is claimed as a dependent, the student is not entitled to claim a HOPE credit for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any qualified tuition and related expenses paid by the student are treated as paid by the parent (or other taxpayer) for purposes of determining the amount of qualified tuition and related expenses paid by such parent (or other taxpayer) under the provision. In addition, for each taxable year, a taxpayer may elect either the HOPE credit or the "Lifetime Learning" credit (described below) with respect to an eligible student.

[6] The HOPE credit is available for "qualified tuition and related expenses," which include tuition and fees required to be paid to an eligible educational institution as a condition of enrollment or attendance of an eligible student at the institution. Charges and fees associated with meals, lodging, insurance, transportation, and similar personal, living or family expenses are not eligible for the credit. The expenses of education involving sports, games, or hobbies are not qualified tuition and related expenses unless this education is part of the student's degree program.

[7] Qualified tuition and related expenses generally include only out-of-pocket expenses. Qualified tuition and related expenses do not include expenses covered by employer-provided educational assistance and scholarships that are not required to be included in the gross income of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related expenses are reduced by any scholarship or fellowship grants excludable from gross income under section 117 and any other tax-free educational benefits received by the student (or the taxpayer claiming the credit) during the taxable year. The HOPE credit is not allowed with respect to any education expense for which a deduction is claimed under section 162 or any other section of the Code.

[8] An eligible student for purposes of the HOPE credit is an individual who is enrolled in a degree, certificate, or other program (including a program of study abroad approved for credit by the institution at which such student is enrolled) leading to a recognized educational credential at an eligible educational institution. The student must pursue a course of study on at least a half-time basis. A student is considered to pursue a course of study on at least a half-time basis if the student carries at least one- half the normal full-time work load for the course of study the student is pursuing for at least one academic period which begins during the taxable year. To be eligible for the HOPE credit, a student must not have been convicted of a Federal or State felony consisting of the possession or distribution of a controlled substance.

[9] Eligible educational institutions generally are accredited post-secondary educational institutions offering credit toward a bachelor's degree, an associate's degree, or another recognized post- secondary credential. Certain proprietary institutions and post- secondary vocational institutions also are eligible educational institutions. In order to qualify as an eligible educational institution, an institution must be eligible to participate in Department of Education student aid programs.

Lifetime Learning credit

[10] Individual taxpayers are allowed to claim a nonrefundable credit, the "Lifetime Learning" credit, against Federal income taxes equal to 20 percent of qualified tuition and related expenses incurred during the taxable year on behalf of the taxpayer, the taxpayer's spouse, or any dependents. For expenses paid after June 30, 1998, and prior to January 1, 2003, up to $5,000 of qualified tuition and related expenses per taxpayer return are eligible for the Lifetime Learning credit (i.e., the maximum credit per taxpayer return is $1,000). For expenses paid after December 31, 2002, up to $10,000 of qualified tuition and related expenses per taxpayer return will be eligible for the Lifetime Learning credit (i.e., the maximum credit per taxpayer return will be $2,000). The Lifetime Learning credit is not available for a year if an exclusion is allowed for distributions from an Education IRA.

[11] In contrast to the HOPE credit, a taxpayer may claim the Lifetime Learning credit for an unlimited number of taxable years. Also in contrast to the HOPE credit, the maximum amount of the Lifetime Learning credit that may be claimed on a taxpayer's return does not vary based on the number of students in the taxpayer's family -- that is, the HOPE credit is computed on a per-student basis, while the Lifetime Learning credit is computed on a family- wide basis. The Lifetime Learning credit that a taxpayer may otherwise claim is phased out ratably over the same range as the HOPE credit, i.e., for taxpayers with modified AGI between $40,000 and $50,000 ($ 80,000 and $100,000 for joint returns).

[12] The Lifetime Learning credit is available in the taxable year the expenses are paid, for academic periods beginning during that year or the first three months of the next year. Qualified tuition and related expenses paid with the proceeds of a loan generally are eligible for the Lifetime Learning credit (rather than repayment of the loan itself).

[13] As with the HOPE credit, a taxpayer may claim the Lifetime Learning credit with respect to a student who is not the taxpayer or the taxpayer's spouse (e.g., in cases where the student is the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year for which the credit is claimed. If a student is claimed as a dependent by the parent or other taxpayer, the student may not claim the Lifetime Learning credit for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any qualified tuition and related expenses paid by the student are treated as paid by the parent (or other taxpayer) for purposes of the provision.

[14] A taxpayer may claim the Lifetime Learning credit for a taxable year with respect to one or more students, even though the taxpayer also claims a HOPE credit for that same taxable year with respect to other students. If, for a taxable year, a taxpayer claims a HOPE credit with respect to a student, then the Lifetime Learning credit is not available with respect to that same student for that year (although the Lifetime Learning credit may be available with respect to that same student for other taxable years).

[15] The Lifetime Learning credit is available for "qualified tuition and related expenses," which include tuition and fees required to be paid to an eligible educational institution as a condition of enrollment or attendance of a student at the institution. Charges and fees associated with meals, lodging, insurance, transportation, and similar personal, living or family expenses are not eligible for the credit. The expenses of education involving sports, games, or hobbies are not qualified tuition expenses unless this education is part of the student's degree program.

[16] In contrast to the HOPE credit, qualified tuition and related expenses for purposes of the Lifetime Learning credit include tuition and fees incurred with respect to undergraduate or graduate- level (and professional degree) courses. ⁶

[17] As with the HOPE credit, qualified tuition and fees generally include only out-of-pocket expenses. Qualified tuition and fees do not include expenses covered by educational assistance that is not required to be included in the gross income of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and fees are reduced by any scholarship or fellowship grants excludable from gross income under section 117 and any other tax-free educational benefits received by the student during the taxable year (such as employer-provided educational assistance excludable under section 127). The Lifetime Learning credit is not allowed with respect to any education expense for which a deduction is claimed under section 162 or any other section of the Code.

[18] In addition to allowing a credit for the tuition and related expenses of a student who attends classes on at least a half- time basis as part of a degree or certificate program, the Lifetime Learning credit also is available with respect to any course of instruction at an eligible educational institution (whether enrolled in by the student on a full-time, half-time, or less than half-time basis) to acquire or improve job skills of the student. Undergraduate and graduate ⁷ students are eligible for the Lifetime Learning credit. Moreover, in contrast to the HOPE credit, the eligibility of a student for the Lifetime Learning credit does not depend on whether or not the student has been convicted of a Federal or State felony consisting of the possession or distribution of a controlled substance.

Description of Proposal

[19] The proposal would expand the Lifetime Learning credit by increasing the credit rate of 20 percent of qualified tuition and related expenses to 28 percent. The proposal also would increase the beginning points of the income phase-out ranges for the credit. Thus, the credit would be phased out ratably for individual taxpayers with modified AGI of $50,000 to $60,000 and for taxpayers filing joint returns with modified AGI of $100,000 to $120,000. These phase-out ranges would be adjusted for inflation after 2000.

[20] In lieu of the Lifetime Learning credit, the proposal would permit taxpayers to claim a deduction for qualified tuition and related expenses. The deduction would be limited to up to $10,000 of qualified tuition and related expenses per taxpayer return ($ 5,000 for expenses paid prior to January 1, 2003). The deduction would be above-the-line; i.e., the deduction could be claimed by taxpayers whether or not they otherwise itemize deductions. The deduction would ⁸ be phased out over the same AGI ranges as the Lifetime Learning credit.

[21] The deduction, like the Lifetime Learning credit, would be computed on a family-wide basis for qualified expenses incurred on behalf of the taxpayer, the taxpayer's spouse, and one or more claimed dependents. In addition, like the credit, the deduction would not be available with respect to expenses incurred on behalf of any student with respect to whom a HOPE credit is claimed for the same taxable year. The proposal would provide that, if a taxpayer claims a HOPE credit for one student and also claims a deduction in lieu of the Lifetime Learning credit with respect to qualified expenses incurred on behalf of other students, the definition of modified AGI for purposes of the HOPE credit would reflect the deduction.

[22] Effective date. -- The proposal would be effective for qualified tuition and related expenses paid on or after January 1, 2001.

Analysis

Overview of the goals of subsidies for education

[23] Economists attempt to analyze subsidies in terms of their efficiency, equity, and administrability. Subsidies to education have been argued to improve both economic efficiency and to promote economic equity.

Efficiency as a goal of subsidies to education

[24] Economists generally favor the outcomes of the free market and argue that taxes or subsidies generally lead to inefficient outcomes. That is, taxes or subsidies distort choices and divert resources from their highest and best use. However, economists also recognize that sometimes markets do not work efficiently. Economists observe that the consumption or acquisition of certain goods may create spillover, or external, effects that benefit society at large as well as the individual consumer who purchases the good. A good example of such a good is a vaccination. The individual who is vaccinated benefits by not contracting an infectious disease, but the rest of society benefits as well, because by not contracting the disease the vaccinated individual also slows the spread of the disease to those who are not vaccinated. Economists call such a spillover effect a "positive externality." On his own, the individual would weigh only his ⁹ own reduced probability of contracting the disease against the cost of the vaccination. He would not account for the additional benefit he produces for society. As a result, he might choose not to be vaccinated, even though from society's perspective total reduction in the rate of infection throughout the population would be more than worth the cost of the vaccination. In this sense, the private market might produce too little of the good. The private market outcome is inefficiently small. Economists have suggested that the existence of positive externalities provides a rationale for the government to subsidize the acquisition of the good that produces the positive externalities. The subsidy will increase the acquisition of the good to its more efficient level.

[25] While much evidence suggests that job skill acquisition and education benefit the private individual in terms of higher market wages, many people have long believed that education also produces positive externalities. Commentators argue that the democracy functions better with an educated populace and that markets function better with educated consumers. They observe that education promotes innovation and that, because ideas and innovations are easily copied in the market place, the market return (wage or profit) from ideas and innovations may not reflect the full value to society from the idea or innovation. Just as the single individual does not appreciate the full benefit of a vaccination, a single individual may not be able to reap the full benefit of an idea or innovation. Thus, it is argued, subsidies for education are needed to improve the efficiency of society.

[26] On the other hand, recognizing that a subsidy might be justified does not identify the magnitude of the subsidy necessary to promote efficiency nor the best method for delivery of the subsidy. It is possible to create inefficient outcomes by over-subsidizing a good that produces positive externalities. Given that the United States already provides substantial subsidies to education, without some empirical analysis of the social benefits that would arise from creating ¹⁰ new subsidies, it is not possible to say whether such subsidies would increase or decrease economic efficiency.

[27] Some observers note that, aside from potential spillover effects that education might create, the market for financing education may be inefficient. They observe that while investors in housing or other tangible assets have property that can be pledged to secure financing to procure the asset, an individual cannot pledge his or her future earnings as security for a loan to obtain education or training designed to increase the individual's future earning potential. This inability to provide security for education loans constrains borrowing as an alternative to finance education for some taxpayers. Taxpayers who cannot borrow to finance education or training may forgo the education or training even though it would produce a high return for the investor. This inefficiency in the market for education finance may offer a justification for public subsidies. The inefficiency in the market for financing likely is most acute among lower-income taxpayers who generally do not have other assets that could be pledged as security for an education loan. This suggests that this potential source of market inefficiency also relates to the considerations of equity as a rationale for subsidies of education (discussed below).

Equity as a goal of subsidies for education

[28] As noted above, there is evidence indicating that education and training are rewarded in the market place. Recognizing this market outcome, some argue that it is appropriate to subsidize education to ensure that educational opportunities are widely available, including to those less well off in society. Commentators argue that education can play an important role in reducing poverty and income inequality. They observe that, even if there were no positive externalities from education, promoting economic equity within a market economy provides a basis for subsidizing education. ¹¹ If equity is the goal of expanded subsidies to education, the cost of the subsidies should be weighed in terms of the private benefits received by the target groups, rather than the social benefits that might be generated by any possible spillovers.

Beneficiaries of tax incentives for education

[29] The immediate beneficiaries of the proposed tax incentive for education provided by the tax credit or deduction are taxpayers who incur education expenses. The recipients of education who would otherwise not have received such education also could benefit, because generally additional education or training increases an individual's earning potential. As discussed previously, to the extent that there are positive spillover effects from education, the public at large could benefit. However, the benefit the parents may expect to receive from the tax credit or deduction might induce parents to save less money for their children's education than they otherwise would. If so, this inducement could decrease the national saving rate, possibly leading to slower economic growth. It also could mean the student's burden of debt upon graduation is not markedly different than the burden he or she otherwise would have incurred.

[30] Some of the benefit of the incentives may accrue to educational institutions and their employees, rather than to taxpayers and their children. As discussed above, the effect of the credit or deduction is to reduce the price of education for a large number of potential students. Some believe that such incentives, by increasing the demand for post-secondary education, would drive up the prices that educational institutions and their employees charge for their services. ¹² Higher prices for educational services could transfer the benefit from the taxpayer to the educational institution. Whether, or by how much, the prices charged by educational institutions might increase would depend on the supply of such education. In the short run, the number of qualifying institutions is fixed. These institutions could increase enrollments, although in the short run many may not have the physical facilities or personnel to do so. An increase in demand with no change in supply usually results in higher prices for a product (higher tuition), in which case some of the benefits of the credit and deduction may be transferred to the educational institution. Even if tuition does not increase, some of the benefits of the credit and deduction may be transferred to the educational institution because increasing enrollments with little or no change in facilities or personnel may lead to a reduced quality of the education product. On the other hand, over time post-secondary educational institutions have demonstrated an ability to accommodate additional students. For example, college enrollments in 1996 were 16 percent greater than they were in 1981 and nearly 50 percent greater than in 1973. ¹³

[31] Whether, or to what extent, tuition charges will increase in response to the increase in demand will determine the effect of the proposals on enrollment. Empirical studies show that both tuition levels and financial aid can affect the enrollment in higher education. The evidence suggests the effects are larger among students who attend low-cost schools or who come from lower income families. ¹⁴ To the extent increases in tuition do not fully offset the tax savings, enrollment at these institutions and by these students may increase. On the other hand, some research suggests that tuition changes may have more of an effect than net cost changes. ¹⁵ That is, enrollment is subject to "sticker shock" and a one dollar increase in tuition does more to discourage enrollment than a one dollar increase in financial aid (or tax reduction) does to encourage enrollment.

Specific issues related to the college opportunity tax cut

[32] The President's proposed expanded Lifetime Learning credit would provide a 28-percent credit for qualified tuition and related expenses. As under present law, the maximum annual expenses that could be taken into account for purposes of the credit would be $10,000 ($ 5,000 for 2001 and 2002). Thus, for example, a taxpayer with $5,000 of qualified tuition and related expenses in 2000 would be able to claim a credit of up to $1,400 under the proposal, compared to a maximum credit of $1,000 under present law. As under present law, the credit could be claimed by the student or the student's parents (subject to a phase-out of the credit based on AGI). As an alternative to claiming the credit, the President's proposal would permit an above-the-line deduction of up to $10,000 per year ($ 5,000 for 2001 and 2002) for qualified tuition and related expenses paid by the student or the student's parents.

[33] Generally, the value of a deduction can be equated to a credit at a rate equivalent to the taxpayer's marginal tax rate. Thus, for example, if a taxpayer in the 28-percent marginal tax bracket is permitted to deduct $1,000 of educational expenses, the taxpayer's income tax liability falls by $280. This would be equivalent to permitting the same taxpayer to claim a 28-percent credit against his or her tax liability for the $1,000 of expenses. The effect under either a deduction or a credit is that the taxpayer's out-of-pocket expenditure is reduced to $720; although the individual paid out $1,000, his or her income tax liability fell by $280. Thus, economists sometimes say that the deduction or credit reduces the "price" of education. In this example, the price of education is reduced to 72 cents per dollar of educational expenditure. ¹⁶

[34] A taxpayer will generally prefer a deduction to a credit if his or her marginal tax rate exceeds the credit rate, and will generally prefer the credit to the deduction if his or her marginal tax rate is less than the credit rate. Taxpayers with marginal tax rates in excess of 28 percent would thus prefer a deduction to a 28- percent credit. However, the proposed income phaseout of the Lifetime Learning deduction and credit effectively precludes anyone with a regular marginal income tax rate in excess of 28 percent from claiming the credit or deduction. Taxpayers with marginal tax rates of 15 percent or less will generally prefer the credit to the deduction, while those in the 28 percent bracket would generally be indifferent. For individuals whose returns are affected by the alternative minimum tax ("AMT"), the deduction would be preferred because nonrefundable credits may not reduce net tax liability below the amount of the tentative minimum tax. For these taxpayers, a deduction would reduce tax liability by an amount equal to the amount of the deduction multiplied by the effective minimum tax marginal rate (generally 26 or 28 percent). For taxable years beginning in 2000 and 2001, personal credits are not limited by the AMT provisions, and for these years the credit option would be preferable for individuals whose income is taxed at the 15 percent rate.

[35] The expansion of the phase-out ranges for the credit or deduction preserves the basic structure whereby the phase-out rate for married taxpayers filing jointly remains at twice the levels for singles or head of households. This structure assures that no marriage penalties exist from the phaseout, though it preserves and may enhance marriage bonuses related to the Lifetime Learning credit. Some might question the relevance of marriage penalty considerations in setting the phaseout ranges for a benefit for post-secondary education that generally accrues to parents of college-age dependents, who will generally have made their marriage decision years earlier. Such observers would argue that the proposal would inappropriately deny any tax benefit to a head of household filer with AGI of $60,000 and three children in college, while granting the full benefit to a married couple with AGI of $100,000 and only one child in college. They would argue that any expansion of the phase- out range for the credit or deduction should be aimed at increasing the range for single and head of household filers to that of the level for married filing jointly. They might further argue that the credit should vary based on the number of individuals incurring educational expenses. This would help reduce an inequity in the present law structure of the Lifetime Learning credit which tends to provide more tax-based assistance to families whose children are further apart in age than to families whose children are closer in age, though the educational expenses of such families may be identical over time.

[36] The proposal may increase complexity for taxpayers with education expenses. Present law contains a variety of different education tax incentives, each with differing requirements. In order to take full advantage of the tax benefits offered under present law, taxpayers must determine which of the available incentives provides the greatest benefit. For many taxpayers, such an analysis will be difficult and cumbersome. By adding another option for taxpayers with educational expenses (i.e., the proposed deduction) and modifying the present-law Lifetime Learning credit, the proposal may make it more difficult for taxpayers to determine which education tax incentive is best for them.

Prior Action

[37] The proposal for a deduction for qualified tuition and related expenses is similar to proposals contained in the President's Fiscal Year 1997 and 1998 Budget Proposals.

2. Extend authority to issue qualified zone academy bonds and expand

Tax-exempt bonds

[38] Interest on State and local governmental bonds generally is excluded from gross income for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities of these governmental units, including the financing of public schools (sec. 103).

Qualified zone academy bonds

[39] As an alternative to traditional tax-exempt bonds, States and local governments are given the authority to issue "qualified zone academy bonds." A total of $400 million of qualified zone academy bonds is authorized to be issued in each of 1998, 1999, 2000, and 2001. The $400 million aggregate bond cap is allocated each year to the States according to their respective populations of individuals below the poverty line. Each State, in turn, allocates the credit within the State.

[40] Certain financial institutions that hold qualified zone academy bonds are entitled to a nonrefundable tax credit in an amount equal to a credit rate multiplied by the face amount of the bond (sec. 1397E). A taxpayer holding a qualified zone academy bond on the credit allowance date is entitled to a credit. The credit is includible in gross income (as if it were a taxable interest payment on the bond), and may be claimed against regular income tax and AMT liability.

[41] The Treasury Department sets the credit rate at a rate estimated to allow issuance of qualified zone academy bonds without discount and without interest cost to the issuer. The maximum term of the bond issued is determined by the Treasury Department, so that the present value of the obligation to repay the bond is 50 percent of the face value of the bond.

[42] "Qualified zone academy bonds" are defined as bonds issued by a State or local government if (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a "qualified zone academy," and (2) private entities have promised to contribute to the qualified zone academy certain equipment, technical assistance or training, employee services, or other property or services with a value equal to at least 10 percent of the bond proceeds.

[43] A school is a "qualified zone academy" if (1) the school is a public school that provides education and training below the college level, (2) the school operates a special academic program in cooperation with businesses to enhance the academic curriculum and increase graduation and employment rates, and (3) either (a) the school is located in one of the 31 designated empowerment zones or one of the 95 designated enterprise communities, or (b) it is reasonably expected that at least 35 percent of the students at the school will be eligible for free or reduced-cost lunches under the school lunch program established under the National School Lunch Act.

Description of Proposal

In general

[44] The proposal would authorize the issuance of additional qualified zone academy bonds and of qualified school modernization bonds. It also would establish new requirements applicable to qualified zone academy bonds and qualified school modernization bonds ("tax credit bonds"). The new requirements would apply to tax credit bonds issued after December 31, 2000.

Qualified zone academy bonds

[45] The proposal would authorize the issuance of an additional $1 billion of qualified zone academy bonds in calendar year 2001 and of $1.4 billion in 2002. As under present law, the aggregate volume limit would be allocated to States according to their respective populations of individuals below the poverty line. The list of permissible uses of proceeds of qualified zone academy bonds would be expanded to include school construction. Property financed with the sale of qualified zone academy bonds would be required to be owned by a State of local government.

Qualified school modernization bonds

[46] Under the proposal, States and local governments also would be able to issue "qualified school modernization bonds" to fund the construction, rehabilitation, or repair of public elementary and secondary schools. ¹⁷ Property financed with the sale proceeds of qualified school modernization bonds would be required to be owned by a State or local government.

[47] A total of $11 billion of qualified school modernization bonds could be issued in each of 2001 and 2002, with this amount to be allocated among the States and qualifying school districts. One half of this annual $11 billion cap would be allocated among the 100 school districts with the largest number of children living in poverty and up to 25 additional school districts that the Secretary of Education determined to be in particular need of assistance. ¹⁸ The remaining half of the annual cap would be divided among the States and Puerto Rico. ¹⁹

[48] An additional $200 million of bonds in each of 2001 and 2002 would be allocated by the Secretary of the Interior for the construction, rehabilitation, and repair of the Bureau of Indian Affairs-funded elementary and secondary schools.

[49] Under the proposal, a bond would be treated as a qualified school modernization bond only if the following three requirements were satisfied: (1) the Department of Education approved the modernization plan of the State or eligible school district, which plan must (a) demonstrate that a comprehensive survey had been undertaken of the construction and renovation needs in the jurisdiction, and (b) describe how the jurisdiction would assure that bond proceeds were used as proposed; (2) the State or local governmental entity issuing the bond received an ²⁰ allocation for the bond from the appropriate entity; and (3) at least 95 percent of the bond proceeds were used to construct, rehabilitate, or repair elementary or secondary school facilities.

[50] Unlike qualified zone academy bonds, the proposed qualified school modernization bonds would not be conditioned on contributions from private businesses.

Rules generally applicable to tax credit bonds generally

[51] The proposal sets forth certain rules that would apply to all tax credit bonds. As with present-law qualified zone academy bonds, the "credit rate" for tax credit bonds would be set daily by the Treasury Department so that, on average, such bonds would be issued without interest, discount, or premium. The maximum term of the bonds would be 15 years. Credits would accrue quarterly.

[52] Unlike under present law, any taxpayer would be able to hold a tax credit bond and thereby claim the tax credit. Treasury would provide regulations regarding the treatment of credits that flow through from a mutual fund to the holder of mutual fund shares. Ownership of the bonds and credits could be separated, or "stripped;" that is, rights to future credits could be sold separately from rights to repayment of principal. Credits could also be transferred through repurchase agreements. Unused credits could not be carried back, but could be carried forward.

[53] Under the proposal, at least 95 percent of the tax credit bond proceeds would have to be used for qualifying purposes for the entire term of the bonds. Any investment earnings on the bonds would be treated as bond proceeds. As of the date of issue, issuers would have to reasonably expect to spend at least 95 percent of bond proceeds for qualifying purposes within three years. In addition, the issuer would have reasonably expect to incur a binding obligation with a third party to spend at least 10 percent of proceeds of the issue within 6 months of the date of issue. To the extent 95 percent of the proceeds was not spent for qualifying purposes within three years, the unexpended proceeds would have to be used to retire bonds within 90 days.

[54] If the issuer established a sinking fund for the repayment of the principal, all sinking fund assets would be required to be held in State and Local Government Securities ("SLGS") issued by the Treasury. Both school modernization bonds and qualified zone academy bonds could be issued using a pooled financing structure as long as each loan satisfied the applicable requirements for bonds issued on a per-project basis.

[55] Any property financed with tax credit bond proceeds would be required to be used for a qualifying purpose for at least a 15- year period after the date of issuance. If the use of a bond-financed facility changed to a non-qualifying use within that 15-year period, the bonds would cease to be qualifying bonds and would accrue no further tax credits. Further, the issuer would be required to reimburse the Treasury for all tax credits (including interest) which accrued within three years of the date of noncompliance. If the issuer failed to make a full and timely reimbursement of tax credits, holders of the bonds would be liable for any remaining amounts. Similar recapture rules would apply in the case of violations of other tax-related requirements of tax credit bonds.

[56] Effective date. -- The proposal would be effective for bonds issued on or after January 1, 2001.

Analysis

[57] The proposals to expand the allocation for (and permissible uses of) zone academy bonds and to establish school modernization bonds would subsidize a portion of the costs of new investment in public school infrastructure and, in certain qualified areas, equipment and teacher training. By subsidizing such costs, it is possible that additional investment will take place relative to investment that would take place in the absence of the subsidy. If no additional investment takes place than would otherwise, the subsidy would merely represent a transfer of funds from the Federal Government to States and local governments. This would enable States and local governments to spend the savings on other government functions or to reduce taxes. ²¹ In this event, the stated objective of the proposals would not be achieved.

[58] Though called a tax credit, the Federal subsidy for tax credit bonds is equivalent to the Federal Government directly paying the interest on a taxable bond issue on behalf of the State or local government that benefits from the bond proceeds. ²² To see this, consider any taxable bond that bears an interest rate of 10 percent. A thousand dollar bond would thus produce an interest payment of $100 annually. The owner of the bond that receives this payment would receive a net payment of $100 less the taxes owed on that interest. If the taxpayer were in the 28-percent Federal tax bracket, such taxpayer would receive $72 after Federal taxes. Regardless of whether the State government or the Federal Government pays the interest, the taxpayer receives the same net of tax return of $72. In the case of tax credit bonds, no formal interest is paid by the Federal Government. Rather, a tax credit of $100 is allowed to be taken by the holder of the bond. In general, a $100 tax credit would be worth $100 to a taxpayer, provided that the taxpayer had at least $100 in tax liability. However, for tax credit bonds, the $100 credit also has to be claimed as income. Claiming an additional $100 in income costs a taxpayer in the 28-percent tax bracket an additional $28 in income taxes, payable to the Federal Government. With the $100 tax credit that is ultimately claimed, the taxpayer nets $72 on the bond. The Federal Government loses $100 on the credit, but recoups $28 of that by the requirement that it be included in income, for a net cost of $72, which is exactly the net return to the taxpayer. If the Federal Government had simply agreed to pay the interest on behalf of the State or local government, both the Federal Government and the bondholder/ taxpayer would be in the same situation. The Federal Government would make outlays of $100 in interest payments, but would recoup $28 of that in tax receipts, for a net budgetary cost of $72, as before. Similarly, the bondholder/ taxpayer would receive a taxable $100 in interest, and would owe $28 in taxes, for a net gain of $72, as before. The State or local government also would be in the same situation in both cases.

[59] The proposed tax credit regime to subsidize public school investment raises some questions of administrative efficiencies and tax complexity. Because potential purchasers of the zone academy bonds and school modernization bonds must educate themselves as to whether the bonds qualify for the credit, certain "information costs" are imposed on the buyer. Additionally, since the determination as to whether the bond is qualified for the credit ultimately rests with the Federal Government, further risk is imposed on the investor. These information costs and other risks serve to increase the credit rate and hence the costs to the Federal Government for a given level of support to the zone academies or school modernization efforts. For these reasons, and the fact that tax credit bonds will be less liquid than Treasury Securities, the bonds would bear a credit rate that is equal to a measure of the yield on outstanding corporate bonds. ²³

[60] The direct payment of interest by the Federal Government on behalf of States or localities, which was discussed above as being economically the equivalent of the credit proposal, would involve less complexity in administering the income tax, as the interest could simply be reported as any other taxable interest. Additionally, the tax credit approach implies that non-taxable entities would only be able to invest in the bonds to assist school investment through repurchase agreements or by acquiring rights to repayment of principal if a tax credit bond is stripped. In the case of a direct payment of interest, by contrast, tax-exempt organizations would be able to enjoy such benefits.

Prior Action

[61] A similar proposal was included in the President's Fiscal Year 1999 and 2000 Budget Proposals.

[62] In 1999, legislation authorizing an additional $400 million per year of qualified zone academy bond issuance during calendar years 2000 and 2001 was enacted.

3. Expand exclusion for employer-provided educational assistance to

[63] Educational expenses paid by an employer for its employees are generally deductible to the employer.

[64] Employer-paid educational expenses are excludable from the gross income and wages of an employee if provided under a section 127 educational assistance plan or if the expenses qualify as a working condition fringe benefit under section 132. Section 127 provides an exclusion of $5,250 annually for employer-provided educational assistance. The exclusion does not apply to graduate courses beginning after June 30, 1996. The exclusion for employer-provided educational assistance expires with respect to undergraduate courses beginning on or after January 1, 2002.

[65] In order for the exclusion to apply, certain requirements must be satisfied. The educational assistance must be provided pursuant to a separate written plan of the employer. The educational assistance program must not discriminate in favor of highly compensated employees. In addition, not more than 5 percent of the amounts paid or incurred by the employer during the year for educational assistance under a qualified educational assistance plan can be provided for the class of individuals consisting of more than 5-percent owners of the employer (and their spouses and dependents).

[66] Educational expenses that do not qualify for the section 127 exclusion may be excludable from income as a working condition fringe benefit. ²⁴ In general, education qualifies as a working condition fringe benefit if the employee could have deducted the education expenses under section 162 if the employee paid for the education. In general, education expenses are deductible by an individual under section 162 if the education (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's employer, applicable law or regulations imposed as a condition of continued employment. However, education expenses are generally not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. ²⁵

Description of Proposal

[67] The proposal would extend the present-law exclusion for employer-provided educational assistance to apply to graduate courses, effective for courses beginning after July 1, 2000, and before January 1, 2002.

[68] Effective date. -- The proposal would be effective for graduate-level courses beginning after July 1, 2000, before June 1, 2002.

Analysis

[69] The exclusion for employer-provided educational assistance programs is aimed at increasing the levels of education and training in the workforce. The exclusion also reduces complexity in the tax laws.

[70] Present-law section 127 reduces the after-tax cost of employer-provided education to the employee. This cost reduction could lead to larger expenditures on education for workers than would otherwise occur. This extra incentive for education may be desirable if some of the benefits of an individual's education accrue to society at large through the creation of a better-educated populace or workforce, i.e., assuming that education creates "positive externalities." In that case, absent the subsidy, individuals would underinvest in education (relative to the socially desirable level) because they would not take into account the benefits that others indirectly receive. To the extent that expenditures on education represent purely personal consumption, a subsidy would lead to over consumption of education. ²⁶

[71] Proponents of extending and expanding the benefits provided by section 127 observe that more education generally leads to higher future wages for the individuals who receive the education. Thus, proponents argue that higher future tax payments by these individuals will compensate for the tax expenditure today. While empirical evidence does indicate that more education leads to higher wages, whether the government is made whole on the tax expenditure depends upon to which alternative uses the forgone government funds may have been put. For example, proponents of increased government expenditures on research and development point to evidence that such expenditures earn rates of return far in excess of those on most private investments. If such returns exceed the financial returns to education, reducing such expenditures to fund education benefits may reduce future tax revenues.

[72] Because present-law section 127 provides an exclusion from gross income for certain employer-provided education benefits, the value of this exclusion in terms of tax savings is greater for those taxpayers with higher marginal tax rates. Thus, higher-paid individuals, individuals with working spouses, or individuals with other sources of income may be able to receive larger tax benefits than their fellow workers. Section 127 does not apply, however, to programs under which educational benefits are provided only to highly compensated employees.

[73] In general, in the absence of section 127, the value of employer-provided education is excludable from income only if the education relates directly to the taxpayer's current job. If the education would qualify the taxpayer for a new trade or business, however, then the value of the education generally would be treated as part of the employee's taxable compensation. Under this rule, higher-income, higher-skilled individuals may be more able to justify education as related to their current job because of the breadth of their current training and responsibilities. For example, a lawyer or professor may find more courses of study directly related to his or her current job and not qualifying him or her for a new trade than would a clerk.

[74] The section 127 exclusion for employer-provided educational assistance may counteract this effect by making the exclusion widely available regardless of the employee's current job status or job description. Proponents argue that the exclusion is primarily useful to nonhighly compensated employees to improve their competitive position in the work force. In practice, however, the scant evidence available seems to indicate that those individuals receiving employer-provided educational assistance are somewhat more likely to be higher-paid workers, particularly if the exclusion is extended to graduate level courses. ²⁷ The amount of the education benefits provided by an employer also appears to be positively correlated with the income of the recipient worker. Such evidence is consistent with the observation that, in practice, the exclusion is more valuable to those individuals in higher marginal tax brackets. A reformulation of the incentive as an inclusion of the value of benefits into income in conjunction with a tax credit could make the value of the benefit more even across recipients subject to different marginal tax brackets. ²⁸

[75] Reinstating the exclusion for graduate-level employer- provided educational assistance may enable more individuals to seek higher education. Some argue that greater levels of higher education are important to having a highly trained and competitive workforce, and may be important in retraining workers who seek new employment. Others argue that the tax benefits from extending the exclusion to graduate-level education will accrue mainly to higher-paid workers. Others would argue that it would be desirable to extend the exclusion to graduate-level education, but that limiting the exclusion in this manner is appropriate given budgetary constraints.

[76] In addition to furthering education objectives, the exclusion for employer-provided educational assistance may reduce tax-law complexity. In the absence of the exclusion, employers and employees must make a determination of whether the exclusion is job- related. This determination is highly factual in nature, and can lead to disputes between taxpayers and the Internal Revenue Service ("IRS"), who may come to different conclusions based on the same facts. The exclusion eliminates the need to make this determination.

Prior Action

[77] A similar proposal to extend the exclusion to graduate- level courses was included in the President's Fiscal Year 1997, 1999, and 2000 Budget Proposals. An extension of the exclusion to graduate- level courses also was included in the Taxpayer Relief Act of 1997, the Education Savings and School Excellence Act of 1998 (105th Cong.), and the Taxpayer Refund Act of 1999, all as passed by the Senate.

4. Eliminate 60-month limit on student loan interest deduction

Present Law

[78] Present law provides an above-the-line deduction for certain interest paid on qualified education loans. The deduction is limited to interest paid on a qualified education loan during the first 60 months in which interest payments are required. Months during which the qualified education loan is in deferral or forbearance do not count against the 60-month period.

[79] The maximum allowable deduction is $2,000 in 2000, and $2,500 in 2001 and thereafter. ²⁹ The deduction is phased out ratably for individual taxpayers with modified adjusted gross income ("AGI") of $40,000-$ 55,000 and $60,000-$ 75,000 for joint returns. The income ranges will be indexed for inflation after 2002.

Description of Proposal

[80] The proposal would eliminate the limit on the number of months during which interest paid on a qualified education loan is deductible.

[81] Effective date. -- The proposal would generally be effective for interest paid on qualified education loans after December 31, 2000.

Analysis

[82] The 60-month rule serves as an overall limit on the amount of interest that may be deducted with respect to qualified education loans. Lengthening the time period over which taxpayers may deduct student loan interest expense would lead to a lower after-tax cost of financing education for those who have used large loans to finance their education or who do not repay the loans within five years (e.g., because of insufficient resources). As a consequence, lowering the after-tax cost of financing education could encourage those students that need large loans in order to finance their education to pursue more education than they would have otherwise. On the other hand, lengthening the time period over which taxpayers may deduct student loan interest expense could encourage some taxpayers to take on more debt for a given level of education expenses in order to finance a greater level of current consumption. This additional debt assumed would not be associated with a greater educational attainment, but rather, because of the fungibility of money, could serve as a way to make some consumer interest expense deductible.

[83] The 60-month rule creates administrative burdens and complexities for individuals. For example, an individual with more than one student loan may have to keep track of different 60-month periods for each loan. Issues may arise as to the proper application of the 60-month rule in the event that an individual consolidates student loans. Special rules are needed to apply the 60-month rule in common situations, such as periods of loan deferment or forbearance and refinancings. Eliminating the 60-month rule would simplify the student loan interest deduction.

[84] Other rules could be adopted to serve the purpose of the 60-month rule, but such rules also would be likely to add complexity. For example, some have suggested that the 60-month rule be replaced with a lifetime limit on the amount of deductible interest. Such a rule would require individuals to keep track of the total amount of interest they have deducted. Such records would need to be kept longer than under the 60-month rule as interest payments may be made over a longer period of time. Additional complexities would have to be addressed, such as how the lifetime limit would be allocated when there is a change in status of the taxpayer, such as through marriage or divorce. A lifetime limit would could also alter the class of taxpayers who benefit from the deduction and could create winners and losers relative to present law.

[85] Some have argued that the 60-month rule (or an alternative) is unnecessary, particularly given its complexity, because of the annual limit on the deduction. In addition, the AGI limits may serve to limit the number of years over which an individual can deduct student loan interest, because AGI may increase to a level in excess of the threshold as the individual works.

[86] In addition to simplifying the student loan interest deduction, the proposal would eliminate possible inconsistent treatment of taxpayers based on how a lender structures the interest payments on a qualified loan and when a taxpayer chooses to make payments. For example, a taxpayer who elects to capitalize interest that accrues on a loan while the taxpayer is enrolled in college (and the loan is in deferment) may be able to deduct more total interest payments than a taxpayer (with the same size qualified education loan) who elects to pay the interest currently during college. This is because the 60-month rule is suspended during the deferment, but would continue to elapse in the latter case while payments are being made.

Prior Action

[87] The proposal is similar to a proposal contained in the President's Fiscal Year 2000 Budget Proposal. A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal the beginning point of the income phaseout for individual taxpayers was increased to $45,000 and for taxpayers filing joint returns to $90,000.

5. Eliminate tax on forgiveness of direct student loans subject to

Tax treatment of student loan forgiveness

[88] In the case of an individual, gross income subject to Federal income tax does not include any amount from the forgiveness (in whole or in part) of certain student loans, provided that the forgiveness is contingent on the student's working for a certain period of time in certain professions for any of a broad class of employers (sec. 108(f)).

[89] Student loans eligible for this special rule must be made to an individual to assist the individual in attending an educational institution that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its education activities are regularly carried on. Loan proceeds may be used not only for tuition and required fees, but also to cover room and board expenses (in contrast to tax free scholarships under section 117, which are limited to tuition and required fees).

[90] The loan must be made by (1) the United States (or an instrumentality or agency thereof), (2) a State (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, county, or municipal hospital and whose employees have been deemed to be public employees under State law, or (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation. In addition, an individual's gross income does not include amounts from the forgiveness of loans made by educational organizations (and certain tax-exempt organizations in the case of refinancing loans) out of private, nongovernmental funds if the proceeds of such loans are used to pay costs of attendance at an educational institution or to refinance any outstanding student loans (not just loans made by educational organizations) and the student is not employed by the lender organization. In the case of loans made or refinanced by educational organizations (as well as refinancing loans made by certain tax-exempt organizations) out of private funds, the student's work must fulfill a public service requirement. The student must work in an occupation or area with unmet needs and such work must be performed for or under the direction of a tax-exempt charitable organization or a governmental entity.

Federal Direct Loan Program; income-contingent repayment option

[91] A major change in the delivery of Federal student loans occurred in 1993. The Student Loan Reform Act ("SLRA"), part of the Omnibus Budget Reconciliation Act of 1993, converted the Federal Family Education Loans ("FFEL"), which were made by private lenders and guaranteed by the Federal government, into direct loans made by the Federal government to students through their schools (the William D. Ford Direct Loan Program). ³⁰ The Direct Loan Program began in academic year 1994-95 and was to be phased in, with at least 60 percent of all student loan volume to be direct loans by the 1998- 1999 academic year.

[92] Federal Direct Loans include Federal Direct Stafford/ Ford Loans (subsidized and unsubsidized), Federal Direct PLUS loans, and Federal Direct Consolidation loans. The SLRA requires that the Secretary of Education offer four alternative repayment options for direct loan borrowers: standard, graduated, extended, and income- contingent. However, the income-contingent option is not available to Direct PLUS borrowers. If the borrower does not choose a repayment plan, the Secretary may choose one, but may not choose the income- contingent repayment option. ³¹ Borrowers are allowed to change repayment plans at any time.

[93] Under the income-contingent repayment option, a borrower must make annual payments for a period of up to 25 years based on the amount of the borrower's Direct Loan (or Direct Consolidated Loan), adjusted gross income (AGI) during the repayment period, and family size. ³² Generally, a borrower's monthly loan payment is capped at 20 percent of discretionary income (AGI minus the poverty level adjusted for family size). ³³ If the loan is not repaid in full at the end of a 25-year period, the remaining debt is canceled by the Secretary of Education. There is no community or public service requirement.

Description of Proposal

[94] The exclusion from income for amounts from forgiveness of certain student loans would be expanded to cover forgiveness of direct student loans made through the William D. Ford Federal Direct Loan Program, if loan repayment and forgiveness are contingent on the borrower's income level.

[95] Effective date. -- The proposal would be effective for loan cancellations after December 31, 2000.

Analysis

[96] There are three types of expenditures incurred by students in connection with their education: (1) direct payment of tuition and other education-related expenses; (2) payment via implicit transfers received from governments or private persons; and (3) forgone wages. The present-law income tax generally treats direct payments of tuition as consumption, neither deductible nor amortizable. By not including the implicit transfers from governments or private persons in the income of the student, present law offers the equivalent of expensing of those expenditures undertaken on behalf of the student by governments and private persons. This expensing-like treatment also is provided for direct transfers to students in the form of qualified scholarships excludable from income. Similarly, because forgone wages are never earned, the implicit expenditure incurred by students forgoing present earnings also receives expensing-like treatment under the present-law income tax. ³⁴

[97] The Federal government could help a student finance his or her tuition and fees by making a loan to the student or granting a scholarship to the student. In neither case are the funds received by the student includible in taxable income. Economically, a subsequent forgiveness of the loan converts the original loan into a scholarship. Thus, as noted above, excluding a scholarship from income or not including a forgiven loan in income is equivalent to permitting a deduction for tuition paid.

[98] While present-law section 117 generally excludes scholarships from income, regardless of the recipient's income level, to the extent they are used for qualified tuition and related expenses, certain other education tax benefits are subject to expenditure and income limitations. For example, the HOPE credit limits expenditures that qualify for tax benefit to $2,000 annually (indexed for inflation after the year 2000) and the Lifetime Learning credit limits expenditures that qualify for tax benefit to $5,000 annually ($ 10,000 beginning in 2003). ³⁵ In addition, the HOPE and Lifetime Learning credits are limited to taxpayers with modified adjusted gross incomes of $50,000 ($ 100,000 for joint filers) or less. No comparable expenditure or income limitations would apply to individuals who benefit from loan forgiveness under the proposal. For example, the expenditure limitation contained in section 117 would not apply; thus, the provision could permit students to exclude from income amounts in excess of the qualified tuition and related expenses that would have been excludable under section 117 had the loan constituted a scholarship when initially made. However, it could be argued that expenditure limits are not necessary because the Federal Direct Loan program includes restrictions on the annual amount that a student may borrow, and that income limitations are unnecessary because an individual who has not repaid an income contingent loan in full after 25 years generally would be a lower- income individual throughout most of that 25-year period.

[99] In addition, it could be argued that expanding section 108(f) to cover forgiveness of Federal Direct Loans for which the income-contingent repayment option is elected is inconsistent with the conceptual framework of 108(f). There is no explicit or implicit public service requirement for cancellation of a Federal Direct Loan under the income-contingent repayment option. Rather, the only preconditions are a low AGI and the passage of 25 years.

[100] As of May 1, 1996, 15 percent of the Direct Loan borrowers in repayment had selected the income-contingent option. ³⁶ Among those who choose the income-contingent repayment option, the Department of Education has estimated that slightly less than 12 percent of borrowers will fail to repay their loans in full within 25 years and, consequently, will have the unpaid amount of their loans discharged at the end of the 25-year period. ³⁷ Thus, the primary revenue effects associated with this provision would not commence until 2019 -- 25 years after the program originated in 1994.

Prior Action

[101] The proposal was included in the President's Fiscal Year 1998, 1999, and 2000 Budget Proposals, as well as in the House and Senate versions of the Taxpayer Relief Act of 1997. The proposal was, however, not included in the conference report.

6. Tax treatment of education awards under certain Federal programs

a. Eliminate tax on awards under National Health Corps Scholarship Program and F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program

Present Law

[102] Section 117 excludes from gross income amounts received as a qualified scholarship by an individual who is a candidate for a degree and used for tuition and fees required for the enrollment or attendance (or for fees, books, supplies, and equipment required for courses of instruction) at a primary, secondary, or post-secondary educational institution. The tax-free treatment provided by section 117 does not extend to scholarship amounts covering regular living expenses, such as room and board. In addition to the exclusion for qualified scholarships, section 117 provides an exclusion from gross income for qualified tuition reductions for certain education provided to employees (and their spouses and dependents) of certain educational organizations.

[103] Section 117(c) specifically provides that the exclusion for qualified scholarships and qualified tuition reductions does not apply to any amount received by a student that represents payment for teaching, research, or other services by the student required as a condition for receiving the scholarship or tuition reduction.

[104] Section 134 provides that any "qualified military benefit," which includes any allowance, is excluded from gross income if received by a member or former member of the uniformed services if such benefit was excludable from gross income on September 9, 1986.

[105] The National Health Service Corps Scholarship Program (the "NHSC Scholarship Program") and the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program (the "Armed Forces Scholarship Program") provide education awards to participants on condition that the participants provide certain services. In the case of the NHSC Program, the recipient of the scholarship is obligated to provide medical services in a geographic area (or to an underserved population group or designated facility) identified by the Public Health Service as having a shortage of health-care professionals. In the case of the Armed Forces Scholarship Program, the recipient of the scholarship is obligated to serve a certain number of years in the military at an armed forces medical facility. These education awards generally involve the payment of higher education expenses (under the NHSC Program, the awards may be also used for the repayment or cancellation of existing or future student loans). Because the recipients are required to perform services in exchange for the education awards, the awards used to pay higher education expenses are taxable income to the recipient.

Description of Proposal

[106] The proposal would provide that amounts received by an individual under the NHSC Scholarship Program or the Armed Forces Scholarship Program are eligible for tax-free treatment as qualified scholarships under section 117, without regard to any service obligation by the recipient.

[107] Effective date. -- The proposal would be effective for education awards received after December 31, 2000.

b. Eliminate tax on repayment or cancellation of student loans under NHSC Scholarship Program, Americorps Education Award Program, and Armed Forces Health Professions Loan Repayment Program

Present Law

[108] In the case of an individual, gross income subject to Federal income tax does not include any amount from the forgiveness (in whole or in part) of certain student loans, provided that the forgiveness is contingent on the student's working for a certain period of time in certain professions for any of a broad class of employers. ³⁸

[109] Student loans eligible for this special rule must be made to an individual to assist the individual in attending an educational institution that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its education activities are regularly carried on. Loan proceeds may be used not only for tuition and required fees, but also to cover room and board expenses (in contrast to tax free scholarships under section 117, which are limited to tuition and required fees).

[110] The loan must be made by (1) the United States (or an instrumentality or agency thereof), (2) a State (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, county, or municipal hospital and whose employees have been deemed to be public employees under State law, or (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation. In addition, an individual's gross income does not include amounts from the forgiveness of loans made by educational organizations (and certain tax-exempt organizations in the case of refinancing loans) out of private, nongovernmental funds if the proceeds of such loans are used to pay costs of attendance at an educational institution or to refinance any outstanding student loans (not just loans made by educational organizations) and the student is not employed by the lender organization. In the case of loans made or refinanced by educational organizations (as well as refinancing loans made by certain tax-exempt organizations) out of private funds, the student's work must fulfill a public service requirement. The student must work in an occupation or area with unmet needs and such work must be performed for or under the direction of a tax-exempt charitable organization or a governmental entity.

[111] The NHSC Scholarship Program, the Americorps Education Award Program, and the Armed Forces Health Professions Loan Repayment Program provide education awards to participants that may be used for the repayment or cancellation of existing or future student loans. However, the repayment or cancellation of student loans under these programs appears not to meet the requirements for exclusion under current-law section 108(f), because the repayment or cancellation of student loans in some instances is not contingent on the participant's working for any of a broad class of employers.

Description of Proposal

[112] The proposal would provide that any repayment or cancellation of a student loan under the NHSC Scholarship Program, the Americorps Education Award Program, or the Armed Forces Health Professions Loan Repayment Program is excludable from income. The tax-free treatment would apply only to the extent that the student incurred qualified tuition and related expenses in excess of those which were taken into account in determining the amount of any education credit claimed during academic periods when the student loans were incurred. ³⁹

[113] Effective date. -- The proposal would be effective for repayments or cancellations of student loans received after December 31, 2000.

Analysis for a. and b.

[114] Proponents of the proposed exclusions assert that the current imposition of tax liability on awards, repayments, or cancellations under the NHSC Scholarship Program, the Armed Forces Scholarship and Loan Repayment Programs, and the Americorps Education Award Program undermines the objective of providing incentives for individuals to serve as health professionals and teachers in underserved areas or as health professionals in the Armed Forces. There are, however, a number of similar federal (e.g., National Institutes of Health Undergraduate Scholarship Program) and state (e.g., Illinois Department of Public Health State Scholarships) programs that are in the same position as the programs that would be assisted by the proposal. Consequently, the proposals would result in unequal treatment of similarly situated taxpayers under various education award programs.

[115] While the Department of Defense takes the position that section 134 applies to awards made under the Armed Forces Health Professions Scholarship and Loan Repayment Programs, it has requested that the programs be included in the proposals.

Prior Action

[116] A provision similar to the proposal to eliminate tax on awards under National Health Corps Scholarship Program and F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program was included in the Education Savings and School Excellence Act of 1998 as passed by Congress and vetoed by the President and in the Taxpayer Refund and Relief Act of 1999 as passed by the Congress and vetoed by the President. There has been no prior action on the proposal to eliminate tax on repayment or cancellation of student loans under NHSC Scholarship Program, Americorps Education Award Program, and Armed Forces Health Professions Loan Repayment Program.

B. Provisions for Poverty Relief and Community Revitalization

1. Expand and simplify the EIC

Present Law

In general

[117] Certain eligible low-income workers are entitled to claim a refundable earned income credit ("EIC") on their Federal income tax returns. A refundable credit is a credit that not only reduces an individual's tax liability but allows refunds to the individual of amounts in excess of income tax liability. The amount of the credit an eligible individual may claim depends upon whether the individual has one, more than one, or no qualifying children, and is determined by multiplying the credit rate by the individual's earned income up to an earned income amount. The maximum amount of the credit is the product of the credit rate and the earned income amount. The credit is phased out above certain income levels. For individuals with earned income (or modified adjusted gross income ("AGI"), if greater) in excess of the beginning of the phase-out range, the maximum credit amount is reduced by the phase-out rate multiplied by the earned income (or modified AGI, if greater) in excess of the beginning of the phase-out range. For individuals with earned income (or modified AGI, if greater) in excess of the end of the phase-out range, no credit is allowed. In the case of a married individual who files a joint return, the income for purposes of these tests is the combined income of the couple.

[118] The parameters of the credit for taxable years beginning in 2000 are provided in Table 1, below.

             Table 1. -- Earned Income Credit Parameters

[119] For purposes of the EIC, earned income has been determined to include both taxable earned income (e.g., taxable wages, salaries, tips and net earnings from self-employment) and some nontaxable earned income (e.g., U.S. military combat pay, certain employer- provided dependent care assistance benefits, and certain housing allowances or the rental value of provided housing for the clergy).

Taxpayer identification number "TIN" requirement for individuals with qualifying children

[120] Generally, an individual must have a principal place of abode for more than one-half of the taxable year in the United States and either have a qualifying child(ren) or meet other requirements to be eligible for the EIC. Each qualifying child must meet a relationship test, a residency test and an age test. If an individual with a one qualifying child or two or more qualifying children meets the requirements of the EIC, then the individual is allowed the EIC for individuals with a qualifying child or two or more qualifying children, respectively. However, generally, the EIC available for individuals with a qualifying child (or two or more qualifying children) is denied unless the individual includes the name, age and TIN of each qualifying child on the individual's Federal income tax return for the taxable year.

[121] To qualify for the EIC available to individuals with no qualifying children, an individual (and spouse, if any) must satisfy an age test and may not be a dependent of any other taxpayer for the taxable year. Further, neither the EIC for individuals with a qualifying child (or two or more qualifying children) nor the EIC for individuals with no qualifying children is available for individuals with one or more qualifying children if the TIN reporting requirement is not satisfied for any qualifying children.

Description of Proposal

In general

[122] There are three proposed changes to the general present- law rules for the EIC. The first proposal would create a new credit rate for individuals with three or more qualifying children by increasing the currently applicable credit rate from ⁴⁰ percent to 45 percent. Because the beginning point of the phase-out range for individuals with three or more qualifying children would be the same as the present-law beginning point for other individuals with qualifying children, the larger maximum credit amount would increase the length of the phase-out range for individuals with three or more qualifying children. The maximum increase in the end-point of the phase-out range attributable to this proposal alone would be $2,307 in 2000. 40 The second proposal would increase the beginning point of the phase-out range of the EIC for certain married couples filing a joint return by $1,450. This proposal would also increase the end- point of the phase-out range by $1,450 for affected individuals and such increase would be in addition to: (1) any increase in the end- point of the phase-out range required by the larger EIC for individuals with three or more qualifying children described above; or (2) any increase attributable to the lower phase-out rate for individuals described below. The third proposal would reduce the phase-out rate of the EIC for families with two or more children from 21.06 percent to 19.06 percent. The maximum increase in the end-point of the phase-out range attributable to the third proposal would be $1,937 in 2000. ⁴¹ In combination the three proposals would increase the end-point of the EIC phase out range by a maximum of $5,937 in 2000. ⁴² The phase-out range of the EIC (including the $1,450 increase for joint returns) will continue to be indexed for inflation, as under present law.

Earned income

[123] The proposal would provide for purposes of the EIC that earned income would not include nontaxable earned income (e.g., 401(k) contributions).

Taxpayer identification number "TIN" requirement for individuals with qualifying children

[124] The proposals would make two changes. First, it would provide that an individual who meets the requirements for an EIC with no qualifying children may claim the EIC for an individual with no qualifying children where the individual has qualifying children for whom the TIN requirement is not satisfied. Second, it would clarify the operation of the AGI tiebreaker test but the specifics of the proposal are unclear.

Effective date

[125] The proposal would be effective for taxable years beginning after December 31, 1999.

Analysis

In general

[126] Proponents of the proposals may argue that they are logical extensions of a program that has already been previously expanded several times. Such proponents argue that the history of the EIC is a series of successful expansions delivering a combination of both tax relief and direct outlay monies (the refundable portion of the EIC) to working individuals and families with relatively low incomes. They argue that the EIC has delivered benefits to millions of working poor. Others note that concerns have been expressed about the size and efficacy of the EIC in recent years. By its nature as a refundable credit with general applicability, the EIC has placed significant administrative demands on the IRS. As the size and complexity of the EIC have grown, the IRS has had to expand the level of resources devoted to the credit's administration. In recent years, numerous administrative and legislative initiatives have been implemented to attempt to reduce error rates in the claiming of the credit. Given the recentness of these efforts, some may argue that a comprehensive review of the EIC and its operation is necessary before another significant expansion is implemented.

[127] The first EIC proposal would expand the EIC for families with three or more qualifying children. It would accomplish this by increasing the credit rate applicable to those families from 40 percent to 45 percent. Thus the maximum EIC for families with three or more qualifying children would be increased from $3,888 to $4,374 in 2000. ⁴³ Proponents of this proposal argue that increasing the size of the EIC to poor working families with three of more children will lift many such families out of poverty. They point out that the poverty rate for families with three of more related children is more than twice the poverty rate for smaller families, and that more than 60 percent of all poor children are in families with three or more children.

[128] Opponents of this expansion might express the concern that this proposal would provide an incentive for poor working families to have more children. They might argue that a logical extension of this proposal would be to provide ever larger credits for families with four children, five children, etc. In addition, opponents might state that help for families of working poor should not be delivered through the EIC, but rather requires a broader approach (e.g., better education or a higher minimum wage). Proponents of this expansion may respond that, in itself, the increased size of the expanded credit is not adequate to compensate for the costs of an additional child and will not act as an incentive for that reason. They may continue that this EIC expansion is very targeted relief for large working poor families, which is necessary even in the context of additional, perhaps broader, initiatives to address the issue of the working poor.

[129] The second proposal would increase the beginning point of the phase out range by $1,450 for married couples where each spouse has at least $725 of earned income. The effect of this proposed increase in the beginning of the phase-out range would be to increase the EIC for married two-earner couples in the phase-out range by an amount up to $1,450 times the phase-out rate. For example, for couples with two or more qualifying children, the maximum increase in the EIC as a result of this provision would be $1,450 multiplied by 21.06 percent, or $305.37. ⁴⁴ This proposal would also expand the number of married couples eligible for the EIC. Specifically, the $1,450 increase in the end point of the phase-out range would make married couples with earnings up to $1,450 beyond the present-law phase-out range eligible for the credit. The other EIC proposals may also increase the end point of the phase-out range in addition to any increase attributable to this proposal.

[130] Proponents of this second proposal would argue that it reduces the marriage penalty applicable to certain two-earner married couples without creating new marriage bonuses. Some opponents may express concern about the cliff effect of conditioning this relief on each spouse having at least $725 of earned income. They point out that an additional refundable credit amount of $305.37 is dependent on the addition of one dollar of earned income (from $724 to $725) to the lesser earning spouse. Notwithstanding this cliff effect, other commentators might argue that the proposal does not go far enough in relieving the marriage penalty related to the EIC. For example, an unmarried individual with $12,000 of earned income and two qualifying children who marries another individual with $24,000 of earned income and no qualifying children would lose the entire EIC ($ 3,888) under present law and would get no relief under this proposal.

[131] The third proposal would reduce the phase-out rate of the EIC for families with two or more children from 21.06 percent to 19.06 percent. Proponents of this proposal argue that high phase-out rates result in high marginal tax rates which can be a disincentive for workers in the phase-out range. They argue that reducing the phase-out rate of the EIC for children with two or more qualifying children will reduce such disincentives to work. Opponents respond that any phase-out rate creates a disincentive to work and the more a phase-out rate is lowered, the longer will be the phase-out range and the greater the likelihood that some individuals who do not need the EIC will become eligible for it.

Earned income

[132] Proponents advance three arguments for the proposal that earned income not include nontaxable earned income. First, they argue that it would ease administration of the EIC for the IRS. The IRS, they argue, would need to track only taxable income which is easier to track than nontaxable income because of the present-law third party reporting requirements. Second, they argue that the proposal would alleviate taxpayer confusion regarding what constitutes taxable and nontaxable income. Others respond that the proposal does not separately define taxable income for these purposes so that no significant simplification would be achieved. Third, since 401(k) contributions would no longer be treated as earned income for purposes of the EIC, it is argued that this provision would provide savings incentives for the working poor. Others respond that the EIC is not the reason why working poor have low savings rates and that this change is unlikely to result in increased savings by affected individuals.

[133] Another concern about this proposal is that affected individuals will have the amount of their EIC changed even though their economic income is unchanged. Approximately one million EIC filers currently in the phase-out range will be treated as having less earned income and therefore will receive a larger EIC as a result of the proposal even though their economic income is unchanged. Similarly, approximately 50,000 filers who currently have less earned income than necessary to receive the maximum EIC or to be subject to the EIC phase-out will have their total EIC decreased even though their economic income is also unchanged.

Taxpayer identification number "TIN" requirement for individuals with qualifying children

[134] This proposal is based on the argument that a technical correction is necessary to satisfy prior legislative intent to extend the EIC for individuals with no qualifying children to certain individuals who are currently ineligible. Proponents argue that the EIC for individuals with no qualifying children should be allowed to individuals who fail to satisfy the TIN reporting requirements with respect to one or more qualifying children. Opponents counter that individuals should be encouraged to obtain a TIN for qualifying children.

Prior Action

[135] No prior action.

2. Increase low-income housing tax credit annual volume limit

Present Law

[136] A tax credit, claimed over a 10-year period is allowed for the cost of rental housing occupied by tenants having incomes below specified levels. The credit percentage for newly constructed or substantially rehabilitated housing that is not otherwise Federally subsidized (with limited exceptions) is adjusted monthly by the IRS so that the 10 annual installments have a present value of 70 percent of the total qualified expenditures. The credit percentage for new substantially rehabilitated housing that also receives other Federal subsidies and for existing housing that is substantially rehabilitated is calculated to have a present value of 30 percent qualified expenditures.

[137] The aggregate credit authority provided annually to each State is $1.25 per resident. Credits that remain unallocated by States after prescribed periods are reallocated to other States through a "national pool." Credits for low-income rental housing projects financed with the proceeds of tax-exempt bonds issued under the annual State private activity bond volume limits are not subject to the credit volume limit.

Description of Proposal

[138] The State $1.25 per resident low-income housing credit limits would be increased to $1.75 per resident beginning in calendar year 2001. The $1.75 amount would be indexed for inflation beginning on calendar year 2002.

[139] Effective date. -- The proposal would be effective for calendar years beginning after December 31, 2000.

Analysis

Demand subsidies versus supply subsidies

[140] As is the case with direct expenditures, the tax system may be used to improve housing opportunities for low-income families either by subsidizing rental payments (increasing demand) or by subsidizing construction and rehabilitation of low-income housing units (increasing supply).

[141] The provision of Federal Section 8 housing vouchers is an example of a demand subsidy. The exclusion of the value of such vouchers from taxable income is an example of a demand subsidy in the Internal Revenue Code. By subsidizing a portion of rent payments, these vouchers may enable beneficiaries to rent more or better housing than they might otherwise be able to afford. The low-income housing credit is an example of a supply subsidy. By offering a subsidy worth 70 percent (in present value) of construction costs, the credit is designed to induce investors to provide housing to low- income tenants, or a better quality of housing, than otherwise would be available.

[142] A demand subsidy can improve the housing opportunities of a low-income family by increasing the family's ability to pay for more or higher quality housing. In the short run, an increase in the demand for housing, however, may increase rents as families bid against one another for available housing. Consequently, while a family who receives the subsidy may benefit by being able to afford more or better housing, the resulting increase in market rents may reduce the well-being of other families. In the long run, investors should supply additional housing because higher rents increase the income of owners of existing rental housing, and therefore may be expected to make rental housing a more attractive investment. This should ameliorate the short-term increase in market rents and expand availability of low-income housing.

[143] A supply subsidy can improve the housing opportunities of a low-income family by increasing the available supply of housing from which the family may choose. Generally, a supply subsidy increases the investor's return to investment in rental housing. An increased after-tax return should induce investors to provide more rental housing. As the supply of rental housing increases, the market rents investors charge should decline as investors compete to attract tenants to their properties. Consequently, not only could qualifying low-income families benefit from an increased supply of housing, but other renters could also benefit. In addition, owners of existing housing may experience declines in income or declines in property values as rents fall.

Efficiency of demand and supply subsidies

[144] In principle, demand and supply subsidies of equal size should lead to equal changes in improved housing opportunities. There is debate as to the accuracy of this theory in practice. Some argue that both direct expenditures and tax subsidies for rental payments may not increase housing consumption dollar for dollar. One study of the Federal Section 8 Existing Housing Program suggests that, for every $100 of rent subsidy, a typical family increases its expenditure on housing by $22 and increases its expenditure on other goods by $78. ⁴⁵ While the additional $78 spent on other goods certainly benefits the family receiving the voucher, the $100 rent subsidy does not increase their housing expenditures by $100.

[145] Also, one study of government-subsidized housing starts between 1961 and 1977 suggests that as many as 85 percent of the government-subsidized housing starts may have merely displaced unsubsidized housing starts. ⁴⁶ This figure is based on both moderate-and low-income housing starts, and therefore may overstate the potential inefficiency of tax subsidies solely for low-income housing. Displacement is more likely to occur when the subsidy is directed at projects the private market would have produced anyway. Thus, if relatively small private market activity exists for low- income housing, a supply subsidy is more likely to produce a net gain in available low-income housing units because the subsidy is less likely to displace otherwise planned activity.

[146] The theory of subsidizing demand assumes that, by providing low-income families with more spending power, their increase in demand for housing will ultimately lead to more or better housing being available in the market. However, if the supply of housing to these families does not respond to the higher market prices that rent subsidies ultimately cause, the result will be that all existing housing costs more, the low-income tenants will have no better living conditions than before, and other tenants will face higher rents. ⁴⁷ The benefit of the subsidy will accrue primarily to the property owners because of the higher rents.

[147] Supply subsidy programs can suffer from similar inefficiencies. For example, some developers who built low-income rental units before enactment of the low-income housing credit, may now find that the projects qualify for the credit. That is, the subsidized project may displace what otherwise would have been an unsubsidized project with no net gain in number of low-income housing units. If this is the case, the tax expenditure of the credit will result in little or no benefit except to the extent that the credit's targeting rules may force the developer to serve lower-income individuals than otherwise would have been the case. In addition, by depressing rents the supply subsidy may displace privately supplied housing.

Efficiency of tax subsidies

[148] Some believe that tax-based supply subsidies do not produce significant displacement within the low-income housing market because low-income housing is unprofitable and the private market would not otherwise build new housing for low-income individuals. In this view, tax-subsidized low-income housing starts would not displace unsubsidized low-income housing starts. However, the bulk of the stock of low-income housing consists of older, physically depreciated properties which once may have served a different clientele. Subsidies to new construction could make it no longer economic to convert some of these older properties to low-income use, thereby displacing potential low-income units.

[149] The tax subsidy for low-income housing construction also could displace construction of other housing. Constructing rental housing requires specialized resources. A tax subsidy may induce these resources to be devoted to the construction of low-income housing rather than other housing. If most of the existing low-income housing stock had originally been built to serve non-low-income individuals, a tax subsidy to newly constructed low-income housing could displace some privately supplied low-income housing in the long run.

[150] Supply subsidies for low-income housing may be subject to some additional inefficiencies. Much of the low-income housing stock consists of older structures. Subsidies to new construction may provide for units with more amenities or units of a higher quality than low-income individuals would be willing to pay for if given an equivalent amount of funds. That is, rather than have $100 spent on a newly constructed apartment, a low-income family may prefer to have consumed part of that $100 in increased food and clothing. In this sense, the supply subsidy may provide an inefficiently large quantity of housing services from the point of view of how consumers would choose to allocate their resources. However, to the extent that maintenance of a certain standard of housing provides benefits to the community, the subsidy may enhance efficiency. If the supply subsidy involves fixed costs, such as the cost of obtaining a credit allocation under the low-income housing credit, a bias may be created towards large projects in order to amortize the fixed cost across a larger number of units. This may create an inefficient bias in favor of large projects. On the other hand, the construction and rehabilitation costs per unit may be less for large projects than for small projects. Lastly, unlike demand subsidies which permit the beneficiary to seek housing in any geographic location, supply subsidies may lead to housing being located in areas which, for example, are farther from places of employment than the beneficiary would otherwise choose. In this example, some of benefit of the supply subsidy may be dissipated through increased transportation cost.

Targeting the benefits of tax subsidies

[151] A supply subsidy to housing will be spent on housing; although, as discussed above, it may not result in a dollar-for- dollar increase in total housing spending. To insure that the housing, once built, serves low-income families, income and rent limitations for tenants must be imposed as is the case for demand subsidies. While an income limit may be more effective in targeting the benefit of the housing to lower income levels than would an unrestricted market, it may best serve only those families at or near the income limit.

[152] If, as with the low-income housing credit, rents are restricted to a percentage of targeted income, the benefits of the subsidy may not accrue equally to all low-income families. Those with incomes beneath the target level may pay a greater proportion of their income in rent than does a family with a greater income. On the other hand, to the extent that any new, subsidy-induced housing draws in only the targeted low-income families with the highest qualifying incomes it should open units in the privately provided low-income housing stock for others.

[153] Even though the subsidy may be directly spent on housing, targeting the supply subsidy, unlike a demand subsidy, does not necessarily result in targeting the benefit of the subsidy to recipient tenants. Not all of the subsidy will result in net additions to the housing stock. The principle of a supply subsidy is to induce the producer to provide something he or she otherwise would not. Thus, to induce the producer to provide the benefit of improved housing to low-income families, the subsidy must provide benefit to the producer.

[154] Targeting tax incentives according to income can result in creating high implicit marginal tax rates. For example, if rent subsidies are limited to families below the poverty line, when a family is able to increase its income to the point of crossing the poverty threshold the family may lose its rent subsidy. The loss of rent subsidy is not unlike a high rate of taxation on the family's additional income. The same may occur with supply subsidies. With the low-income housing credit, the percentage of units serving low-income families is the criteria for receiving the credit. Again, the marginal tax rate on a dollar of income at the low-income threshold may be very high for prospective tenants.

Data relating to the low-income housing credit

[155] Comprehensive data from tax returns concerning the low- income housing tax credit currently are unavailable. However, Table 2, below, presents data from a survey of State credit allocating agencies.

 Table 2. -- Allocation of the Low-Income Housing Credit, 1987-1997

[157] A Department of Housing and Urban Development study has attempted to measure the costs and benefits of the low-income housing credit compared to that of the Federal Section 8 housing voucher program. ⁴⁹ This study attempts to compare the costs of providing a family with an identical unit of housing, using either a voucher or the low-income housing credit. The study concludes that on average the low-income housing credit provides the same unit of housing as would the voucher at two and one half times greater cost than the voucher program. However, this study does not attempt to measure the effect of the voucher on raising the general level of rents, nor the effect of the low-income housing credit on lowering the general level of rents. The preceding analysis has suggested that both of these effects may be important. In addition, as utilization of the credit has risen, the capital raised per credit dollar has increased. This, too, would reduce the measured cost of providing housing using the low-income credit.

Increasing State credit allocations

[158] The dollar value of the State allocation of $1.25 per capita was set in the 1986 Act and has not been revised. Low-income housing advocates observe that because the credit amount is not indexed, inflation has reduced its real value since the dollar amounts were set in 1986. The Gross Domestic Product ("GDP") price deflator for residential fixed investment measures 47.6 percent price inflation between 1986 and the fourth quarter of 1999. Had the per capita credit allocation been indexed for inflation, using this index to reflect increased construction costs, the value of the credit today would be approximately $1.84. ⁵⁰ While not indexing for inflation, present law does provide for annual adjustments to the State credit allocation authority based on current population estimates. Because the need for low-income housing can be expected to correlate with population, the annual credit limitation already is adjusted to reflect changing needs.

[159] The revenue consequences estimated by the Joint Committee staff of increasing the per capita limitation understate the long-run revenue cost to the Federal Government. This occurs because the Joint Committee staff reports revenue effects only for the 10-year budget period. Because the credit for a project may be claimed for 10 years, only the total revenue loss related to those projects placed in service in the first year are reflected fully in the Joint Committee staff's 10-year estimate. The revenue loss increases geometrically throughout the budget period as additional credit authority is granted by the States and all projects placed in service after the first year of the budget period produce revenue losses in years beyond the 10-year budget period.

Prior Action

[160] A similar proposal was included in the President's Fiscal Year 1999 and 2000 Budget Proposals.

[161] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, and in the Wage and Employment Growth Act of 1999, as passed by the House.

3. Provide new markets tax credit

Present Law

[162] A number of tax incentives are available for investments and loans in low-income communities. For example, tax incentives are available to taxpayers that invest in specialized small business investment companies licensed by the Small Business Administration ("SBA") to make loans to, or equity investments in, small businesses owned by persons who are socially or economically disadvantaged. A tax credit is allowed over a 10-year period for qualified contributions to selected community development corporations that provide assistance in economically distressed areas. A tax credit is allowed over a 10-year period for rental housing occupied by tenants having incomes below specified levels. Certain businesses that are located in empowerment zones and enterprise communities designated by HUD and the Secretary of the Department of Agriculture also qualify for Federal tax incentives.

Description of Proposal

[163] The proposal would create a new tax credit for qualified investments made to acquire stock (or other equity interests) in a selected community development entity ("CDE"). The credits would be allocated to CDEs pursuant to Treasury Department regulations. During the period 2001-2005, the maximum amount of investments that would qualify for the credit would be capped at an aggregate annual amount of $3 billion (a maximum of $15 billion for the entire period of the tax credit). If a CDE fails to sell equity interests to investors up to the amount authorized within five years of the authorization, then the remaining authorization would be canceled, and the Treasury Department could authorize another CDE to issue equity interests for the unused portion. ⁵¹

[164] The credit allowed to the investor (either the original purchaser or a subsequent holder) would be a six-percent credit for the year in which the equity interest is purchased from the CDE and each anniversary date (for four years) after the qualified equity interest is purchased from the CDE. The taxpayer's basis in the investment would be reduced by the amount of the credit. The credit would be subject to the general business credit rules.

[165] A "qualified equity investment" refers to common stock or a similar equity interest acquired directly from a CDE in exchange for cash. ⁵² The stock or equity interest must not be redeemed (or otherwise cashed out) by the CDE for at least five years. Substantially all of the investment proceeds must be used by the CDE to make "qualified low-income community investments," meaning equity investments in, or loans to, qualified active businesses located in low-income communities, certain financial counseling and other services provided to businesses and residents in low-income communities. ⁵³ Qualified low-income community investments could be made directly by a CDE, or could be made indirectly through another CDE. ⁵⁴

[166] A CDE would include (but would not be limited to) Community Development Financial Institutions, Community Development Corporations, Small Business Investment Corporations-LMIs, New Market Venture Capital Firms, America's Private Investment Corporations, or other investment funds (including for-profit subsidiaries of nonprofit organizations). To be selected for a credit allocation, the CDE's primary mission must be serving or providing investment capital for low-income communities or low-income persons. The CDE also must maintain accountability to residents of low-income communities through representation on governing or advisory boards, or otherwise.

[167] As part of the credit allocation process, the Treasury Department would certify entities as eligible CDEs. Certified entities would be required to file annual reports demonstrating that they continue to meet the requirements for initial certification. The certified entities also would be required to identify the amount (and purchasers) of equity interests with respect to which allocated credits may be claimed by the purchaser and to demonstrate that the entity monitors its investments to ensure that capital is used in low-income communities. If an entity fails to be a CDE during the five-year period following the taxpayer's purchase of an equity interest in the entity, or if the equity interest is redeemed by the issuing entity during that five-year period, then any credits claimed with respect to the equity interest would be recaptured (with interest) and no further credits would be allowed.

[168] A "low-income community" would be defined as census tracts with either (1) poverty rates of at least 20 percent (based on the most recent census data), or (2) median family income which does not exceed 80 percent of the greater of metropolitan area income or statewide median family income (or for a non-metropolitan census tract, 80 percent of non-metropolitan statewide median family income). In addition, any area that is part of an "empowerment zone" or "enterprise community" designated by section 1391 would be treated as a low-income community for purposes of the proposal.

[169] A "qualified active businesses" generally would be defined as a business which satisfies ⁵⁵ the following requirements (1) at least 50 percent of the total gross income of the business is derived from the active conduct of trade or business activities in low-income communities; (2) a substantial portion of the use of the tangible property of such business is used within low-income communities; (3) a substantial portion of the services performed for such business by its employees is performed in low-income communities; and (4) less than 5 percent of the average aggregate of unadjusted bases of the property of such business is attributable to certain financial property (e.g. debt, stock, partnership interests, options, futures contracts) or to collectibles (other than collectibles held primarily for sale to customers). For purposes of the credit, there would be no requirement that employees of a "qualified active business" be residents of the low income community.

[170] Rental of improved commercial real estate located in a low-income community (e.g., an office building or shopping mall) would be a qualified active business, regardless of the characteristics of the commercial tenants of the property. In addition, a qualified active business that receives a loan from a CDE could include an organization that is organized and operated on a non-profit basis. The purchase and holding of unimproved real estate would not be a qualified active business. In addition, a qualified active business would not include (a) any business consisting predominantly of the development or holding of intangibles for sale or license; (b) operation of any facility described in sec. 144(c)(6)(B); or (c) any business if a significant equity interest in such business is held by a person who also holds a significant equity interest in the CDE.

[171] The Treasury Department would be granted authority to prescribe such regulations as may be necessary or appropriate to carry out the purposes of the proposal, including regulations limiting the benefit of the proposed tax credit in circumstances where investments are directly or indirectly being subsidized by other Federal programs (e.g., low-income housing credit and tax- exempt bonds), regulations preventing abuse of the credit through the use of related parties and regulations which apply the provisions to newly formed entities. The Treasury Department would issue regulations describing the certification process for CDEs, and annual reporting requirements for selected entities.

[172] Effective date. -- The proposal would be effective for qualified investments made after December 31, 2000.

Analysis

[173] The proposal would create a new incentive for taxpayers that make capital available for use in inner cities and isolated rural communities, in the form of a guaranteed return on an equity investment. Generally, a non-preferred equity investment carries few or no guarantees of return. The incentive provided under the proposal is in effect a guaranteed return in the form of a tax credit. Hence, for taxpayers who can claim the new markets tax credit, their equity investment in the CDE is similar to owning preferred stock in the CDE which converts to common stock after five years, except that the preferred dividend (the tax credit) is guaranteed by the Federal government rather than backed by the revenue of the CDE. By guaranteeing a return, the proposal both reduces the aggregate return the CDE must hope to earn in order to attract investors to the CDE and reduces the risk of an investment in a CDE. Thus, the proposal should reduce the cost of raising capital to the CDE. The proposal requires the CDE to use substantially all of the new capital to make qualified low-income community investments.

[174] There may be a loss of efficiency from funneling a tax benefit to qualified low-income community businesses through CDEs. If the pool of potential qualifying investments is large relative to the pool of CDE funds, the competing businesses would bid up the returns they promise the CDE and, thereby, the tax benefit would remain with the CDE rather than the businesses. On the other hand, if the pool of potential qualifying investments is small relative to the pool of CDE funds, the CDEs would compete among themselves for qualifying investments and the businesses would receive the benefits of a lower cost of capital.

[175] Proponents would argue that capital markets are not fully efficient. In particular, a bias may exist against funding business ventures in low-income communities, with investors demanding a higher rate of return on such ventures than the proponents believe is justified by market conditions. The proposal attempts to influence investment decisions by increasing the net, after-tax, return to qualified low-income investments compared to other investments in order to reverse the effects of this bias. By reducing the cost of capital, the proposal could make location in a qualifying low-income community profitable.

[176] Opponents would argue that a higher cost of capital does not imply that markets are ⁵⁶ inefficient. The cost of capital reflects investors' perceptions of risk. Where a business locates may increase the probability of its failure and thereby increase its cost of capital. Artificially diverting investment funds in one direction results in certain investments that offer a lower rate of return being funded in lieu of other investments that offer a higher rate of return. Moreover, the proposal does not limit the CDE's investments to those investments that otherwise have a higher cost of capital. Loans to a Fortune 500 company would be permissible under the proposal. However, a CDE's plans to make such loans presumably would be a factor taken into account when the CDE applies for a credit allocation.

[177] Proponents would argue that, even if the higher cost of capital to such businesses is not the result of inefficiency of the capital market, an important social goal can be achieved by helping target investment to low-income communities. Opponents would argue that this objective could be addressed through existing programs, such as the community development corporations, the empowerment zone and empowerment communities, and by requirements of the Community Redevelopment Act and other similar legislation. ⁵⁷ They also would question whether the proposal is the most efficient means of achieving this objective. It will take time and resources to implement this proposal. By contrast, the SBA already has programs in place that are designed to achieve similar objectives. ⁵⁸

[178] The proposal is expected to result in the imposition of new recordkeeping and other administrative burdens on CDEs. Each CDE presumably would have to establish extensive procedures by which it evaluates, selects and monitors the businesses in which it invests (and with its community accountability requirements) on an ongoing basis to ensure its continued qualification as a CDE. For example, a CDE that makes a loan to a qualified active business in the low- income community would need to verify that the business satisfies the requirements of a "qualified active business" throughout the term of the loan. Each CDE also would need to develop a process by which it allocates the tax credit to investors, and keep sufficient records concerning its investors (and former investors) in the event it fails to maintain its CDE status (which would result in a recapture of any credits claimed by investors within the previous five years). The CDEs also would have additional reporting requirements for the IRS.

[179] The proposal provides that the Treasury Department allocate the tax credits among CDEs. The description of the proposal notes that the Treasury Department would give priority to entities with records of having successfully provided capital or technical assistance to disadvantaged business or communities. However, it should be expected that many of the entities seeking CDE status will be new entities and, as such, would not have a proven record upon which the Treasury

[180] Department could rely. In the absence of legislative criteria providing qualifications for the allocation of the credits among CDEs, some also might question whether the proposal raises concerns regarding the delegation of such taxing power by the Congress to the Executive Branch.

Prior Action

[181] A similar proposal was included in the President's Fiscal Year 2000 Budget Proposal. ⁵⁹

4. Extend and expand empowerment zone incentives

Present Law

[182] Pursuant to the Omnibus Budget Reconciliation Act of 1993 ("OBRA 1993"), the Secretaries of the Department of Housing and Urban Development and the Department of Agriculture designated a total of nine empowerment zones (and 95 enterprise communities). Of the nine empowerment zones, six are located in urban areas and three are located in rural areas. ⁶⁰ The Taxpayer Relief Act of 1997 ("1997 Act") authorized the designation of two additional urban empowerment zones (collectively, the "11 Round I empowerment zones"), with respect ⁶¹ to which the same tax benefits generally are available for businesses located in the nine original empowerment zones.

[183] Businesses located in the 11 Round I empowerment zones qualify for the following tax incentives: (1) a 20-percent wage credit for the first $15,000 of wages paid to a zone resident who works in the empowerment zone (the "wage credit"); (2) an additional $20,000 of section ⁶² 179 expensing for "qualified zone property" placed in service by an enterprise zone business; (3) special tax- exempt financing for certain zone facilities and (4) "brownfields" expensing for certain environmental remediation expenditures. ⁶³ The tax incentives with respect to the nine empowerment zones designated by OBRA 1993 are generally available during the 10-year period of 1995 through 2004. The tax incentives with respect to the two additional urban empowerment zones are generally available during the 10-year period of 2000 through 2009 (except for the wage credit, which begins to phase down in 2005 and expires after 2007).

[184] The 1997 Act also authorized the designation of 20 additional empowerment zones ("Round II empowerment zones"), of which 15 are located in urban areas and five are located in rural areas. ⁶⁴ Businesses in the Round II empowerment zones are not eligible for the wage credit (but are eligible to receive up to $20,000 of additional section 179 expensing, to utilize brownfields expensing, and to utilize the special tax-exempt financing benefits). The tax incentives with respect to the Round II empowerment zones are generally available during the 10-year period of 1999 through 2008.

Description of Proposal

[185] The proposal would expand the tax incentives available to the existing empowerment zones and provide for the designation of ten new empowerment zones.

[186] First, the designation of empowerment zone status for Round I and II empowerment zones would be extended through December 31, 2009.

[187] Second, the 20-percent wage credit would be made available in all Round I and II empowerment zones. The credit rate would remain at 20 percent (rather than being phased down) through December 31, 2009, in all empowerment zones.

[188] Third, an additional $35,000 (rather than $20,000) of section 179 expensing would be available for qualified zone property placed in service after December 31, 2000, and prior to December 31, 2009, by a qualified business in any of the empowerment zones. ⁶⁵

[189] Fourth, the Secretaries of the Department of Housing and Urban Development and the Department of Agriculture would be authorized to designate 10 additional empowerment zones (the "Round III empowerment zones"). Eight of these Round III empowerment zones would be located in urban areas, and two would be located in rural areas. The eligibility and selection criteria for the 10 Round III empowerment zones would be the same as the criteria that applied to the Round II empowerment zones authorized by the 1997 Act. During the period 2002 through 2009, businesses located in the Round III empowerment zones would be eligible for the 20-percent wage credit, an additional $35,000 of section 179 expensing, special tax-exempt financing benefits, and brownfields expensing. ⁶⁶

[190] Effective date. -- The proposal would be effective after December 31, 2000.

Analysis

Extension of scheduled expiration date

[191] The proposal would extend the empowerment zone designation for all presently existing empowerment zones through December 31, 2009. Extending the program beyond its scheduled expiration would allow these communities additional time to further promote economic development. Some would argue that extension would assist in attracting new businesses and help retain current ones because of the certainty that the tax incentives will be available through 2009. On the other hand, evidence is limited and mixed regarding the extent to which empowerment zone tax incentives help attract new business or retain current business. ⁶⁷

Expansion of wage credit and section 179 expensing

[192] The proposal expands two tax incentives for empowerment zones. First, the proposal makes the 20-percent wage credit available to all empowerment zones. Currently, the Round II empowerment zones are not eligible for the wage credit, and the wage credit for the Los Angeles and Cleveland zones are scheduled to phase down in 2005 and expire after 2007. Second, the proposal increases the amount of additional section 179 expensing from $20,000 to $35,000 for qualified zone property.

[193] The effect of the tax incentives on the success of the empowerment zone program is unclear. A recent GAO report analyzed the use of empowerment zone tax incentives. ⁶⁸ The GAO identified 13,590 business operating in the original nine empowerment zones. It surveyed 2,400 of these businesses on their usage of the empowerment zone tax incentives. The report highlights a general lack of knowledge among the survey respondents about the availability of the incentives.

[194] The GAO report found that the wage credit was the most frequently used tax incentive. According to the responses to the GAO survey, 42 percent of large urban businesses, 6 percent of small urban businesses and 32 percent of the rural businesses used the wage credit. The most frequently cited reasons for not claiming the credit were (1) that the business did not qualify for the credit because its employees lived outside the zone and (2) that the businesses did not know about the credit.

[195] Extending the wage credit, as recommended by the proposal, would provide uniformity among the various empowerment zones and could increase use of the credit. It would provide all empowerment zones with the same length of wage credit benefit. In addition, the GAO reported that the number of employees working in empowerment zones has increased for the survey respondents present in the zone since its designation. The survey respondents stated that the wage credit was at least "somewhat important" to making decisions about hiring employees who live in the zones. Expanding the availability of the wage credit could assist in increasing employment of those persons living inside the empowerment zones.

[196] According to the GAO, the increased section 179 expensing deduction was used less than the wage credit. The GAO reported that of the businesses surveyed, 9 percent of large urban businesses, 4 percent of small urban businesses, and 8 percent of rural businesses used the increased expensing deduction. The four most frequently cited reasons for not claiming the deduction were (1) a lack of knowledge about the increased deduction, (2) a lack of investment in "qualified zone property," (3) insufficient business investments to use the deductions and (4) insufficient income to use the deduction. ⁶⁹

[197] Some would argue that, given the lack of knowledge suggested by the GAO report, instead of increasing the expensing deduction, emphasis should be placed on educating the public about its current availability. The other reasons given for not using the deduction suggest that increasing the amount of the deduction would not increase its use. The businesses not using the deduction reported that they did not invest in qualified zone property, had insufficient business investments to use the deduction, or had insufficient income to use the deduction. An increase in the amount of the deduction would not remove these obstacles. Nonetheless, an increased public awareness effort in combination with the increased amount may make the deduction more attractive to businesses, therefore, triggering investment and resulting in increased economic activity within the zone.

Round III empowerment zones

[198] The proposal would authorize the Secretaries of Housing and Urban Development and Agriculture to designate 10 additional empowerment zones, eight in urban areas and two in rural areas. During the period 2002 to 2009, these empowerment zones would be eligible for the 20 percent wage credit, an additional $35,000 in section 179 expensing, tax-exempt financing, and brownfields expensing.

[199] Some would argue that it is difficult to gauge the success of the empowerment zone program. The proposal seeks to extend the expiration date for the original empowerment zones to allow them to reach the desired level of economic development. In light of this proposed extension, some would argue against expanding the program further without an empirical analysis of the current program. On the other hand, each empowerment zone, while sharing characteristics of poverty and distress, is still unique in its composition and environment. Therefore, the degree of success in any particular zone, is not necessarily an indicator of the success that could be achieved in future zones. Extension of the empowerment zone designation may assist additional communities in their effort to address their economic distress.

Prior Action

[200] A proposal in the President's Fiscal Year 2000 Budget Proposal would have made the wage credit available to businesses located in the two additional urban empowerment zones.

5. Tax credit for contributions to qualified zone academies and

Qualified zone academy bonds

[201] As an alternative to traditional tax-exempt bonds, States and local governments are given the authority to issue "qualified zone academy bonds." A total of $400 million of qualified zone academy bonds is authorized to be issued in each of 1998, 1999, 2000, and 2001. The $400 million aggregate bond cap is allocated each year to the States according to their respective populations of individuals below the poverty line. Each State, in turn, allocates the credit within the State.

[202] Certain financial institutions that hold qualified zone academy bonds are entitled to a nonrefundable tax credit in an amount equal to a credit rate multiplied by the face amount of the bond (sec. 1397E). A taxpayer holding a qualified zone academy bond on the credit allowance date is entitled to a credit. The credit is includible in gross income (as if it were a taxable interest payment on the bond), and may be claimed against regular income tax and AMT liability.

[203] The Treasury Department sets the credit rate at a rate estimated to allow issuance of qualified zone academy bonds without discount and without interest cost to the issuer. The maximum term of the bond issued is determined by the Treasury Department, so that the present value of the obligation to repay the bond is 50 percent of the face value of the bond.

[204] "Qualified zone academy bonds" are defined as bonds issued by a State or local government if (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a "qualified zone academy," and (2) private entities have promised to contribute to the qualified zone academy certain equipment, technical assistance or training, employee services, or other property or services with a value equal to at least 10 percent of the bond proceeds.

[205] A school is a "qualified zone academy" if (1) the school is a public school that provides education and training below the college level, (2) the school operates a special academic program in cooperation with businesses to enhance the academic curriculum and increase graduation and employment rates, and (3) either (a) the school is located in one of the 31 designated empowerment zones or one of the 95 designated enterprise communities, or (b) it is reasonably expected that at least 35 percent of the students at the school will be eligible for free or reduced-cost lunches under the school lunch program established under the National School Lunch Act.

Rules applicable to corporate contributions

[206] The maximum charitable contribution deduction that may be claimed by a corporation for any one taxable year is limited to 10 percent of the corporation's taxable income for that year (disregarding charitable contributions and with certain other modifications) (sec. 170(b)(2)). Corporations also are subject to certain limitations based on the type of property contributed. In the case of a charitable contribution of short-term gain property, inventory, or other ordinary income property, the amount of the deduction generally is limited to the taxpayer's basis (generally, cost) in the property. However, special rules in the Code provide augmented deductions for certain corporate contributions of specific types of property. Under these special ⁷⁰ rules, the amount of the augmented deduction available to a corporation making a qualified contribution generally is equal to its basis in the donated property plus one-half of the amount of ordinary income that would have been realized if the property had been sold. However, the augmented deduction cannot exceed twice the basis of the donated property.

Description of Proposal

[207] A credit against Federal income taxes would be allowed for corporate sponsorship payments made to a qualified zone academy, public library, or community technology center located in a designated empowerment zone or enterprise community. The credit would equal 50 percent of cash contributions. For purposes of the credit, a qualified zone academy located outside of a designated empowerment zone or enterprise community would be treated as located within such a zone or community if a significant percentage of the academy's students reside in the zone or community. A public library or community technology center located outside of a designated empowerment zone or enterprise community would be treated as located within such a zone or community if it is adjacent to such a zone or community.

[208] For this purpose, a community technology center generally would refer to any nonprofit organization that is eligible to receive deductible charitable contributions (including a governmental instrumentality) and whose principal purpose is to provide disadvantaged residents of economically distressed communities with access to information technology and related training.

[209] The credit would be available only if a credit allocation has been made with respect to the corporate sponsorship payment by the local governmental agency with responsibility for implementing the strategic plan of the empowerment zone or enterprise community under section 1391(f)(2). The local governmental agency for each of the empowerment zones (including the 10 new empowerment zones proposed under the President's Fiscal Year 2001 Budget) would be allowed to designate up to $16 million of sponsorship payments to qualified zone academies, public libraries, and community technology centers as eligible for the 50-percent credit (that is, up to $8 million of credits). The local governmental agency for each of the enterprise communities would be allowed to designate up to $4 million of contributions to qualified zone academies, public libraries, and community technology centers as eligible for the 50-percent credit (that is, up to $2 million of credits). There is no limit on the amount of allocated credits that could be claimed by any one corporate sponsor; thus one sponsor could claim all the credits available in a particular zone or community. The deduction otherwise allowed for a corporate sponsorship payment would be reduced by the amount of the credit claimed with respect to such payment by the corporate sponsor. The proposed credit would be subject to the general business credit rules under present-law section 38.

[210] Effective date. -- The proposal would be effective for corporate sponsorship payments made after December 31, 2000.

Analysis

[211] The proposal's objective is to encourage private sector support of and participation in educational programs conducted at certain qualified zone academies, public libraries, and community technology centers located in empowerment zones and enterprise communities. By offering a tax credit to participating corporations, the proposal would lower the after-tax cost of a corporate contribution beyond that currently provided by the deduction for charitable contributions. Specifically, under present law, a corporate taxpayer in the 35-percent bracket faces an after-tax cost of only 65 cents for each dollar of charitable contributions, since the dollar deduction yields a tax saving of 35 cents. With the proposed 50-percent credit, this same taxpayer would have more than half of its contribution, in effect, subsidized by the federal government. In addition to the 50-cent credit per dollar of contribution, the taxpayer would still be permitted to deduct from taxable income 50 cents of that dollar (the contribution amount minus the credit). Such 50-cent deduction would be worth 17.5 cents to a corporate taxpayer in the 35-percent tax bracket. Thus, the total after-tax cost of a dollar contribution under the proposal is only 32.5 cents (1 dollar less the 50-cent credit less the 17.5-cent value of the 50-cent deduction), as compared to 65 cents under present-law rules. The effect of the credit cuts the taxpayer's cost of giving in half compared to present law. ⁷¹

[212] The purpose of the present-law charitable deduction, and the proposed credit, is to encourage charitable giving by making giving less expensive. Economic studies have generally found that, at least with respect to individual donors, the charitable contribution deduction has ⁷² both encouraged giving, and done so efficiently in that the additional charitable contributions that the deduction encourages exceed the revenue cost to the federal government of the deduction. Thus, to the extent that the charitable contribution serves a useful public service, it is argued that the deduction is cheaper than appropriating the funds that would be necessary to achieve the same public service. At the same time, it is also argued that private organizations can in many instances perform a charitable function more efficiently than a government agency. Others argue that not all activities subsidized by the deduction serve a truly public purpose, and thus would prefer to see the deduction eliminated and replaced with greater direct public spending. However, since the proposed credit is restricted to certain purposes, the latter objection is not relevant provided a true public service is promoted by the credit.

[213] The proposal defines qualified zone academies for purposes of the proposed tax credit differently than under current law. Specifically, the proposal would limit eligible qualified zone academies to those schools that are located in an empowerment zone or enterprise community, or that have a "significant" percentage of their students residing in an empowerment zone or enterprise community. The proposal does not define the term "significant" for purposes of the residency requirement. In contrast to present law, the proposal would exclude from the definition of qualified zone academy those schools located outside a zone or community at which at least 35 percent of the students are eligible for free or reduced- cost lunches, but which do not meet the proposal's student residency requirement. In addition, under the proposal's definition, those schools located outside a zone or community that fail the present-law subsidized lunch qualification, but that meet the proposal's student residency requirement, would qualify as qualified zone academies for purposes of the proposed tax credit, although they are not qualified zone academies under present law. Presumably, the objective of the proposal's different definition of qualified zone academy is to ensure that allocated tax credits reach only those schools with a relatively high percentage of students who are residents of an empowerment zone or enterprise community. However, the differing definitions of qualified zone academies for purposes of the proposed tax credit and for other purposes may cause some confusion on the part of affected schools.

[214] The proposal also would permit corporations to receive a tax credit for contributions to public libraries and community technology centers, which are not located in an empowerment zone or enterprise community, but which are "adjacent" to such a zone or community. The proposal does not define what areas are considered to be adjacent to a zone or community; however, presumably the local governmental agencies that are responsible for making the credit allocations for sponsorship payments would have an interest in ensuring that such allocations are appropriate.

Prior Action

[215] A similar proposal was included in the President's Fiscal Year 2000 Budget Proposal.

6. Enhanced deduction for corporate contributions of computers

Present Law

[216] The maximum charitable contribution deduction that may be claimed by a corporation for any one taxable year is limited to 10 percent of the corporation's taxable income for that year (disregarding charitable contributions and with certain other modifications) (sec. 170(b)(2)). Corporations also are subject to certain limitations based on the type of property contributed. In the case of a charitable contribution of short-term gain property, inventory, or other ordinary income property, the amount of the deduction generally is limited to the taxpayer's basis (generally, cost) in the property. However, special rules in the Code provide an augmented deduction for certain corporate contributions. Under these special rules, the amount of the augmented deduction is equal to the lesser of (1) the basis of the donated property plus one-half of the amount of ordinary income that would have been realized if the property had been sold, or (2) twice the basis of the donated property.

[217] Section 170(e)(6) allows corporate taxpayers an augmented deduction for qualified contributions of computer technology and equipment (i.e., computer software, computer or peripheral equipment, and fiber optic cable related to computer use) to be used within the United States for educational purposes in grades K-12. Eligible donees are: (1) any educational organization that normally maintains a regular faculty and curriculum and has a regularly enrolled body of pupils in attendance at the place where its educational activities are regularly carried on; and (2) tax-exempt charitable organizations that are organized primarily for purposes of supporting elementary and secondary education. A private foundation also is an eligible donee, provided that, within 30 days after receipt of the contribution, the private foundation contributes the property to an eligible donee described above.

[218] Qualified contributions are limited to gifts made no later than two years after the date the taxpayer acquired or substantially completed the construction of the donated property. In addition, the original use of the donated property must commence with the donor or the donee. Accordingly, qualified contributions generally are limited to property that is no more than two years old. Such donated property could be computer technology or equipment that is inventory or depreciable trade or business property in the hands of the donor.

[219] Donee organizations are not permitted to transfer the donated property for money or services (e.g., a donee organization cannot sell the computers). However, a donee organization may transfer the donated property in furtherance of its exempt purposes and be reimbursed for shipping, installation, and transfer costs. For example, if a corporation contributes computers to a charity that subsequently distributes the computers to several elementary schools in a given area, the charity could be reimbursed by the elementary schools for shipping, transfer, and installation costs.

[220] The special treatment applies only to donations made by C corporations. S corporations, personal holding companies, and service organizations are not eligible donors.

[221] The provision is scheduled to expire for contributions made in taxable years beginning after December 31, 2000.

Description of Proposal

[222] The proposal would extend the current enhanced deduction for donations of computer technology and equipment through June 30, 2004. The proposal also would expand the deduction to apply to contributions of computer equipment to a public library or community technology center located in a designated empowerment zone or enterprise community, or in a census tract with a poverty rate of 20 percent of more (currently defined by the 1990 census). For this purpose, a community technology center generally would refer to any nonprofit organization that is eligible to receive deductible charitable contributions (including a governmental instrumentality) and whose principal purpose is to provide disadvantaged residents of economically distressed communities with access to information technology and related training.

[223] Effective date. -- The proposal would be effective for contributions made after December 31, 2000 and before July 1, 2004.

Analysis

[224] The enhanced deduction for charitable contributions of computer technology and equipment is intended to provide an incentive for businesses to contribute computer equipment and software for the benefit of primary and secondary school students in order to provide schools with the technological resources necessary to prepare both teachers and students for an increasingly technologically advanced society. The proposed expansion of this provision to include public libraries or community technology centers located in a designated empowerment zone or enterprise community, or in a census tract with a poverty rate of 20 percent of more is generally consistent with these original purposes, although it is not clear that simply making computers available without providing computer education programs is effective in providing persons in the targeted low-income areas with basic computer skills.

[225] The proposal also would extend the enhanced deduction for charitable contributions of computer technology and equipment for an additional three and one-half years. Extension of the provision for a limited period of time would allow additional time to assess the efficacy of the law, which was adopted as part of the Taxpayer Relief Act of 1997. Some critics of the enhanced deduction contend that the provision has failed to increase significantly the number of computer donations. Various proposals have been introduced in the last two years in an effort to increase use of the enhanced deduction, including proposals to expand the deduction by increasing the age of eligible computers, to offer a credit rather than an enhanced deduction, and to expand the class of eligible donors to include S corporations.

Prior Action

[226] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999 as passed by the Senate, but was not included in the conference agreement.

7. Tax credit for employer-provided workplace literacy and basic

[227] Educational expenses paid by an employer for its employees are deductible to the employer.

[228] Employer-paid educational expenses are excludable from the gross income of an employee if provided under a section 127 educational assistance plan or if the expenses qualify as a working condition fringe benefit under section 132. Section 127 provides an exclusion of $5,250 annually for employer-provided educational assistance. The exclusion does not apply to graduate courses. The exclusion for employer-provided educational assistance expires with respect to courses beginning on or after January 1, 2002.

[229] In order for the exclusion to apply, certain requirements must be satisfied. The educational assistance must be provided pursuant to a separate written plan of the employer. The educational assistance program must not discriminate in favor of highly compensated employees. In addition, not more than 5 percent of the amounts paid or incurred by the employer during the year for educational assistance under a qualified educational assistance plan can be provided for the class of individuals consisting of more than 5-percent owners of the employer (and their spouses and dependents).

[230] Educational expenses that do not qualify for the section 127 exclusion may be excludable from income as a working condition fringe benefit. ⁷³ In general, education qualifies as a working condition fringe benefit if the employee could have deducted the education expenses under section 162 if the employee paid for the education. In general, education expenses are deductible by an individual under section 162 if the education (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's employer, applicable law or regulations imposed as a condition of continued employment. However, education expenses are generally not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. ⁷⁴

Description of Proposal

[231] Employers who provide certain literacy, English literacy, and basic education programs for their eligible employees would be allowed to claim a credit against the employer's Federal income taxes. The amount of the credit would equal 20 percent of the employer's eligible expenses incurred with respect to qualified education programs, with a maximum credit of $1,050 in a taxable year per eligible employee. The credit would be treated as a component of the general business credit, and would be subject to the limitations of that credit.

[232] Qualified education would be limited to: (1) basic skills instruction at or below the level of a high school degree; (2) basic, entry-level computer skills of broad applicability; and (3) English literacy instruction. In general, the credit could not be claimed with respect to an employee who has received a high school degree or its equivalent. The employer could claim a credit with respect to employees with high school degrees but who lack sufficient mastery of basic educational skills to function effectively in the workplace only if an eligible provider both assesses the educational level of the employees and provides the instructional program for the employer. With respect to English literacy instruction, eligible employees would be employees with limited English proficiency. Eligible employees must be citizens or resident aliens aged 18 or older who are employed by the taxpayer in the United States for at least six months. The terms qualified education and eligible employees would be further defined in Treasury regulations.

[233] To be eligible for the credit, the provision of literacy or basic education by an employer must meet the nondiscrimination requirements for educational assistance programs under present-law section 127. Expenses eligible for the credit (up to $5,250) would be excludable from income and wages as a working condition fringe benefit if not otherwise excludable under section 127. ⁷⁵

[234] Expenses eligible for the credit would include payments to third parties and payments made directly to cover instructional costs, including but not limited to salaries of instructors, curriculum development, textbooks, and instructional technology used exclusively to support basic skills instruction. Wages paid to workers while they participate as students in education programs would not be eligible for the credit. The amount of the credit claimed would reduce, dollar for dollar, the amount of education expenses that the employer could otherwise deduct in computing its taxable income.

[235] Unless the employer provides the instruction through an eligible provider, the curriculum must be approved by a State adult education authority, defined as an "eligible agency" in section 203(4) of the Adult Education and Family Literacy Act. An "eligible provider" would be an entity that is receiving Federal funding for adult education and literacy services or English literacy programs under the Adult Education and Family Literacy Act, Title II of the Workforce Investment Act of 1998. Eligible providers would include local education agencies, certain community-based or volunteer literacy organizations, institutions of higher education, and other public or private nonprofit agencies.

[236] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2000.

Analysis

[237] The proposal is intended to provide employers with an additional incentive to provide basic education programs to their employees. The proposal focuses on this type of education due to concern that low-skilled workers may not undertake needed education because they lack resources to overcome barriers such as cost, child care, and transportation. It is argued that present law (i.e., the section 127 exclusion) does not provide sufficient incentive because employers of low-skilled workers may hesitate to provide general education; the benefits of basic skills and literacy education may be more difficult for employers to capture through increased productivity than the benefits of more job-specific education.

[238] Providing additional tax benefits for certain educational expenses could lead to larger expenditures on education for workers than would otherwise occur. This extra incentive for education may be desirable if some of the benefits of an individual's education accrue to society at large (through the creation of a better-educated populace or workforce). In that case, absent the subsidy, individuals would under invest in education (relative to the socially desirable level) because they would not take into account the benefits that others indirectly receive. To the extent that expenditures on education represent purely personal consumption, a subsidy would lead to over-consumption of education. Some argue that concerns about over-consumption of education are reduced under the proposal because it targets basic skills and literacy training for individuals who, for the most part, lack a high school degree.

[239] The requirements with respect to eligible providers may increase the cost of education that would otherwise be provided under the proposal. On the other hand, providing the credit without limitations on the provider or curriculum could create potentially difficult issues of expense allocation, compliance, and tax administration.

Prior Action

[240] A similar provision was included in the President's Fiscal Year 2000 Budget Proposal, except that the prior proposal did not include a credit for basic computer training. In addition, the prior proposal was limited to 10 percent of eligible expenses, with a maximum per employee credit of $525.

8. Authorize issuance of tax-credit "Better America Bonds"

Present Law

Tax-exempt bonds

[241] Interest on debt incurred by States or local governments is excluded from income if the proceeds of the borrowing are used to carry out governmental functions of those entities or the debt is repaid with governmental funds ("governmental bonds"). These bonds may include bonds used to finance the acquisition of land (or interests in land) and buildings. Interest on bonds that nominally are issued by States or local governments, but the proceeds of which are used (directly or indirectly) by a private person and payment of which is derived from funds of such a private person ("private activity bonds") is taxable unless the purpose of the borrowing is approved specifically in the Code or in another provision of a revenue Act. These specified purposes include, but are not limited to, privately owned and/ or operated: (1) sewage facilities; (2) solid waste disposal facilities; (3) water systems; and (4) activities of section 501(c)(3) organizations. Issuance of most qualified private activity bonds (other than qualified 501(c)(3) bonds) is subject to annual state volume limits, currently the greater of $50 per resident, or $150 million. A phased increase in the volume limits to the greater of $75 per resident or $225 million is scheduled to begin in calendar year 2003, with the new levels being fully effective in calendar year 2007.

Tax credits for interest on qualified zone academy bonds

[242] A nonrefundable income tax credit in an amount equal to a credit rate (set by the Treasury Department) multiplied by the face amount of certain qualified zone academy bonds is allowed to certain financial institutions (i.e., banks, insurance companies, and corporations actively engaged in the business of lending money). A taxpayer holding a qualified zone academy bond on the credit allowance date (i.e., the annual anniversary of the bond's issuance) is entitled to a credit. The credit is includible in gross income (as if it were an interest payment on the bond), and may be claimed against regular income tax liability and alternative minimum tax liability. A qualified zone academy bond is defined as any bond issued by a State or local government, provided that (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a "qualified zone academy" and (2) private entities have promised to contribute to the qualified zone academy certain equipment, technical assistance or training, employee services, or other property or services with a value equal to at least 10 percent of the bond proceeds.

Expensing of certain environmental remediation expenses

[243] Taxpayers can elect to treat certain environmental remediation expenditures that would otherwise be chargeable to capital account as deductible in the year paid or incurred (sec. 198). The deduction applies for both regular and alternative minimum tax purposes. The expenditure must be incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site. A qualified contaminated site generally is any property that: (1) is held for use in a trade or business, for the production of income, or as inventory; (2) is certified by the appropriate State environmental agency to be located within certain targeted areas; and (3) contains (or potentially contains) a hazardous substance (so-called "brownfields"). In the case of property to which a qualified environmental remediation expenditure otherwise would have been capitalized, any qualified environmental remediation expenditure deductions are subject to recapture as ordinary income upon sale or other disposition of the property (sec. 1245). The provision applies only to eligible expenditures paid or incurred in taxable years ending after August 5, 1997, and before January 1, 2002.

Description of Proposal

In general

[244] The proposal would authorize issuance of a new category of tax-credit bonds, Better America Bonds, by States and local governments for certain specified purposes. The amount of ⁷⁶ the credit would be set to equal interest that otherwise would accrue on the taxable bonds. Bondholders would accrue credits quarterly. The maximum maturity of the bonds would be 15 years. The credit would be includible in gross income (as if it were an interest payment on the bond), and could be claimed against regular income tax liability and alternative minimum tax liability.

Authority to issue bonds

[245] The Administrator of the Environmental Protection Agency ("EPA") would be given authority to allocate up to $2.1 billion of Better America Bond authority to eligible issuers (i.e., States and local governments, including tribal governments and U.S. Possessions) annually for five years beginning in calendar year 2001. Any amounts unallocated for a year could be allocated in the following year. Any amounts allocated to an eligible issuer in any year could be used for bond issuance in that year or in any of the following three years. After the third year, unused allocation would be available for reallocation by the EPA.

[246] The EPA would be directed to publish guidelines, before January 1, 2001, establishing the criteria to be used in an annual competition for authority to issue the bonds. Eligible issuers would apply for an allocation of authority to issue the bonds, and the EPA, in consultation with other Federal agencies, would review these applications and allocate authority to issue Better America Bonds in conjunction with the Community Empowerment Board.

[247] An additional $50 million of Better America Bonds would be authorized for each of the five years beginning in 2001 for environmental assessment and remediation of property damaged by anthracite coal mining. Special rules would be provided for these bonds.

Qualifying purposes for bonds

[248] Except in the case of certain brownfields remediation activities, acquisition, construction, remediation or use of land and facilities would be a qualifying purpose only if the property was available for use by the public. Any agreement, other than a management contract that would be a qualified management contract for property financed with tax-exempt bonds would be treated as violating the public use requirement. Further, in general, repayment of principal could not be secured or paid with monies derived from private persons in any capacity other than that of the general public.

[249] Better America Bonds could be issued by eligible issuers for: (1) acquisition of land for open space, wetlands, public parks or green ways to be owned by the State or local government or 501(c)(3) entity whose exempt purpose includes environmental preservation; (2) construction of visitors' facilities related to such land and owned by the State or local government or 501(c)(3) entity whose exempt purpose includes environmental preservation; (3) remediation of land, in order to improve water quality, acquired under (1) above, or of publicly owned open space, wetlands, or parks, by undertaking reasonable measures to control erosion and remediating conditions caused by prior disposal of toxic or other waste; (4) acquisition of easements on privately owned open land that prevent commercial development and any substantial change in the use or character of the land; (5) environmental assessment and remediation of contaminated property owned by State or local governments if the property was acquired before January 1, 2000 or by reason of abandonment by the prior owner; or (6) environmental assessment and ⁷⁷ remediation of certain property damaged by anthracite coal mining if the property is owned by a State or local government or a 501(c)(3) organization.

Other rules

[250] For a discussion of additional requirements governing issuance and use of the proceeds of these tax-credit bonds, see the discussion of the rules governing issuance of qualified zone academy bonds and school modernization bonds, above.

Effective date

[251] The proposal would apply to bonds issued on or after January 1, 2001.

Analysis

[252] The proposal would subsidize a portion of the cost of new investment in "green space" land and facilities, as well as certain environmental remediation expenditures. Subsidizing such costs, it is argued, increases the level of investment in socially desirable assets over the level of investment that would take place in the absence of the subsidy. It is argued that significant public benefits will result, in the form of more public green space and a cleaner environment.

[253] Though called a tax credit, the Federal subsidy for Better America Bonds would be economically equivalent to a direct payment by the Federal government of interest on taxable bonds, on behalf of the eligible issuers that benefit from the bond proceeds. ⁷⁸ To illustrate, consider any taxable bond that bears an interest rate of 10 percent. A $1,000 bond would produce an interest payment of $100 annually. The bondholder receiving this payment would have $100, less the tax owed on the interest income. If the taxpayer were in the 28- percent Federal tax bracket, taxpayer would have $72 after Federal tax. Regardless of whether the eligible issuer or the Federal Government pays the interest, the taxpayer receives the same net-of- tax return of $72. In the case of Better America Bonds, interest is not actually paid by the Federal Government, but rather, a tax credit of $100 is allowed to the holder of the bond. In general, a $100 tax credit would be worth $100 to a taxpayer, provided that the taxpayer had at least $100 in tax liability. However, the Better America Bonds proposal requires the amount of the $100 credit to be included in the taxpayer's income. The taxpayer in the 28-percent tax bracket nets $72 after Federal tax, just as on the bond. Similarly, the Federal Government would be in the same position under the Better America Bonds proposal as if it had paid the $100 interest on the bond. The Federal Government loses $100 on the credit, but recoups $28 of that by the requirement that it be included in income, for a net cost of $72. The State and local government would also be in the same situation in both cases.

[254] The proposed tax credit arrangement to subsidize environmental preservation and remediation raises some questions of administrative efficiency and tax complexity. An alternative, direct expenditure program under the direct control of the EPA would avoid the involvement of the IRS in the administration of a program outside its traditional area of expertise. Because potential purchasers of the bonds must educate themselves as to whether the bonds qualify for the credit, certain "information costs" are imposed on the buyer. Additionally, since the determination as to whether the bond is qualified for the credit ultimately rests with the Federal Government, further risk is imposed on the investor. These information costs and other risks serve to increase the credit rate and hence the costs to the Federal Government for a given level of support for environmental improvements. For these reasons, and the fact that tax credit bonds will be less liquid than Treasury securities, the bonds would bear a credit rate that is equal to a measure of the yield on outstanding corporate bonds. The direct payment of interest by the Federal Government on behalf of eligible issuers, which was discussed above as being economically the equivalent of the credit proposal, would be less complex, both as to the substantive tax law, and as to the administration of the tax law, because the interest could simply be reported like any other taxable interest.

Prior Action

[255] A similar provision was included in the President's Fiscal Year 2000 Budget Proposal.

9. Make permanent the expensing of brownfields remediation costs

Present Law

[256] Code section 162 allows a deduction for ordinary and necessary expenses paid or incurred in carrying on any trade or business. Treasury regulations provide that the cost of incidental repairs which neither materially add to the value of property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted currently as a business expense. Section 263(a)(1) limits the scope of section 162 by prohibiting a current deduction for certain capital expenditures. Treasury regulations define "capital expenditures" as amounts paid or incurred to materially add to the value, or substantially prolong the useful life, of property owned by the taxpayer, or to adapt property to a new or different use. Amounts paid for repairs and maintenance do not constitute capital expenditures. The determination of whether an expense is deductible or capitalizable is based on the facts and circumstances of each case.

[257] Under Code section 198, taxpayers can elect to treat certain environmental remediation expenditures that would otherwise be chargeable to capital account as deductible in the year paid or incurred. The deduction applies for both regular and alternative minimum tax purposes. The expenditure must be incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site. In general, any expenditure for the acquisition of depreciable property used in connection with the abatement or control of hazardous substances at a qualified contaminated site does not constitute a qualified environmental remediation expenditure. However, depreciation deductions allowable for such property, which would otherwise be allocated to the site under the principles set forth in Commissioner v. Idaho Power Co. and section 263A, are treated as qualified environmental remediation expenditures. ⁷⁹

[258] A "qualified contaminated site" generally is any property that: (1) is held for use in a trade or business, for the production of income, or as inventory; (2) is certified by the appropriate State environmental agency to be located within a targeted area; and (3) contains (or potentially contains) a hazardous substance (so-called "brownfields"). Targeted areas are defined as: (1) empowerment zones and enterprise communities as designated under present law and under the Act (including any supplemental empowerment zone designated on December 21, 1994); (2) ⁸⁰ sites announced before February 1997, as being subject to an Environmental Protection Agency ("EPA") Brownfields Pilot; (3) any population census tract with a poverty rate of 20 percent or more; and (4) certain industrial and commercial areas that are adjacent to tracts described in (3) above.

[259] Both urban and rural sites qualify. However, sites that are identified on the national priorities list under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA") cannot qualify as targeted areas. The chief executive officer of a State, in consultation with the Administrator of the EPA, was authorized to designate an appropriate State environmental agency. If no State environmental agency was so designated within 60 days of the date of enactment, the Administrator of the EPA was authorized to designate the appropriate environmental agency for such State. Hazardous substances generally are defined by reference to sections 101(14) and 102 of CERCLA, subject to additional limitations applicable to asbestos and similar substances within buildings, certain naturally occurring substances such as radon, and certain other substances released into drinking water supplies due to deterioration through ordinary use.

[260] In the case of property to which a qualified environmental remediation expenditure otherwise would have been capitalized, any deduction allowed under the Act is treated as a depreciation deduction and the property is treated as section 1245 property. Thus, deductions for qualified environmental remediation expenditures are subject to recapture as ordinary income upon sale or other disposition of the property. In addition, sections 280B (demolition of structures) and 468 (special rules for mining and solid waste reclamation and closing costs) do not apply to amounts which are treated as expenses under this provision.

[261] The provision applies only to eligible expenditures paid or incurred before January 1, 2002.

Description of Proposal

[262] The proposal would eliminate the requirement that expenditures must be paid or incurred before January 1, 2002, to be deductible as eligible environmental remediation expenditures. Thus, the provision would become permanent.

[263] Effective date. -- The proposal would be effective on the date of enactment.

Analysis

[264] The proposal to make permanent the expensing of brownfields remediation costs would promote the goal of environmental remediation and remove doubt as to the future deductibility of remediation expenses. Removing the doubt about deductibility may be desirable if the present-law expiration date is currently affecting investment planning. For example, the temporary nature of relief under present law may discourage projects that require a significant ongoing investment, such as groundwater clean-up projects. On the other hand, extension of the provision for a limited period of time would allow additional time to assess the efficacy of the law, adopted only recently as part of the Taxpayer Relief act of 1997, prior to any decision as to its permanency.

[265] The proposal is intended to encourage environmental remediation, and general business investment, in sites located in enterprise communities and empowerment zones, the original EPA Brownfields Pilots, or in census tracts with poverty rates of 20 percent or more, or certain adjacent tracts. With respect to environmental remediation, it is not clear that the restriction to certain areas will lead to the most socially desirable distribution of environmental remediation. It is possible that the same dollar amount of expenditures for remediation in other areas could produce a greater net social good, and thus the restriction to specific areas diminishes overall efficiency. On the other hand, property located in a nonqualifying area may have sufficient intrinsic value so that environmental remediation will be undertaken absent a special tax break. With respect to environmental remediation tax benefits as an incentive for general business investment, it is possible that the incentive may have the effect of distorting the location of new investment, rather than increasing investment overall. If the new investments are offset by less ⁸¹ investment in neighboring, but not qualifying, areas, the neighboring communities could suffer. On the other hand, the increased investment in the qualifying areas could have spillover effects that are beneficial to the neighboring communities.

[266] Further, permanently extending the brownfields provision raises administrative issues. For example, it is unclear whether currently qualified zone sites will continue to qualify after such designation expires, by law, after 10 years. Similarly, it is unclear whether the application to census tracts (currently defined by the 1990 census) with poverty rates of 20 percent or more (or certain adjacent tracts) applies to tracts that meet such qualifications on (1) August 5, 1997 (the effective date of the original brownfields legislation), (2) the effective date of this proposal, or (3) the date of the expenditure.

Prior Action

[267] The special expensing for environmental remediation expenditures was enacted as part of the Taxpayer Relief Act of 1997. Identical proposals were included in the President's Fiscal Year 1999 and Fiscal Year 2000 Budget Proposals.

10. Specialized small business investment company tax incentives

Present Law

[268] Under present law, a taxpayer may elect to roll over without payment of tax any capital gain realized upon the sale of publicly-traded securities where the taxpayer uses the proceeds from the sale to purchase common stock in a specialized small business investment company ("SSBIC") within 60 days of the sale of the securities. The maximum amount of gain that an individual may roll over under this provision for a taxable year is limited to the lesser of (1) $50,000 or (2) $500,000 reduced by any gain previously excluded under this provision. For corporations, these limits are $250,000 and $1 million.

[269] In addition, under present law, an individual may exclude 50 percent of the gain from ⁸² the sale of qualifying small business stock held more than five years. An SSBIC is automatically deemed to satisfy the active business requirement which a corporation must satisfy to qualify its stock for the exclusion.

[270] Regulated investment companies ("RICs") are entitled to deduct dividends paid to shareholders. To qualify for the deduction, 90 percent of the company's income must be derived from dividends, interest and other specified passive income, the company must distribute 90 percent of its investment income, and at least 50 percent of the value of its assets must be invested in certain diversified investments.

[271] For purposes of these provisions, an SSBIC means any partnership or corporation that is licensed by the Small Business Administration under section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993). SSBICs make long-term loans to, or equity investments in, small businesses owned by persons who are socially or economically disadvantaged.

Description of Proposal

[272] Under the proposal, the tax-free rollover provision would be expanded by (1) extending the 60-day period to 180 days, (2) making preferred stock (as well as common stock) in an SSBIC an eligible investment, and (3) increasing the lifetime caps to $750,000 in the case of an individual and to $2 million in the case of a corporation, and repealing the annual caps.

[273] The proposal also would provide that an SSBIC that is organized as a corporation may convert to a partnership without imposition of a tax to either the corporation or its shareholders, by transferring its assets to a partnership in which it holds at least an 80-percent interest and then liquidating. The corporation would be required to distribute all its earnings and profits before liquidating. The transaction must take place within 180 days of enactment of the proposal. The partnership would be liable for a tax on any "built-in" gain in the assets transferred by the corporation at the time of the conversion.

[274] The 50-percent exclusion for gain on the sale of qualifying small business stock would be increased to 60 percent where the taxpayer, or a pass-through entity in which the taxpayer holds an interest, sells qualifying stock of an SSBIC.

[275] For purposes of determining status as a RIC eligible for the dividends received deduction, the proposal would treat income derived by a SSBIC from its limited partner interest in a partnership whose business operations the SSBIC does not actively manage as income qualifying for the 90-percent test; would deem the SSBIC to satisfy the 90-percent distribution requirement if it distributes all its income that it is permitted to distribute under the Small Business Investment Act of 1958; and would deem the RIC diversification of assets requirement to be met to the extent the SSBIC's investments are permitted under that Act.

[276] Effective date. -- The rollover and small business stock provisions of the proposal would be effective for sales after date of enactment. The RIC provisions would be effective for taxable years beginning after date of enactment.

Analysis

[277] The proposal would make investments in SSBICs more attractive by providing tax advantages of deferral and lower capital gains taxes. Present law, and the proposal, attempt to distort taxpayer investment decisions by increasing the net, after-tax, return to investments in SSBICs compared to other assets. Economists argue that distortions in capital markets lead to reduced economic growth. In an efficient capital market, relative market values indicate sectors of the economy where investment funds are most needed. Artificially diverting investment funds may cause capital to be diverted to investments that offer a lower rate of return and away from investments that offer a higher rate of return. The net outcome is a reduction in national income below that which would otherwise be achieved. Proponents of the proposal argue that capital markets are not fully efficient. In particular, they argue that a bias exists against funding business ventures undertaken by persons who are socially or economically disadvantaged.

[278] Generally, the cost of capital is greater for small businesses than for larger businesses. That is, investors demand a greater rate of return on their investment in smaller businesses than in larger businesses. The higher cost of capital may take the form of higher interest rates charged on business loans or a larger percentage of equity ownership per dollar invested. A higher cost of capital does not imply that capital markets are inefficient. The cost of capital reflects investors' perceptions of greater risk and the higher failure rates among small business ventures. There has been little study of whether the cost of capital to small businesses, regardless of the economic or social background of the entrepreneur, is "too high" when the risk of business failure is taken into account.

[279] Proponents of the proposal argue that, even if the higher cost of capital to small businesses is not the result of inefficiency of the capital market, investors in small businesses can achieve an important social goal by helping more persons who are socially or economically disadvantaged gain entrepreneurial experience. Opponents observe that, under present law, that objective is addressed by the Small Business Administration's subsidized loan program and present- law Code sections 1045 and 1202. They note that the proposal would not lower the cost of capital for all small businesses or for all small businesses organized by persons who are socially or economically disadvantaged, only those businesses that receive some of their financing through an SSBIC. Other investors do not receive these tax benefits even if they make substantial investments in business ventures organized by persons who are socially or economically disadvantaged. They argue there is a loss of efficiency from funneling a tax benefit to entrepreneurs through only one type of investment fund pool. In the near term, some of the tax benefit may accrue to current owners of SSBICs rather than to entrepreneurs as taxpayers seeking to take advantage of the proposal bid up the price of shares of existing SSBICs. Proponents note that over the longer term, as more funds flow into SSBICs and as new SSBICs are formed, there will be a larger pool of funds available to qualified entrepreneurs, and those entrepreneurs will receive the benefits of a lower cost of capital.

Prior Action

[280] Similar proposals were included in the President's Fiscal Year 1999 and 2000 Budget Proposals, and in The Financial Freedom Act of 1999 as passed by the House.

C. Health Care Provisions

1. Assisting taxpayers with long-term care needs

Present Law

[281] Present law provides special rules for taxpayers with a disabled family member or with long-term care needs. A child and dependent care tax credit is provided for expenses incurred to care for a disabled spouse or dependent so the taxpayer can work. A low- income working taxpayer may qualify for the earned income tax credit if he or she resides with a disabled child (of any age). An itemized deduction is provided for expenses for qualified long-term care services or insurance if the taxpayer is chronically ill, or such expenses were incurred on behalf of a chronically ill spouse or dependent, provided that such expenses, together with other medical expenses of the taxpayer, exceed 7.5 percent of adjusted gross income ("AGI"). An additional standard deduction is provided to a taxpayer who does not itemize deductions if the taxpayer (or spouse) is over age 65 or blind. A credit is provided to certain low income taxpayers who are elderly or disabled. The impairment-related work expenses of a handicapped individual are classified as a miscellaneous itemized deduction not subject to the 2-percent floor.

[282] To qualify as a dependent under present law, an individual must: (1) be a specified relative or member of the taxpayer's household; (2) be a citizen or resident of the U.S. or resident of Canada or Mexico; (3) not be required to file a joint tax return with his or her spouse; (4) have gross income below the dependent exemption amount ($ 2,900 in 2001) if not the taxpayer's ⁸³ child; and (5) receive over half of his or her support from the taxpayer. If no one person contributes over half the support of an individual, the taxpayer is treated as meeting the support requirement if: (1) over half the support is received from persons each of whom, but for the fact that he or she did not provide over half such support, could claim the individual as a dependent; (2) the taxpayer contributes over 10 percent of such support; and (3) other caregivers who provide over 10 percent of the support file written declarations stating that they will not claim the individual as a dependent.

Description of Proposal

[283] A credit of up to $3,000 would be provided to an individual taxpayer, if the individual, the spouse of the individual, or a qualifying dependent of the taxpayer has long-term care needs. The credit (aggregated with the child credit and the proposed disabled worker credit) would be phased out for taxpayers with modified AGI above certain thresholds. Under the proposal, the sum of the otherwise allowable present-law child credit, the proposed disabled workers credit, and the proposed long-term care credit would be phased out at a rate of $50 for each $1,000 (or fraction thereof) of modified AGI above the threshold amount. Modified AGI and the threshold amounts would be the same as under the present-law phaseout rules for the child tax credit.

[284] Thus, modified AGI would be AGI plus the amount otherwise excluded from gross income under Code sections 911, 931, or 933 (relating to the exclusion of income of U.S. citizens or residents living abroad; residents of Guam, American Samoa, and the Northern Mariana Islands; and residents of Puerto Rico, respectively). The threshold modified AGI amount would be $110,000 for married individuals filing a joint return, $75,000 for unmarried taxpayers, and $55,000 for married taxpayers filing separate returns. These threshold amounts would not be indexed for inflation. An individual may be eligible for both this proposed credit and the proposed disabled workers tax credit.

[285] For purposes of the proposed credit only, the definition of a dependent would be modified in two ways. First, the gross income threshold would be increased to the sum of the personal exemption amount, the standard deduction, and the additional deduction for the elderly and blind (if applicable). In 2001, the gross income threshold would generally be $7,400 for a non-elderly single dependent and $8,500 for an elderly single dependent. ⁸⁴

[286] Second, the present-law support test would be deemed to be met, for purposes of the proposed credit, if the taxpayer and an individual with long-term care needs reside together for a specified period. The length of the specified period would depend on the relationship between the taxpayer and the individual with long-term care needs. The specified period would be over half the year if the individual is the parent (including stepparents and in-laws), or ancestor of the parent, or child, or descendant of the child, of the taxpayer. Otherwise, the specified period would be the full year. If more than one taxpayer resides with the person with long-term care needs and would be eligible to claim the credit for that person, then only the taxpayer with the highest AGI would be eligible for the credit.

[287] An individual age 6 or older would be considered to have long-term care needs if he or she were certified by a licensed physician (prior to the filing of a return claiming the credit) as being unable for at least 6 months to perform at least 3 activities of daily living ("ADLs") without substantial assistance from another individual, due to a loss of functional capacity (including individuals born with a condition that is comparable to a loss of functional capacity). ⁸⁵ As under the present-law rules relating to long-term care, ADLs would be eating, toileting, transferring, bathing, dressing, and continence. Substantial assistance would include both hands-on assistance (that is, the physical assistance of another person without which the individual would be unable to perform the ADL), and stand-by assistance (that is, the presence of another person within arm's reach of the individual that is necessary to prevent, by physical intervention, injury to the individual when performing the ADL).

[288] As an alternative to the 3-ADL test described above, an individual would be considered to have long-term care needs if he or she were certified by a licensed physician as (1) requiring substantial supervision for at least 6 months to be protected from threats to health and safety due to severe cognitive impairment and (2) being unable for at least 6 months to perform at least one or more ADLs or to engage in age-appropriate activities as determined under regulations prescribed by the Secretary of the Treasury in consultation with the Secretary of Health and Human Services.

[289] A child between the ages of 2 and 6 would be considered to have long-term care needs if he or she were certified by a licensed physician as requiring substantial assistance for at least 6 months with at least 2 of the following activities: eating, transferring, and mobility. A child under the age of 2 would be considered to have long-term care needs if he or she were certified by a licensed doctor as requiring for at least 6 months specific durable medical equipment (for example, a respirator) by reason of a severe health condition, or requiring a skilled practitioner trained to address the child's condition when the parents are absent. The Department of the Treasury and the Department of Health and Human Services would be directed to report to Congress within 5 years of the date of enactment on the effectiveness of the definition of disability for children and recommend, if necessary, modifications to the definition.

[290] The taxpayer would be required to provide a correct taxpayer identification number for the individual with long-term care needs, as well as a correct physician identification number (e.g., the Unique Physician Identification Number that is currently required for Medicare billing) for the certifying physician. Failure to provide correct taxpayer and physician identification numbers would be subject to the mathematical error rule. Under that rule, the IRS may summarily assess additional tax due without sending the individual a notice of deficiency and giving the taxpayer an opportunity to petition the Tax Court. Further, the taxpayer could be required to provide other proof of the existence of long-term care needs in such form and manner, and at such times, as the Secretary requires.

[291] The long-term care credit would generally be nonrefundable, which means that the credit generally would be allowed only to the extent that the individual's regular tax liability exceeds the individual's tentative minimum tax, determined without regard to the alternative minimum tax foreign tax credit (the "tax liability limitation"). However, the credit would be coordinated with the present-law child credit and the proposed disabled workers credit so that the credits would be refundable for a taxpayer claiming three or more credit amounts under the credits. More than one credit amount could be attributable to a single individual. For example, a disabled worker with long-term care needs would have two credit amounts, a disabled workers credit and a long-term care credit. Similarly, a taxpayer with two children under age 17, one of whom has long-term care needs, would have three credit amounts: two child credit amounts and one long-term care credit amount. As under the present-law child credit, the amount of refundable credit would be the amount that the nonrefundable personal credits would increase if the tax liability limitation were increased by the excess of the taxpayer's social security taxes over the taxpayer's earned income credit (if any).

[292] The credit would be phased in as illustrated in the following table.

                                             Maximum

Analysis

[294] The proposal is intended to provide assistance to individuals who have long-term care needs or who care for others with such needs. Those in favor of the proposal argue that the credit is appropriate because such individuals have additional costs and do not have the same ability to pay as other taxpayers. Some also argue that the present-law favorable tax treatment for long-term care services and expenses is not sufficient to provide relief to all individuals with long-term care needs. For example, present law does not provide relief for family members who provide care for an individual with long-term care needs because they cannot afford to hire assistance. Present law also provides relief only to individuals with substantial expenses (i.e., in excess of the 7.5 percent of AGI threshold).

[295] Some argue that the proposal should be expanded to apply to long-term care insurance expenses, even if the taxpayer currently does not have long-term care needs, in order to make more long-term care insurance more affordable.

[296] On the other hand, some argue that the proposal is unfair to taxpayers not eligible for the credit who also might have reduced ability to pay. For example, the credit would not be available for individuals who have significant medical expenses during a year due to an illness that does not qualify the individual for the credit. As another example, the credit would not apply to individuals with extraordinary losses, such as the destruction of a home. Some argue that the present-law tax benefits for long-term care expenses and insurance already provide sufficient benefits for individuals with long-term care needs.

[297] The proposal could be criticized because it would create new complexities in the Code. Taxpayers would need to keep records to demonstrate eligibility for the credit. In addition, the proposal could cause confusion among some taxpayers because it modifies for credit purposes only the dependency tests used elsewhere in the Code.

[298] It could further be argued that phaseouts are inequitable because they increase marginal tax rates for taxpayers in the phaseout range. ⁸⁶ On the other hand, it could be argued that a phaseout is needed if the proposal is to be targeted to individuals with limited ability to pay.

Prior Action

[299] A similar proposal was included in the President's Fiscal Year 2000 Budget Proposal.

2. Encourage COBRA continuation coverage

Present Law

[300] Under present law, the tax treatment of health insurance expenses depends on whether a taxpayer is covered under a health plan paid for by an employer, whether an individual has self-employment income, or whether an individual itemizes deductions and has medical expenses that exceed a certain threshold.

[301] An employer's contribution to a plan providing health benefits coverage for an employee, and his or her spouse and dependents, is excludable from the employee's income for both income and payroll tax purposes. In addition, active employees participating in a cafeteria plan may pay their employee share of premiums on a pre-tax basis.

[302] Self-employed individuals may deduct a portion of health insurance expenses for themselves and their spouse and dependents. The deductible percentage is 60 percent for taxable years beginning in 1999 to 2001, 70 in 2002, and 100 percent in 2003 and thereafter. The deduction is not available for any month in which the self- employed individual is eligible to participate in an employer- subsidized health plan. The deduction may not exceed the individual's self-employment income.

[303] Other individuals who pay for their own health insurance may claim an itemized deduction for their health insurance premiums only to the extent that premiums, when combined with other unreimbursed medical expenses, exceed 7.5 percent of adjusted gross income.

[304] Under the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA"), qualified beneficiaries are eligible to purchase continuation coverage under an employer-sponsored plan upon the occurrence of certain events that would otherwise result in loss of coverage, such as termination of employment. The employer may charge up to 102 percent of the average cost of the employer's health plan for continuation coverage. Depending on the circumstances, former employees and their dependents can elect to continue COBRA coverage for up to 18 to 36 months.

Description of Proposal

[305] The proposal would provide that retired employees whose employers eliminate retiree health benefits after retirement would be eligible to purchase COBRA continuation coverage under the former employer's plan until reaching age 65. Unless the retired employee is otherwise eligible to purchase continuation coverage, the employer would be permitted to charge up to 125 percent of the average cost of the employer's group health plan for the coverage.

[306] Under the proposal, individuals would be eligible for a 25 percent nonrefundable tax credit for their COBRA continuation coverage premiums (including the premiums for the proposed retiree continuation coverage). For individuals who purchase COBRA continuation coverage under the proposal regarding extended retiree continuation coverage, eligibility for the tax credit would continue until the retiree reaches age 65. For all others, eligibility for the credit would be limited to the present-law COBRA continuation period applicable to the individual. The Secretary of the Treasury would be directed to issue regulations regarding reporting requirements for employers needed to administer the credit.

[307] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2001.

Analysis

Expansion of COBRA continuation coverage to retirees who lose retiree health coverage

[308] The COBRA health care continuation rules were designed to help eliminate or reduce gaps in health coverage due to the occurrence of certain events, such as termination of employment, by making it possible for individuals to continue to be covered under an employer-sponsored plan. In order to balance concerns of employers regarding the cost of such coverage and making coverage affordable, COBRA included a limit on the premium that could be charged to those electing continuation coverage. While the COBRA health care continuation rules may increase health insurance coverage, they also impose administrative burdens on employers.

[309] The proposal to expand COBRA continuation coverage is designed to provide retirees with a health coverage option until they are eligible for Medicare. The proposal is limited to retirees whose employer eliminates retiree health coverage, and thus is limited to those employers who have plans that cover (or have covered) retirees. The proposal recognizes that an older population may be more costly to insure by allowing a greater premium to be charged for such individuals than the regular COBRA premium. If this maximum premium understates the cost of such coverage, then some portion of the cost would be borne by persons other than those purchasing the coverage. It is not clear who would bear the burden of the additional cost in that case, for example, the employer (who would nominally pay the additional cost) could pass the cost along to customers of the employer in the form of higher prices or to current employees in the form of lower total wages.

Tax credit for COBRA premiums

[310] As discussed above, present law provides different tax benefits for the purchase of health insurance depending on the manner in which the health insurance is purchased (e.g., by an employer or self-employed individual). Individuals covered under an employer- subsidized health plan receive the greatest tax benefits, because employer contributions for such coverage are excludable from income. In addition, if the individual purchases the coverage through a cafeteria plan, the individual's premium may also be paid on a pre- tax basis.

[311] This favorable tax treatment does not generally extend to individuals who elect COBRA continuation coverage for two reasons. First, employer contributions toward the purchase of health coverage typically decline after termination of employment. In other words, many employers do not contribute toward the premium for COBRA continuation coverage or provide a lower subsidy for such coverage than for coverage for active employees. In addition, the individual's share of COBRA premiums are paid on an after-tax basis.

[312] The proposal is designed to encourage more individuals to purchase continuation coverage by lowering the cost of such coverage for those that have a tax liability to offset by the credit. Like all tax benefits for health coverage, the proposed tax credit may lead to larger expenditures on health insurance than might otherwise be the case. This extra incentive for health insurance may be desirable if some of the benefits of an individual's having health insurance accrue to society at large (e.g., through a healthier, more productive workforce, or a reduction in health expenditures for uninsured individuals). In that case, absent the subsidy, individuals would underinvest in health insurance (relative to the socially desirable level) because they would not take into account the benefits that others receive. To the extent that expenditures on health insurance represent purely personal consumption, a subsidy would lead to over consumption of health insurance.

[313] By providing a credit rather than a deduction for the cost of health insurance, the proposal would provide the same tax benefits for all individuals who have the same health insurance costs. In contrast, if the tax benefit were provided in the form of a deduction, a greater benefit would be provided to individuals in higher marginal tax brackets.

[314] Some argue that, because the objective of the proposal is to increase health insurance coverage, it would be more efficient to provide a tax benefit to individuals for the purchase of any health insurance, rather than just COBRA continuation coverage. This would allow individuals more health coverage options.

[315] The proposal addresses some of the present-law inequity of tax treatment between employer-subsidized health insurance and insurance purchased by individuals. However, the proposal does not eliminate this inequity; it provides tax benefits only for the purchase of employer-sponsored insurance. Some argue that any new subsidy for the purchase of health insurance should more directly address the inequity in tax treatment of health insurance coverage.

Prior Action

[316] No prior action.

3. Provide tax credit for Medicare buy-in program

Present Law

[317] Under present law, the tax treatment of health insurance expenses depends on whether a taxpayer is covered under a health plan paid for by an employer, whether an individual has self-employment income, or whether an individual itemizes deductions and has medical expenses that exceed a certain threshold.

[318] An employer's contribution to a plan providing health benefits coverage for an employee, and his or her spouse and dependents, is excludable from the employee's income for both income and payroll tax purposes. In addition, active employees participating in a cafeteria plan may pay their employee share of premiums on a pre-tax basis.

[319] Self-employed individuals may deduct a portion of health insurance expenses for themselves and their spouse and dependents. The deductible percentage is 60 percent for taxable years beginning in 1999 to 2001, 70 in 2002, and 100 percent in 2003 and thereafter. The deduction is not available for any month in which the self- employed individual is eligible to participate in an employer- subsidized health plan. The deduction may not exceed the individual's self-employment income.

[320] Other individuals who pay for their own health insurance may claim an itemized deduction for their health insurance premiums only to the extent that premiums, when combined with other unreimbursed medical expenses, exceed 7.5 percent of adjusted gross income.

[321] Under the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA"), qualified beneficiaries are eligible to purchase continuation coverage under an employer-sponsored plan upon the occurrence of certain events that would otherwise result in loss of coverage, such as termination of employment. The employer may charge up to 102 percent of the average cost of the employer's health plan for continuation coverage. Depending on the circumstances, former employees and their dependents can elect to continue COBRA coverage for up to 18 to 36 months.

Description of Proposal

[322] Under the proposal, taxpayers would be allowed to claim a nonrefundable tax credit for health insurance purchased through the new Medicare buy-in program proposed in the President's Fiscal Year 2001 Budget Proposal. The credit would equal 25 percent of Medicare buy-in premiums paid by a taxpayer prior to reaching age 65.

[323] Under the Medicare buy-in proposal, individuals age 62 through 64 years of age who do not have access to employer-provided health coverage or certain other subsidized health insurance coverage would be eligible for the program. Qualifying individuals would have a one-time election to voluntarily join the Medicare buy-in program. These individuals would pay a base premium, adjusted for location, that on average equals the average cost of insuring individuals in this age range. The base premium would be paid every year prior to reaching age 65 and would be eligible for the tax credit. Once an individual turns 65 years old, the individual would no longer pay the base premium, but instead would pay an (estimated smaller) amortized amount every year the individual is enrolled in Medicare until age 85. This latter cost would be assessed to cover the above-average costs of this particular risk-pool and would not be eligible for the tax credit.

[324] In addition, workers involuntarily separated from their jobs between 55 and 62 years of age could make a one-time election (per qualifying event) to voluntarily join the Medicare buy-in program. Eligibility would be limited to individuals who do not have access to employer-provided health coverage or certain other subsidized health insurance coverage. In addition, individuals would be required to have had health benefit coverage on their previous job for at least one year. Spouses of eligible individuals would also be eligible. Unlike the 62-64 age group, these individuals would pay a premium each year that would approximately cover the total cost of their risk-pool. Because the entire premium would be paid before reaching age 65, the entire premium would qualify for the tax credit.

[325] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2001.

Analysis

[326] The proposal to allow certain retired individuals to buy in to Medicare is designed to address concerns regarding lack of heath care coverage for such individuals. It is argued that retirees who are not yet eligible for Medicare may have difficulty purchasing insurance in the individual market because the insurance is likely to be expensive. In addition, some individuals may have difficulty obtaining coverage for preexisting conditions. Premiums charged the individuals, plus a surcharge to the Medicare Part B premium are designed to make the buy-in program self financing.

[327] The stated rationale for tax credit for the buy-in premiums is to encourage healthy as well as wealthy individuals to participate, creating a broad risk pool with more affordable premiums. Like all tax benefits for health coverage, the proposed tax credit may lead to larger expenditures on health insurance than might otherwise be the case. This extra incentive for health insurance may be desirable if some of the benefits of an individual's having health insurance accrue to society at large (e.g., through a healthier, more productive workforce, or a reduction in health expenditures for uninsured individuals). In that case, absent the subsidy, individuals would underinvest in health insurance (relative to the socially desirable level) because they would not take into account the benefits that others receive. To the extent that expenditures on health insurance represent purely personal consumption, a subsidy would lead to over consumption of health insurance.

[328] By providing a credit rather than a deduction for the cost of health insurance, the proposal would provide the same tax benefits for all individuals who have the same health insurance costs (provided they have tax liability). In contrast, if the tax benefit were provided in the form of a deduction, a greater benefit would be provided to individuals in higher marginal tax brackets. The credit may provide a subsidy for individuals who arguably do not need a subsidy, such as higher-income retirees.

[329] Some argue that, because the objective of the proposal is to increase health insurance coverage, it would be more efficient to provide a tax benefits to individuals for the purchase of any health insurance, rather than the Medicare buy-in program. This would allow individuals more health coverage options.

[330] The proposal addresses some of the present-law inequity of tax treatment between employer-subsidized health insurance and insurance purchased by individuals. However, the proposal does not eliminate this inequity. Some argue that any new subsidy for the purchase of health insurance should more directly address the inequity in tax treatment of health insurance coverage.

Prior Action

[331] No prior action.

4. Provide tax relief for workers with disabilities

Present Law

Tax credit for elderly and disabled individuals

[332] A nonrefundable income tax credit is provided under present law for certain low-income individuals who are age 65 or older. The credit also is available to an individual, regardless of age, who is retired on disability and who was permanently and totally disabled at retirement. For this purpose, an individual is considered permanently and totally disabled if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death, or that has lasted or can be expected to last for a continuous period of not less than 12 months. The individual must furnish proof of disability to the IRS. The maximum credit is $750 for unmarried elderly or disabled individuals and for married couples filing a joint return if only one spouse is eligible; $1,125 for married couples filing a joint return with both spouses eligible; or $562.50 each, for married couples with both spouses eligible who are filing separate returns. The credit is phased out for individuals with middle-and higher-income levels.

Deduction for impairment-related work expenses

[333] Under present law, the impairment-related work expenses of a handicapped individual are classified as miscellaneous itemized deductions not subject to the two-percent adjusted gross income ("AGI") floor. Impairment-related work expenses are expenses for attendant care services at an individual's place of employment and other expenses (but not depreciation expenses) in connection with such place of employment which are necessary for the individual to work and which are deductible as a necessary business expense. For purposes of this deduction, a handicapped individual is someone with a physical or mental disability which results in a functional limitation to employment, or who has any physical or mental impairment which substantially limits at least one major life activity.

Description of Proposal

In general

[334] The proposal would provide a tax credit to disabled individuals, not to exceed the lesser of $1,000 or the individual's earned income for the taxable year. The credit (aggregated with the child credit and the proposed long-term care credit) would be phased out for taxpayers with modified AGI above certain thresholds. Under the proposal, the sum of the otherwise allowable present-law child tax credit, the proposed disabled workers credit, and the proposed long-term care credit would be phased out at a rate of $50 for every $1,000 (or fraction thereof) of modified AGI above the threshold amount. Modified AGI and the threshold amounts would be the same as under the present-law phaseout of the child tax credit. Thus, modified AGI would be AGI plus the amount otherwise excluded from gross income under Code sections 911, 931, or 933 (relating to the exclusion of income of U.S. citizens or residents living abroad; residents of Guam, American Samoa, and the Northern Mariana Islands; and residents of Puerto Rico, respectively). The threshold amount would be $110,000 for married individuals filing a joint return, $75,000 for unmarried taxpayers, and $55,000 for married individuals filing separately. These threshold amounts would not be indexed for inflation. An individual may be able to claim both this credit and the proposed long-term care credit.

Disability rules

[335] An individual would qualify as a disabled individual if the individual is certified by a licensed physician as being unable for a period of at least one year to perform at least one activity of daily living ("ADL") without substantial assistance from another person, due to a loss of functional capacity. As under the present- law rules relating to long-term care, ADLs would be eating, toileting, transferring, bathing, dressing, and continence. Substantial assistance would include both hands-on assistance (that is, the physical assistance of another person without which the individual would be unable to perform the ADL) and stand-by assistance (that is, the presence of another person within arm's reach of the individual that is necessary to prevent, by physical intervention, injury to the individual when performing the ADL). The initial certification by a licensed physician would be required prior to the filing of the tax return in which the individual initially claims the disabled workers credit. A portion of the period certified by the physician would have to occur within the taxable year for which the credit is claimed. After the initial certification, the individual would have to be recertified by a licensed physician every three years or such other period as the Secretary prescribes.

[336] The individual would be required to provide a correct physician identification number (e.g., the Unique Physician Identification Number that is currently required for Medicare billing) for the physician making the certification. Failure to provide a correct physician identification number would be subject to the mathematical error rule (sec. 6213). Under that rule, the IRS may summarily assess additional tax due without sending the individual a notice of deficiency and giving the taxpayer an opportunity to petition the Tax Court. The taxpayer could be required to provide other proof of the existence of disability in such form and manner, and at such times, as the Secretary requires.

Tax liability limitation; refundable credits

[337] The disabled workers credit would generally be nonrefundable, which means that the credit generally would be allowed only to the extent that the individual's regular tax liability exceeds the individual's tentative minimum tax, determined without regard to the alternative minimum tax foreign tax credit (the "tax liability limitation"). However, the credit would be coordinated with the present-law child credit and the proposed long-term care credit so that the credits would be refundable for a taxpayer claiming three or more credit amounts under the credits. More than one credit amount could be attributable to a single individual. For example, a disabled worker with long-term care needs would have two credit amounts, a disabled workers credit and a long-term care credit. Similarly, a taxpayer with two children under age 17, one of whom has long-term care needs, would have three credit amounts: two child care credit amounts and one long-term care credit amount. As under the present- law child credit, the amount of refundable credit would be the amount that the nonrefundable personal credits would increase if the tax liability limitation were increased by the excess of the taxpayer's social security taxes over the taxpayer's earned income credit (if any).

Effective date

[338] The proposal would be effective for taxable years beginning after December 31, 2000.

Analysis

[339] Proponents of the proposal argue that a disabled worker's ability to pay tax may be limited compared to an identical worker who is not disabled, because the disabled worker incurs additional costs in order to work and earn income. The proposal, however, allows disabled workers to claim the credit regardless of whether they actually incur any such additional expenses. If the purpose of the proposal is to subsidize these additional expenses, it may be more efficient to condition the credit on the worker actually incurring the expenses. This, however, would entail more record keeping.

[340] Proponents of the proposed credit argue that it is intended to provide a tax benefit for lower and middle income disabled taxpayers. While present law provides some relief to such taxpayers, it is argued that some disabled taxpayers may not benefit from the present-law provisions because they have insufficient expenses to benefit from itemizing deductions, have expenses that do not qualify under present law, or rely on unpaid assistance. Opponents respond that the present-law benefits are sufficient. They also argue that the proposal is poorly targeted. For example, it does not provide relief to other individuals who have reduced ability to pay, such as individuals with significant medical expenses.

[341] Some argue that it is appropriate to extend the credit to all disabled taxpayers, irrespective of their earned income or AGI. A taxpayer's ability to pay tax is reduced by the costs of being disabled regardless of the taxpayer's income level. Nevertheless, it could be said that additional costs associated with disability reduce a higher-income taxpayer's ability to pay tax proportionately less than the same amount of costs reduce a lower-income taxpayer's ability to pay.

[342] The proposal also may be criticized for increasing the effective marginal tax rates with their inherent efficiency, equity, and complexity questions for taxpayers in the phase-out ranges. ⁸⁷ Proponents may respond, however, that phase-outs are necessary to appropriately target the benefits of the proposal to lower-and middle-income taxpayers. Others may argue that the proposal is inequitable, because it gives a $1,000 tax credit to a disabled worker with a modified AGI of $100,000 who files a joint return, but no tax credit to an unmarried worker who also has an AGI of $100,000.

[343] Another issue presented by the proposal is its efficiency. For example, a direct expenditure program could be designed to subsidize all disabled workers, even if the disabled workers had no tax liability. Such an approach would provide a benefit to a broader category of disabled workers than the tax credit structure of the proposal, because some workers are not eligible for the refundable credit under the proposal. It could also be argued that the refundable aspect of the credit adds complexity to the tax law. One response to this criticism is that the present-law child tax credit has similar rules, which may already be familiar to taxpayers and tax practitioners. Finally, some might question whether the IRS is the government agency best suited to the responsibility for verifying the disability of each worker and the identification numbers of each physician making disability certifications.

Prior Action

[344] An identical proposal was included in the President's Fiscal Year 2000 Budget Proposal.

5. Provide tax relief for small business health plans

Present Law

[345] Under present law, the tax treatment of health insurance expenses depends on the individual circumstances. Employer contributions toward employee accident or health insurance are generally deductible by employers and excludable from income and wages by employees. An individual who itemizes may deduct his or her health insurance premiums to the extent that such premiums, together with the individual's other medical expenses exceed 7.5 percent of the individual's AGI.

[346] A self-employed individual may deduct a percentage of premiums for health insurance covering the individual and his or her spouse and dependents, but only if the individual is not eligible to participate in a subsidized health plan maintained by any employer of the individual or the individual's spouse. The deduction is limited by the self-employed individual's earned income derived from the relevant trade or business. The deduction is equal to 60 percent of health insurance expenses for 1999-2000, 70 percent for 2002, and 100 percent for 2003 and thereafter.

[347] A multiple employer welfare arrangement ("MEWA") is an employee benefit plan or other arrangement that provides medical or certain other benefits to employees of two or more employers. MEWAs are generally subject to applicable State insurance laws, including provisions of State insurance law that generally comply with requirements imposed on insurance issuers under the Health Insurance Portability and Accountability Act of 1996 ("HIPAA") and other Federal laws. MEWAs (whether or not funded through insurance) are also regulated under the Employee Retirement Income Security Act of 1974, as amended ("ERISA") with respect to reporting, disclosure, fiduciary, and claims procedures.

[348] Private foundation grants (including loans) must be used by the recipient for charitable purposes. To ensure that foundation grants are used for the intended charitable purpose, so-called "expenditure responsibility" requirements apply whenever such grants are made to noncharitable organizations for exclusively charitable purposes. These requirements involve certain recordkeeping and reporting requirements. Among other things, there must be a written agreement between the foundation and the grantee that specifies clearly how the grant funds will be expended, the grantee's books and records must account separately for the grant funds, and the grantee must report annually to the foundation on the use of the grant funds and the progress made in accomplishing the purposes of the grant.

Description of Proposal

In general

[349] The proposal has two parts. First, it would provide that a grant or loan made by a private foundation to a qualified health purchasing coalition ("qualified coalition") would be treated as a grant or loan made for charitable purposes. Second, it would create a new income tax credit for the purchase of certain health insurance through a qualified coalition by small businesses that currently do not provide health insurance to their employees. Both provisions would be temporary.

Foundation grants to qualified health benefit purchasing coalitions

[350] Under the proposal, any grant or loan made by a private foundation to a qualified coalition to support the coalition's initial operating expenses would be treated as a grant or loan made for charitable purposes. As with any other grant or loan to a noncharitable organization for exclusively charitable purposes, private foundations would be required to comply with the "expenditure responsibility" recordkeeping and reporting requirements under present law.

[351] Initial operating expenses of a qualified coalition would include all ordinary and necessary expenses incurred in connection with the establishment of the qualified coalition and its initial operations, including the payment of reasonable compensation for services provided to the qualified coalition and rental payments. In addition, initial operating expenses would include the cost of tangible personal property purchased by the qualified coalition for its own use. Initial operating expenses would not include (1) the purchase of real property, (2) any payment made to, or for the benefit of, members (or employees or affiliates of members) of the qualified coalition, such as any payment of insurance premiums on policies insuring members (or their employees or affiliates), or (3) any expense incurred more than 24 months after the date of formation of the qualified coalition.

Small business health plan tax credit

[352] The proposal also would create a temporary tax credit for small businesses that purchase employee health insurance through qualified coalitions. The credit would be available to employers with at least two, but not more than 50, employees, counting only employees with annual compensation (including 401(k) and SIMPLE employer contributions) of at least $10,000 in the prior calendar year. Eligible employers could not have had an employee health plan during any part of 1998 or 1999. The credit would be available only with respect to insurance purchased through a qualified coalition. The credit would equal 20 percent of employer contributions to the cost of employee health insurance purchased through a qualified coalition. The maximum credit amount per policy would be $400 per year for individual coverage and $1,00 per year for family coverage (to be ratably reduced if coverage is provided for less than 12 months during the employer's taxable year). The credit would be allowed to a qualifying small employer only with respect to contributions made during the first 24 months that the employer purchases health insurance through a qualified coalition. This 24- month limit would not include months beginning before January 1, 2001. As a condition of qualifying for the credit, employers would need to cover at least 70 percent of those workers who have compensation (including 401(k) and SIMPLE employer contributions) of at least $10,000 and who are not covered by another employer health plan. ⁸⁸ A self-employed individual who is eligible to take a deduction for health insurance premiums would not be allowed to include any of the premiums eligible for the deduction in the calculation of the credit amount. The small business health plan credit would be treated as a component of the general business credit, and would be subject to the limitations of that credit. The amount of the credit would reduce the employer's deduction for employee health care expenses.

Requirements imposed on qualified health benefit purchasing coalitions

[353] A qualified coalition would be required to operate on a nonprofit basis and to be formed as a separate legal entity whose objective is to negotiate with health insurers for the purpose of providing health insurance benefits to the employees of its members. A qualified coalition would be authorized to collect and distribute health insurance premiums and provide related administrative services. It would need to be certified annually by an appropriate State or Federal agency as being in compliance with the following requirements. Its board would be required to have both employer and employee representatives of its small business members, but could not include service providers, health insurers, insurance agents or brokers, and others who might have a conflict of interest with the coalition's objectives. The qualified coalition could not bear insurance or financial risk, or perform any activity relating to the licensing of health plan issuers. Where feasible, the coalition would have to enter into agreements with three or more unaffiliated, licensed health plans, and would be required to offer at least one open enrollment period per calendar year. The qualified coalition would have to service a significant geographic area, but would not be required to cross State boundaries. It would be required to accept as members all eligible employers on a first-come, first-served basis, and would need to market its services to all eligible employers within its designated area. An eligible employer would be defined as any small employer, as defined under HIPPA (generally, businesses that employ an average of at least two, but not more than 50, employees).

[354] Qualified coalitions would be subject to HIPAA and other Federal health laws, including participant nondiscrimination rules and provisions applicable to MEWAs under ERISA and the Code. Thus, coalition health plans could not discriminate against any individual participant as regards enrollment eligibility or premiums on the basis of his or her health status or claims experience. In addition, employers would have guaranteed renewability of health plan access. Health plans sold through qualified coalitions would also be required to meet State laws concerning health insurance premiums and minimum benefits. State "fictitious group" laws would be preempted, and States would be required to permit an insurer to reduce premiums negotiated with a qualified coalition in order to reflect administrative and other cost savings or lower profit margins. Health plans sold through qualified coalitions would not be considered to be 10-or-more employer plans for purposes of the welfare benefit fund rules. Accordingly, participating employers would be subject to the welfare benefit fund contribution limits.

Effective date

[355] The proposal would be effective for taxable years beginning after December 31, 2000. The special foundation rule would apply to grants and loans made prior to January 1, 2009, for initial operating expenses incurred prior to January 1, 2011. The small business tax credit would be available only for health plans established before January 1, 2009. No carrybacks of the credit would be allowed to taxable years beginning before January 1, 2001.

Analysis

[356] Health insurance coverage of employees of small businesses is significantly lower than that of larger employers. One possible reason for this lower coverage is that the costs of setting up and operating health plans in the current small business insurance market can be higher than those for larger employers. Consequently, small employers may pay more for similar employee health insurance benefits than do larger employers. In addition, insurance companies may need a minimum number of covered employees in order to be able to provide insurance to a group. This makes it difficult for small employers to offer multiple health plans to their employees. Most small businesses that offer health insurance benefits do not provide their workers with a choice of health plans.

[357] The proposal is intended to increase health care coverage by reducing the cost of such coverage to small businesses in two ways. First, the proposal is intended to facilitate the establishment of health benefit purchasing coalitions. Proponents of the proposal argue that such coalitions will reduce the cost of health coverage for small businesses. It is anticipated that such coalitions will pool employer workforces, negotiate with insurers over health plan benefits and premiums, provide comparative information about available health plans to participating employees, and may administer premium payments made by employers and their participating employees. Proponents of the provision believe that, if the proposal were enacted, health care purchasing coalitions would be established and the additional tax incentives under the proposal would not be necessary on a permanent basis to help make health insurance more affordable and available to employees of small businesses. It is unclear whether coalitions will operate as intended. Under present law, in some cases MEWAs have proved unsuccessful in reducing costs, and have in some cases failed to provide the promised coverage. In some cases this has been due to fraud, while in other cases simply to mismanagement. The requirements imposed on purchasing coalitions under the proposal may reduce the likelihood of such occurrences under the proposal.

[358] The second way the proposal intends to decrease health insurance costs is by providing a tax credit for the purchase of health insurance through the health benefit purchasing coalitions. While the credit is in effect, it will directly reduce the cost of health care coverage purchased by small businesses through a health benefit purchasing coalition. By reducing the effective price of health insurance, providing a tax credit for the purchase of health insurance may lead to larger expenditures on health insurance than might otherwise be the case. This extra incentive for health insurance may be desirable if some of the benefits of an individual's having health insurance accrue to society at large (e.g., through a healthier, more productive workforce, or a reduction in health expenditures for uninsured individuals). In that case, absent the subsidy, individuals would underinvest in health insurance (relative to the socially desirable level) because they would not take into account the benefits that others receive. To the extent that expenditures on health insurance represent purely personal consumption, a subsidy would lead to over consumption of health insurance.

[359] The proposed credit does not target all individuals without health insurance, only those who work for small employers. Some argue that, because the objective of the proposal is to increase health insurance coverage, it would be more efficient to provide a tax benefit to individuals for the purchase of health insurance rather than to employers. For example, individuals who do not have access to subsidized employer insurance or who have been uninsured for a certain period of time could be provided a tax credit or deduction for the purchase of health insurance. Others question why the tax credit should apply only to the purchase of health care through a health benefit purchasing coalition. They argue that if such coalitions were the most economically efficient means of purchasing insurance, they would be competitive without the requirement that the tax credit is available only for insurance purchased through them. Furthermore, they would question how restricting the health care choices available to small businesses in order to qualify for the credit could help such businesses find the best insurance at the best price.

[360] Proponents of the proposal relating to private foundations argue that the formation of health benefit purchasing coalitions has been hindered by their limited access to capital. Some private foundations have indicated a willingness to fund coalition start-up expenses; however, private foundations are prohibited under the Code from making grants for other than charitable purposes. It is unclear under present law whether the funding of start-up expenses of health benefit purchasing coalitions would qualify as a "charitable purpose." Consequently, private foundations are reluctant to make grants to fund coalition start-up expenses.

[361] The temporary nature of the provisions may result in additional complexity. Present law contains a variety of expiring tax provisions, such as the exclusion for employer provided educational assistance and the research and development credit. These provisions, initially enacted on a temporary basis, have been repeatedly extended, sometimes on a retroactive basis after the provision has expired. Such expiring provisions create uncertainty and complexity, because it is often unclear whether (or when) the provision will be extended. Enacting a new temporary provision would likely involve the same complexity and uncertainty.

Prior Action

[362] A similar proposal was included in the President's Fiscal Year 2000 Budget Proposal, except that the small business tax credit in the prior proposal was 10 percent of eligible expenses, with per policy maximums of $200 for individual coverage and $500 for family coverage. In addition, in the prior proposal, the provisions would have been in effect for only four years.

6. Encourage the development of vaccines for targeted diseases

Present Law

In general

[363] No credit is provided for the sale of vaccines. However, present law does have three provisions relating to the development of vaccines.

Research credit

[364] Section 41 provides for a research tax credit equal to 20 percent of the amount by which a taxpayer's qualified research expenditures for a taxable year exceeded its base amount for that year. The research tax credit expired and generally does not apply to amounts paid or incurred after June 30, 2004.

[365] Except for certain university basic research payments made by corporations, the research tax credit applies only to the extent that the taxpayer's qualified research expenditures for the current taxable year exceed its base amount. The base amount for the current year generally is computed by multiplying the taxpayer's "fixed-base percentage" by the average amount of the taxpayer's gross receipts for the four preceding years. The taxpayer's "fixed-base percentage" generally is the ratio that its total qualified research expenditures for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum ratio of .16). All other taxpayers (so- called "start-up firms") are assigned a fixed-base percentage of 3 percent.

[366] Taxpayers are allowed to elect an alternative incremental research credit regime. If a taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered fixed- base percentage (that is lower than the fixed-base percentage otherwise applicable under present law) and the credit rate likewise is reduced. Under the alternative credit regime, a credit rate of 2.65 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1 percent (i.e., the base amount equals 1 percent of the taxpayer's average gross receipts for the four preceding years) but do not exceed a base amount computed by using a fixed-base percentage of 1.5 percent. A credit rate of 3.2 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1.5 percent but do not exceed a base amount computed by using a fixed-base percentage of 2 percent. A credit rate of 3.75 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 2 percent. An election to be subject to this alternative incremental credit regime may be made for any taxable year beginning after June 30, 1996, and such an election applies to that taxable year and all subsequent years (in the event that the credit subsequently is extended by Congress) unless revoked with the consent of the Secretary of the Treasury.

Orphan drug credit

[367] Taxpayers may claim a 50-percent credit for expenses related to human clinical testing of drugs for the treatment of certain rare diseases and conditions, generally those that afflict less than 200,000 persons in the United States (sec. 45C). Qualifying expenses are those paid or incurred by the taxpayer after the date on which the drug is designated as a potential treatment for a rare disease or disorder by the Food and Drug Administration ("FDA") in accordance with the section 526 of the Federal Food, Drug, and Cosmetic Act.

Vaccine excise tax

[368] A manufacturer's excise tax is imposed at the rate of 75 cents per dose (sec. 4131) on the following vaccines recommended for routine administration to children: diphtheria, pertussis, tetanus, measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, varicella (chicken pox), rotavirus gastroenteritis, and any conjugate vaccine against streptococcus pneumoniae. The tax applied to any vaccine that is a combination of vaccine components equals 75 cents times the number of components in the combined vaccine.

[369] Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury Compensation Trust Fund ("Vaccine Trust Fund") to finance compensation awards under the Federal Vaccine Injury Compensation Program for individuals who suffer certain injuries following administration of the taxable vaccines. This program provides a substitute Federal, "no fault" insurance system for the State-law tort and private liability insurance systems otherwise applicable to vaccine manufacturers and physicians.

Description of Proposal

[370] The proposal would provide a credit against the taxpayer's income tax liability for the sale of a qualifying vaccine to a qualifying nonprofit organization. The credit would be equal to 100 percent of the taxpayer's receipts from a qualified sale. The total amount of credit that may be claimed annually by taxpayers is subject to an annual limitation. The credit would be a general business credit.

[371] A qualifying vaccine is a vaccine against a specified "targeted" disease that receives Food and Drug Administration ("FDA") approval after the date of enactment. Malaria, tuberculosis, and HIV/ AIDS would comprise targeted diseases. In addition, the Secretary of the Treasury, with the consultation of the Centers for Disease Control and Prevention ("CDC") and the U.S. Agency for International Development ("USAID"), could designate any infectious disease (of a single etiology) that is estimated to cause more than one million deaths annually worldwide as a targeted disease.

[372] A qualified nonprofit organization is a nonprofit organization that purchases and distributes vaccines for developing countries. Taxpayers could claim a credit for certain sales to such organizations only if the nonprofit organization has received a credit allocation from the USAID with respect to specific purchases of qualifying vaccines.

[373] The USAID could make up to $100 million in credit allocations for calendar years 2002 through 2006 and up to $125 million in credit allocations for calendar years 2007 through 2010. Credits unallocated in any year could be carried forward for up to ten succeeding years and made available for allocations in such succeeding year. For example, if USAID allocated $75 million in credits to qualified nonprofit organizations in 2005, all or part of the remaining $25 million could be made available for allocation in any year between 2006 through 2015. Credits unallocated after the ten-year carried forward would be canceled.

[374] Effective date. -- The proposal would be effective for sales of qualifying vaccines with respect to which a credit allocation has been made after December 31, 2001.

Analysis

Vaccines and spillover benefits

[375] Intentional distortions to markets generally reduce overall economic efficiency. However, consumption of certain goods may yield benefits to individuals other than solely the individual who consumes the good. Such benefits are called spillover benefits or positive externalities. Because individuals make their purchase decisions based on their private benefit without accounting for the spillover benefits that others might receive, economists argue that too little of such goods are provided in the private market and that a subsidy might be warranted to produce a more socially efficient outcome. Most analysts concur that vaccines are an example of goods that provide society with spillover benefits. A vaccination provides the patient with protection against infectious disease and also reduces the probability with which other individuals become exposed to such a disease.

[376] To be fully efficient, the magnitude of the subsidy provided for the purchase or supply of vaccines should vary with the magnitude of the external benefit the vaccine provides. The proposal would target malaria, tuberculosis, and HIV/ AIDS. There may be other vaccines with substantial spillover benefits that are excluded from the subsidy provided by the credit or the spillover benefit from an effective vaccine against one disease may be greater than that of another. On the other hand, calculation of such spillover benefits is difficult in practice and may not justify making distinctions in the magnitude of subsidies for different vaccines.

Subsidy value of the proposed credit

[377] The proposal would provide a tax credit equal to 100 percent of the revenue from a qualifying vaccine sale. With an allocation of credits, a qualified nonprofit buyer of vaccines could make a bid to the seller of vaccines to purchase the vaccines for less than the market price. Because such a sale would permit the seller to claim a tax credit for the sale, the seller might be willing to sell the vaccines for a below market price. Although the seller takes in less revenue, the seller also may claim a tax credit.

[378] In a competitive market, a 100-percent credit on the sale of vaccine has the effect of providing a subsidy in excess of 50- percent of the market price of the vaccine. To see this consider a vaccine that would otherwise sell for $1.00 per dose. If a buyer offered the seller 50 cents for the dose, normally the seller would reject the offer. However, if the buyer's offer of 50 cents were accompanied by a tax credit entitling the seller to reduce his income tax liability then the seller would receive 50 cents from the sale and a reduction in income taxes by 50 cents for a total of $1.00 received by the seller as a result of the sale. The seller would be just as well off as if he had sold the vaccine for $1.00 in the absence of the tax credit. Thus, for an offer of 50 cents, the buyer has been able to purchase a vaccine worth $1.00. At this initial level of analysis, the tax credit would appear to be equivalent to a 50-percent subsidy to the market price of the vaccine.

[379] The tax credit is not exactly the same as a direct subsidy to the purchase of the vaccine. A direct subsidy generally is paid on a "before tax" basis while the tax credit provides an "after tax" benefit. For example, if a direct subsidy were provided to vaccine purchases, the buyer would pay the seller 50 cents and the government would pay the seller 50 cents. The seller would receive $1.00 in revenue, from which the seller would deduct costs, compute taxable income, and pay income tax. ⁸⁹ In short, 50 cents of tax credit generally is worth more than 50 cents of revenue. With the tax credit, the seller's gross revenue is 50 cents less than it otherwise would be. Hence, the seller's income tax liability is reduced by 50 cents times the seller's marginal income tax rate. In addition, the seller may claim a 50 cent income tax credit. Thus, the sale to a buyer who offers a tax credit reduces the seller's income tax liability by 50 t + 50] cents, where t is the seller's marginal income tax rate. Thus, the effective subsidy provided by the tax credit exceeds 50 percent of the purchase price. For a corporate taxpayer subject to the top statutory marginal tax rate of 35 percent, the effective subsidy provided by the tax credit is approximately 61 percent. ⁹⁰

[380] The credit may not be of equal value to all taxpayers. As discussed above, to the extent that different taxpayers are subject to different marginal income tax rates, the value of the subsidy will differ. In addition, the alternative minimum tax minimum tax effectively may defer when the taxpayer may claim the benefit of the credit. Deferring the credit reduces the present value of the credit.

Subsidies to supply, subsidies to demand, and the market for vaccines

[381] A subsidy may be structured to increase the supply of a product, generally by reducing the cost of supplying the product. As the supply of a product increases, generally the price of the product declines and the quantity of the product consumed increases. The present-law research tax credit and orphan drug tax credit are examples of supply subsidies. ⁹¹ These credits reduce the cost of the research and testing necessary to bring new vaccines to market. These credits should work to increase the supply of vaccines.

[382] Alternatively, a subsidy may be structured to increase the demand for a product, generally by reducing the net price that consumers pay for the subsidized product while not altering the gross price received by suppliers. If the demand for a product increases, generally the quantity of the product consumed increases and the price of the product increases. The proposed tax credit for vaccine sales is an example of a demand subsidy. By making it cheaper for qualified organizations to procure targeted vaccines, the demand for targeted vaccines should increase. ⁹² The proposal would provide a credit for the qualified sale of targeted vaccines that do not currently exist. By increasing the potential demand for a product that does not currently exist, the profit potential of such a product increases and investment may flow into research to create and market the targeted vaccines.

[383] The discussion in the preceding section suggested that the credit may have the effect of reducing the price of a targeted vaccine sold to a qualified nonprofit buyer by 50 to 61 percent. That analysis was predicated on stringent assumptions regarding the competitiveness of the market for vaccines and the nature of supply conditions in the market for vaccines. ⁹³ If it is assumed that the market for vaccines is competitive, the extent to which prices and quantities ⁹⁴ consumed increase in response to a demand subsidy depends upon the responsiveness to supply to changes in price. If small changes in price bring forth substantial additional quantities of a product to the market, then the benefit of a subsidy will accrue primarily to consumers of the subsidized good. If a large change in price brings forth only modest increases in quantities of a product to the market, then the benefit of a subsidy will accrue primarily to the supplier of the good. In general, by increasing demand, the proposed credit may increase market prices. While the credit would still have the effect of reducing the price of a targeted vaccine sold to a qualified nonprofit buyer by 50 to 61 percent, the new net price paid by the nonprofit buyer may be less than 50 to 61 percent below the unsubsidized market price.

[384] The discussion of the preceding paragraph assumes the market for vaccines is competitive. In practice, developers of new vaccines patent their discovery. The patent grants the developer monopoly rights for a limited period. As the sole seller, there is no competitor providing an incentive for the seller to accept a below market bid for a vaccine from a qualified nonprofit buyer with a tax credit allocation. Some studies of oligopolistic markets have found "undershifting" of excise tax reductions and "overshifting" of excise tax increases. ⁹⁵ That is, prices in the markets fell by less than the tax reduction and rose by more than the tax increase. On the other hand, the proposal would allocate credits to a limited number of nonprofit buyers. This may create bargaining power on the part of the buyers sufficient to offset the seller's position as monopolist in the vaccine.

[385] The cost of the tax credit will be borne by U.S. taxpayers generally. Under the proposal, the subsidy to purchase would apply directly to purchases for vaccinations given overseas. If the increase in demand created by this subsidy leads to increases in prices of vaccines above those which would otherwise occur, then in addition to bearing the a tax cost of the subsidy to foreign consumption of the vaccines, U.S. persons who use the vaccines also would bear a price increase. In addition, if a premise for providing the subsidy via tax credit is that targeted vaccines provide spillover benefits, subsidizing only foreign purchases may mitigate the spillover benefits produced as most of the spillover benefits from increasing vaccinations accrue within local populations receiving vaccinations. On the other hand, given that there currently are no vaccines against these diseases, if an increase in worldwide demand leads to the discovery of vaccines, the U.S. persons will benefit. In addition, most cases of tuberculosis within the United States arrived in the United States with persons from less developed countries. Inoculations abroad may be the most efficacious method to eliminate tuberculosis within the United States.

Other issues

[386] The proposal acts as a targeted source of foreign aid administered by USAID and the IRS. The USAID is granted authority to allocate $1 billion of tax benefits which, as discussed above, is equivalent to granting spending authority to subsidize purchases of certain vaccines for administration in certain foreign countries. Some criticize funding an explicit foreign aid program through the tax code and outside the normal oversight of the appropriate congressional committees. Such critics note that funding such programs through the tax code masks the true size of the USAID budget and programs.

[387] The proposal also would grant to the Secretary of the Treasury authority to expand the scope of the tax credit, albeit subject to guidelines. Some see such authority as an inappropriate delegation of the Congress's constitutional authority to impose taxes. They argue that tax subsidies for new products should be granted only after congressional deliberation. Others respond that such authority, while it does substantially alter the tax liabilities of certain taxpayers, provides the flexibility needed to address new diseases and vaccines as they arise. Moreover, they note that because the amount of total credits that could be allocated is limited to $1 billion over the ten years 2001 through 2010, the Secretary would not be able to substantially modify the scope of the tax credit benefit.

[388] As noted above, the proposal would target tax credits for vaccines that do not yet exist. The tax benefits would be available for years 2001 through 2010. Often pharmaceutical and biological research and product approval consume more than ten years. Some suggest that a credit of limited duration may not yield a substantial increase in research efforts due to the long lead times necessary to bring new vaccines to market.

Prior Action

[389] No prior action.

D. Family and Work Incentive Provisions

1. Provide marriage penalty relief and increase the basic standard

Marriage tax penalty

[390] A married couple is treated as one tax unit that must pay tax on the couple's total taxable income. This filing status is referred to as "married individuals filing joint returns." Married couples may elect to file separate returns; however, the rate schedules and other provisions are structured so that filing separate returns usually results in a higher tax than filing a joint return. Other rate schedules apply to single persons, to single heads of households, to surviving spouses, and to trusts and estates.

[391] A "marriage penalty" exists when the combined tax liability of a married couple filing a joint return is greater than the sum of the tax liabilities of each individual computed as if the couple were not married. A "marriage bonus" exists when the combined tax liability of a married couple filing a joint return is less than the sum of the tax liabilities of each individual computed as if the couple were not married.

[392] While the size of any marriage penalty or bonus under present law depends upon the individuals' incomes, number of dependents, and itemized deductions, married couples whose incomes are split more evenly than 70 percent/ 30 percent generally incur a marriage penalty. Married couples whose incomes are largely attributable to one spouse generally receive a marriage bonus.

[393] Under present law, the size of the standard deduction and the tax bracket breakpoints follow certain customary ratios across filing statuses. The standard deduction and tax bracket breakpoints for single filers are roughly 60 percent of those for joint filers. ⁹⁶ Thus, the sum of the standard deductions for two unmarried individuals exceeds the standard deduction for a married couple filing a joint return. ⁹⁷

Basic standard deduction

[394] Taxpayers who do not itemize deductions may use the basic standard deduction which is ⁹⁸ subtracted from adjusted gross income ("AGI") in arriving at taxable income. The size of the basic standard deduction varies according to filing status and is indexed for inflation. For 2000, the size of the basic standard deduction for each filing status is shown in the following table:

            Table 3. -- Basic Standard Deduction Amounts

Description of Proposal

Marriage tax penalty relief

[396] The proposal would increase the basic standard deduction for a two-earner married couple filing jointly to the lesser of: (1) the basic standard deduction for a one-earner married couple filing jointly plus the earned income of the lower earning spouse; or (2) twice the basic standard deduction amount for a single return. Earned income would be defined as the sum of wages, salaries, and net income from self employment less certain deductions for IRA, Keogh, SEP, and SIMPLE plan contributions, self-employed health insurance, and one- half of self-employment taxes. This increase would be phased in over five years. The maximum increase for each year is the following percentage of the difference between the basic standard deduction for joint filers and twice the basic standard for unmarried filers.

                        Maximum increase in the size of

Increase in the standard deduction

[398] The proposal would also increase the otherwise allowable maximum basic standard deduction by $250 for single filers, $350 for heads of households, and $500 for married couples filing a joint return in 2005. Beginning in 2006, the amount of these increases would be indexed for inflation under the present-law rules for indexing of the standard deductions. These increases would be in addition to the increase, if any, in the basic standard deduction for two-earner couples filing jointly.

Effective date

[399] The proposal relating to marriage tax penalty relief would be effective for taxable years beginning after December 31, 2000. The proposal to increase the basic standard deductions would be effective for taxable years beginning after December 31, 2004.

Analysis

Marriage tax penalty relief

[400] A marriage penalty exists when the combined tax liability of a married couple filing a joint return is greater than the sum of their tax liabilities had each spouse filed his or her taxes as if they were not married. This measure of the marriage penalty may represent the combined effects of many provisions of the Code. In the case of taxpayers who do not itemize their deductions, at least a part of the marriage penalty is attributable to the basic standard deduction. ⁹⁹ In the case of a married couple with no dependents who claim the basic standard deduction, the marriage penalty attributable to the basic standard deduction is the tax attributed to the amount by which the sum of two basic standard deductions for unmarried individuals exceeds the basic standard deduction for married couples filing jointly. If a married couple who claim the basic standard deduction has one or more dependents, the marriage penalty relating to the basic standard deduction depends on whether each spouse; if unmarried, would file as an unmarried individual or a head of household. In such a case, the marriage penalty attributable to the basic standard deduction is the amount by which the sum of the standard deductions attributable to each of the spouses exceeds the standard deduction for married couples filing jointly.

[401] Because marriage penalties are greater the more evenly divided the spouses incomes, marriage penalties tend to be concentrated in two-earner couples. By contrast, most single-earner couples experience a marriage bonus. Proponents of this proposal argue that it is targeted to address the circumstances that are most likely to produce a marriage penalty without affecting couples with a marriage bonus. Specifically, it would limit tax relief to married couples where each spouse has earned income. ¹⁰⁰ Opponents argue that this targeting is unduly complex and fails to address some marriage penalties. They argue that the calculations required by the proposal are more complicated than simply claiming a single larger standard deduction. Further, they argue that the proposal would not address a marriage penalty in the case where both spouses have taxable income but one spouse's taxable income is entirely unearned income. Examples include a married couple where one spouse's only source of income is unemployment compensation, Social Security and railroad retirement benefits, or taxable disability payments from a private insurance contract purchased by the individual. Advocates of this proposal argue that the level of complexity associated with this proposal is low and that it addresses the majority of cases where the present-law standard deduction results in a marriage penalty. They contend that extending tax relief to taxpayers without earned income would give more couples marriage bonuses than it would reduce the number of couples with marriage penalties.

[402] Some argue that the proposal fails to properly address the marriage penalty in the case of married couples with dependents who claim the basic standard deduction. In that case, critics argue that the marriage penalty as it relates to the basic standard deduction can be eliminated only if the basic standard for a married couple filing jointly is increased to an amount equal to the sum of the basic standard deductions for the two spouses had one or both spouses claimed the basic standard deduction for heads of households. Proponents of the proposal respond that increasing the basic standard deduction for married couples filing a joint return to twice the basic standard deduction for a head of household would create additional marriage bonuses (e.g., if only one spouse would have been eligible for head of household status had the couple filed separate returns). They also argue that any attempts to attribute head of household status to one or both spouses for purposes of computing the marriage penalty as it relates to the basic standard deduction would be imprecise and possibly subject to manipulation (i.e., absent rules regarding the allocation of children between the spouses, a couple may simply allocate the children between themselves so as to minimize the combined tax liability).

Increase in the standard deduction

[403] Proponents of the proposal argue that increasing the basic standard deduction for each filing status is a fair and responsible form of comprehensive tax relief. In fact, most taxpayers claim the standard deduction and would therefore benefit from this proposal. The proposal would also reduce the number of taxpayers who claim itemized deductions. This should relieve those taxpayers of certain record keeping requirements and ease some of the complexity of filing their tax returns. Others may respond that the proposal is unfair because it provides no tax relief to taxpayers who do not claim the basic standard deduction (e.g., approximately one half of married couples filing jointly).

Reduction of regular tax liability and the alternative minimum tax "AMT"

[404] Both of the proposals relating to the basic standard deduction would reduce the regular tax liability of affected taxpayers without changing their tentative minimum tax liability. This would result in an increase in the AMT liability of some taxpayers already on the AMT and would increase the number of taxpayers who have AMT liability. Other taxpayers would not experience an increase in AMT liability but would not fully benefit from the proposal because their ability to claim nonrefundable personal credits would be affected by their tentative minimum tax liability. The proposals relating to the AMT would mitigate these effects, but not completely offset them. Those proposals would: (1) allow taxpayers who use a standard deduction for regular income tax purposes to use it for AMT purposes in the years 2000 and 2001; and (2) allow dependent personal exemptions for AMT purposes. ¹⁰¹ The proposal to allow dependent personal exemptions for AMT purposes would be phased in over 10 years (2000-2010). Opponents of this proposal argue that if more individuals become subject to the AMT as a result of the proposal, these individuals will have to include a calculation of the tentative minimum tax and file the appropriate minimum tax forms. This increased complexity could lead to greater taxpayer confusion and tax preparation costs for affected individuals.

Prior Action

[405] The Marriage Tax Penalty Relief Act of 2000, as passed by the House, contains a proposal to increase the basic standard deduction for joint filers to twice the basic standard deduction for single filers.

2. Increase, expand, and simplify the dependent care credit

Present Law

Dependent care credit

[406] A nonrefundable credit is provided under present-law for up to 30 percent of a limited amount of employment-related dependent care expenses of a taxpayer who maintains a household which includes one or more qualifying individuals (sec. 21). Eligible employment- related expenses are limited to $2,400 if there is one qualifying individual or $4,800 if there are two or more qualifying individuals. Generally, a qualifying individual is a dependent under the age of 13 or a physically or mentally incapacitated dependent or spouse. No credit is allowed for any qualifying individual unless a valid taxpayer identification number ("TIN") has been provided for that individual. A taxpayer is treated as maintaining a household for a period if the taxpayer (or the taxpayer's spouse, if married) provides more than one-half the cost of maintaining the household for that period. In the case of married taxpayers, the credit is not available unless they file a joint return.

[407] Employment-related dependent care expenses are expenses for household services and for the care of a qualifying individual incurred to enable the taxpayer to be gainfully employed, other than expenses incurred for an overnight camp. For example, amounts paid for the services of a housekeeper generally qualify if such services are performed at least partly for the benefit of a qualifying individual; amounts paid for a chauffeur or gardener do not qualify.

[408] Expenses that may be taken into account in computing the credit generally may not exceed an individual's earned income or, in the case of married taxpayers, the earned income of the spouse with the lesser earnings. Thus, if one spouse has no earned income, generally no credit is allowed.

[409] The 30-percent credit rate is reduced, but not below 20 percent, by 1 percentage point for each $2,000 (or fraction thereof) of adjusted gross income ("AGI") above $10,000.

Interaction with employer-provided dependent care assistance

[410] The maximum amount of employment-related expenses that can be taken into account for purposes of the dependent care credit is reduced to the extent that the taxpayer has received employer- provided dependent care assistance that is excludable from gross income (sec. 129). The exclusion for dependent care assistance is limited to $5,000 per year and does not vary with the number of children.

Additional credit for taxpayers with dependents under the age of one

[411] There is no additional credit for taxpayers with dependents under the age of one.

Description of Proposal

[412] The proposal would make several changes to the dependent care tax credit.

Refundability

The basic credit would be made refundable.

Expand basic dependent care credit

[413] The credit percentage would be increased to 50 percent for taxpayers with AGI of $30,000 or less. This increase would be phased in as follows:

 Phase in for Increase of Maximum Credit Percentage of Basic Credit

[415] Under the proposal, an otherwise qualifying taxpayer would generally qualify for the dependent care tax credit if the taxpayer resided in the same household as the qualifying individual for more than one half the year, regardless of whether the taxpayer contributed over one-half the cost of maintaining the household. The proposal would extend the credit to a qualifying spouse filing a separate return. However, in that case, the spouse claiming the dependent care tax credit would have to satisfy the present-law household maintenance test.

[416] Finally, under the proposal, the dollar amounts of the starting point of the new phase-down range and the maximum amount of eligible employment-related expenses would be indexed for inflation beginning in 2002.

Additional credit for dependents under the age of one ("infants")

[417] The proposal would expand the dependent care credit to provide an additional nonrefundable credit for all taxpayers with qualifying dependents under the age of one, regardless of whether or not they incur any employment-related expenses and regardless of whether both spouses work. The proposal would provide up to $250 of additional credit ($500 for two or more qualifying infants). This additional credit, would be equal to the applicable credit rate times $500 ($1,000 for two or more qualifying infants).

Effective date

[418] Generally, the proposal would be effective for taxable years beginning after December 31, 2000. The proposal relating to the refundability of the basic credit would be effective for taxable years beginning after December 31, 2002. The starting point of the phase-down range for the credit, the maximum amounts of eligible employment-related expenses generally and the maximum amount of the additional credit for taxpayers with infants would be indexed for inflation for taxable years beginning after December 31, 2001.

Analysis

Economic analysis of tax benefits for child care

[419] One of the many factors that may influence the decision as to whether the second parent in a two-parent household works outside the home is the tax law. ¹⁰² The basic structure of the present-law graduated income tax may act as a deterrent to work outside of the home. The reason for this is that the income tax taxes only labor the value of which is formally recognized through the payment of wages. ¹⁰³ Work in the home, though clearly valuable, is not taxed. One way to see the potential impact of this bias is to consider the case of a parent who could work outside the home and earn $10,000. Assume that in so doing the family would incur $10,000 in child care expenses. Thus, in this example, the value of the parent's work inside or outside the home is recognized by the market to have equal value. ¹⁰⁴ From a purely monetary perspective (ignoring any work- related costs such as getting to work, or buying clothes for work), this individual should be indifferent between working inside or outside the home. The government also should be indifferent to the choice of where this parent expends the parent's labor effort, as the economic value is judged to be the same inside or outside the home. However, the income tax system taxes the labor of this person in the formal marketplace, but not the value of the labor if performed in the home. Thus, of the $10,000 earned in the market place, some portion would be taxed, leaving a net wage of less than $10,000. ¹⁰⁵ From a strictly monetary perspective, this parent would be better off by staying at home and enjoying the full $10,000 value of home labor without taxation. ¹⁰⁶

[420] Because labor in the home is not taxed, most economists view the income tax as being biased towards the provision of home labor, resulting in inefficient distribution of labor resources. For example, if the person in the above example could earn $12,000 in work outside the home and pay $10,000 in child care, work outside the home would be the efficient choice in the sense that the labor would be applied where its value is greatest. However, if the $12,000 in labor resulted in $2,000 or more in additional tax burden, this individual would be better off by working in the home. The government could eliminate or reduce this bias in several ways. First, it could consider taxing the value of "home production." Most would consider this unfair and not feasible for administrative reasons. The second alternative would be to eliminate or reduce the burden of taxation on "secondary" earners when they do enter the formal labor force. This approach was implemented through the two-earner deduction (from 1982- 1986), which allowed a deduction for some portion of the earnings of the lesser-earning spouse. ¹⁰⁷ Another approach, and part of present law, is to allow tax benefits for child care expenses, provided both parents (or if unmarried, a single parent) work outside the home. This latter approach is targeted to single working parents and two-earner families with children, whereas the two-earner deduction applied to all two-earner couples regardless of child care expenses.

[421] The proposal to expand the basic dependent care credit would reduce the tax burden on families that pay for child care relative to all other taxpayers. Alternatives such as expanding the child tax credit ¹⁰⁸ or the value of personal exemptions for dependents would target tax relief to all families with children regardless of the labor choices of the parents. However, families without sufficient income to owe taxes would not benefit.

[422] Proponents of the proposal argue that child care costs have risen substantially, and the dependent care credit needs to be expanded to reflect this and ensure that children are given quality care. Opponents would argue that the current credit is a percentage of expenses, and thus as costs rise so does the credit. However, to the extent one has reached the cap on eligible expenses, this would not be true. Furthermore, the maximum eligible employment-related expenses and the income levels for the phaseout have not been adjusted for inflation since 1982, when the amounts of maximum eligible employment-related expenses were increased. It also could be argued that the increase is needed to lessen the income tax bias against work outside of the home. However, the increase in the number of families with two working parents might suggest that any bias against work outside of the home has been mitigated by other forces, such as increased wages available for work outside of the home. Others argue that the increasing number of two-earner couples with children is not the result of any reduction in the income tax bias against work outside of the home, but rather reflects economic necessity in many cases.

[423] Opponents of the proposal contend that all families with children should be given any available tax breaks aimed at children, regardless of whether they qualify for the dependent care tax credit. In this regard, they may support the element of the proposal extending a tax benefit to all taxpayers with dependents under the age of one. This latter group may cite as support for their position that the size of the personal exemption for each dependent is much smaller than it would have been had it been indexed for inflation in recent decades. In their view, even with the addition of the child tax credit, the current Federal income tax does not adequately account for a family with children's decreased ability to pay taxes.

[424] It is not clear whether opponents of the proposal also believe that there should be biases in the income tax in favor of a parent staying at home with the children. It should be noted that two-earner married couples with children are often affected by the so-called marriage penalty. ¹⁰⁹ Conversely, those for whom one parent stays at home generally benefit from a "marriage bonus." The proposal to increase the dependent care credit can be thought of as a proposal to decrease the marriage penalty for families with children. ¹¹⁰

Complexity and marginal rate issues

[425] Some argue that the replacement of the maintenance of household test with a residency test for purposes of the dependent care credit is a significant simplification. Others respond that taxpayers' compliance burden will not be significantly reduced because the dependency requirement which is retained under the proposal requires the application of a set of rules, including a support test, with a compliance burden similar to that of the maintenance of household test.

[426] The proposal's modifications relating to the phase-out of the credit increase complexity for some taxpayers while reducing complexity for others. By phasing out the dependent care credit over the $30,000 to $60,000 income range, many more families are likely to be in the phase out ranges. For those families, the application of a phase-out is an increase in complexity. In contrast, families with income levels who would be subject to the present-law phase-down range but not the phase out range under the proposal would enjoy a reduction in complexity.

[427] Additionally, the phase-out rate under the proposal is steeper than under present law. Present law has a reduction in the credit rate of 1 percent for each additional $2,000 of AGI in the phase-out range. This proposal would reduce the credit rate by 1 percent for each $1,000 of AGI in the phase-out range. The marginal tax rate implied by the phaseout is thus twice as great as the marginal tax rate under present law. Under present law, a taxpayer with maximum eligible expenses of $4,800 will thus lose $48 in credits for each $2,000 of income in the phase-out range, which is equivalent to a marginal tax rate increase of 2.4 percentage points ($ 48/$ 2,000). Under the proposal, marginal tax rates would be increased by 4.8 percentage points ($ 48/$ 1,000) for those in the phase-out range. Thus, the dependent care credit could decrease work effort for two reasons. By increasing marginal tax rates for those in the phase-out range, the benefit from working is reduced. Additionally, for most recipients of the credit, after-tax incomes will have been increased, which would enable the taxpayer to consume more of all goods, including leisure. A positive effect on labor supply will exist for those currently not working, for whom the increased credit might be an incentive to decide to work outside of the home. ¹¹¹

Prior Action

[428] A substantially similar proposal (not including the proposals to make the basic credit refundable and to create the additional credit for taxpayers with qualifying dependents under the age of one) was included in the President's Fiscal Year 1999 Budget Proposal. Another substantially similar proposal (which included the additional credit for taxpayers with qualifying dependents under the age of one but not the proposal to make the basic credit refundable) was included in the President's Fiscal Year 2000 Budget Proposal. A similar proposal was included in the Taxpayer Refund and Relief Act of 1999 as passed by Congress and vetoed by the President.

3. Provide tax incentives for employer-provided child care facilities

Present Law

[429] Generally, present law does not provide a tax credit to employers for supporting child care or child care resource and referral services. ¹¹² An employer, however, may be able to deduct such expenses as ordinary and necessary business expenses. Alternatively, the taxpayer may be required to capitalize and amortize the expenses over time.

Description of Proposal

Employer tax credit for supporting employee child care

[430] Under the proposal, a tax credit would be provided equal to 25 percent of qualified expenses for employee child care. These expenses would include costs incurred: (1) to acquire, construct, rehabilitate or expand property that is to be used as part of a taxpayer's qualified child care facility; (2) for the operation of a taxpayer's qualified child care facility, including the costs of training and continuing education for employees of the child care facility; or (3) under a contract with a qualified child care facility to provide child care services to employees of the taxpayer. To be a qualified child care facility, the principal use of the facility must be for child care, and the facility must be duly licensed by the State agency with jurisdiction over its operations. Also, if the facility is owned or operated by the taxpayer, at least 30 percent of the children enrolled in the center (based on an annual average or the enrollment measured at the beginning of each month) must be children of the taxpayer's employees. If a taxpayer opens a new facility, it must meet the 30-percent employee enrollment requirement within two years of commencing operations. If a new facility failed to meet this requirement, the credit would be subject to recapture.

[431] To qualify for the credit, the taxpayer must offer child care services, either at its own facility or through third parties, on a basis that does not discriminate in favor of highly compensated employees.

Employer tax credit for child care resource and referral services

[432] Under the proposal, a tax credit would be provided equal to 10 percent of expenses incurred to provide employees with child care resource and referral services.

Other rules

[433] The maximum aggregate credits that a taxpayer could receive under the proposal would be $150,000 per year. Any amounts of qualified expenses that would otherwise be deductible would be reduced by the amount of these credits. Similarly, the taxpayer's basis in a facility would be reduced by the amount of the credits for expenses of acquiring, constructing, rehabilitating, or expanding the facility.

Effective date

[434] The credits would be effective for taxable years beginning after December 31, 2000.

Analysis

[435] It is argued that providing these tax benefits may encourage employers to spend more money on child care services for their employees and that increased quality and quantity of these services will be the result. On the other hand, less desirable results may include a windfall tax benefit to employers who would have engaged in this behavior without provision of these tax benefits, and a competitive disadvantage in the hiring and retaining of workers for nonprofit organizations who cannot take advantage of these new tax benefits.

[436] Opponents of the proposal argue that adding complexity to the tax law can undermine the public's confidence in the fairness of the tax law, and that the country's child care problems and other social policy concerns can be more efficiently addressed through a spending program than through a tax credit. Proponents argue that any additional complexity in the tax law is outweighed by increased fairness. They contend that present law has not taken into account the changing demographics of the American workforce and the need to provide improved child care for the ever increasing numbers of two- earner families.

Prior Action

[437] The proposal was included in the President's Fiscal Year 1999 and 2000 Budget Proposals. Also, the Taxpayer Refund and Relief Act of 1999, as passed by the Senate, included a similar provision. Finally, the Taxpayer Relief Act of 1997, as passed by the Senate, would have provided a temporary tax credit (taxable years 1998 through 2000) equal to 50 percent of an employer's qualified child care expenses for each taxable year. The maximum credit allowable would not have exceeded $150,000 per year.

E. Savings, Retirement Security, and Portability Provisions

1. Retirement Savings Accounts

Present Law

[438] Present law provides favorable tax treatment for a variety of retirement savings vehicles, including employer-sponsored retirement plans and individual retirement arrangements ("IRAs").

[439] Several different types of tax-favored employer-sponsored retirement plans exist, such as section 401(a) qualified plans (including plans with a section 401(k) qualified cash-or-deferred arrangement), section 403(a) qualified annuity plans, section 403(b) annuities, section 408(k) simplified employee pensions ("SEPs"), section 408(p) SIMPLE retirement accounts, and section 457(b) eligible deferred compensation plans. In general, an employer and, in certain cases, employees, contribute to the plan. Taxation of the contributions and earnings thereon is generally deferred until benefits are distributed from the plan to participants or their beneficiaries. ¹¹³ Contributions and benefits under tax-favored employer-sponsored retirement plans are subject to specific limitations.

[440] Coverage and nondiscrimination rules also generally apply to tax-favored employer-sponsored retirement plans to ensure that plans do not disproportionately cover higher-paid employees and that benefits provided to moderate-and lower-paid employees are generally proportional to those provided to higher-paid employees.

[441] IRAs include both traditional IRAs and Roth IRAs. In general, an individual makes contributions to an IRA, and investment earnings on those contributions accumulate on a tax-deferred basis. Total annual IRA contributions per individual are limited to $2,000 (or the compensation of the individual or the individual's spouse, if smaller). Contributions to a traditional IRA may be deducted from gross income if an individual's adjusted gross income (AGI) is below certain levels or the individual is not an active participant in certain employer-sponsored retirement plans. Contributions to a Roth IRA are not deductible from gross income, regardless of adjusted gross income. A distribution from a traditional IRA is includible in the individual's gross income except to the extent of individual contributions made on a nondeductible basis. A qualified distribution from a Roth IRA is excludable from gross income.

[442] Taxable distributions made from employer retirement plans and IRAs before the employee or individual has reached age 59-1/2 are subject to a 10-percent additional tax, unless an exception applies.

Description of Proposal

[443] The proposal would create Retirement Savings Accounts ("RSAs") that would provide progressive matching contributions with respect to individual contributions made by eligible taxpayers to a 401(k)-type retirement plan or an account held by a financial institution. The matching contribution would supplement any employer matching contributions.

[444] The RSA matching contribution would be provided through employers and financial institutions that choose to participate in the program. A participating employer or financial institution would contribute an amount equal to the applicable RSA matching contribution for each participating individual and would be entitled to claim a nonrefundable tax credit equal to the same amount. Financial institutions would also be entitled to claim a $10 per account tax credit to defray the administrative costs of establishing each new RSA. These credits would be general business tax credits.

[445] Taxpayers would receive notification of eligibility for an RSA matching contribution, including the specific rate of matching contribution for which the taxpayer would qualify. A taxpayer's eligibility would be based on the taxpayer's AGI on the prior year's tax return. The RSA matching contribution would be available for taxpayers with AGI up to $80,000 ($40,000 from 2002 to 2004) on joint returns, $60,000 ($30,000 from 2002 to 2004) on head-of-household returns, and $40,000 ($20,000 from 2002 to 2004) on single returns.

[446] The RSA matching contribution would consist of a basic matching contribution and an additional matching contribution. The basic matching contribution would be as much as 100 percent for up to $1,000 in contributions ($500 from 2002 to 2004) and would phase down to 20 percent for taxpayers with AGI in the following ranges: between $25,000 and $50,000 ($20,000 and $40,000 from 2002 to 2004) for married taxpayers filing a joint return, $18,750 to $37,500 ($15,000 to $30,000 from 2002 to 2004) for taxpayers filing a head-of- household return, and $12,500 to $25,000 ($10,000 to $20,000 from 2002 to 2004) for single taxpayers.

[447] The additional matching contribution would be as much as $100 for the first $100 contributed to the account. The additional match would phase out over the same income ranges as the basic match.

[448] Eligible taxpayers would be those age 25 to 60 who have at least $5,000 in earnings (which may be joint earnings for married taxpayers filing a joint return) and who are not claimed as a dependent by another taxpayer. An otherwise eligible individual without earnings would be eligible if his or her spouse earns at least $5,000. If each spouse filing a joint return satisfies the age requirement, each spouse would be permitted to establish a separate RSA and receive up to the maximum match.

[449] Eligible taxpayers and spouses would participate by making voluntary salary reduction contributions to a 401(k)-type employer plan in which they participate, or cash contributions to an RSA held in a qualifying and participating financial institution. The employer or financial institution would make the matching contribution to the taxpayer's or spouse's RSA upon receipt of verification of the individual's eligibility.

[450] An eligible taxpayer's salary reduction contributions to an employer plan that receives RSA matching contributions would receive the same tax treatment and be subject to the same qualification requirements as any other salary reduction contribution (e.g., excluded from income when made, taken into account in nondiscrimination testing, and subject to the general salary reduction contribution limits). The RSA matching contributions would also be excluded from income when deposited, but would not be taken into account in nondiscrimination testing or for any other qualified plan limits.

[451] An eligible taxpayer would be permitted to deduct the taxpayer's RSA individual contributions to an RSA held by a qualifying and participating financial institution if the taxpayer is eligible for a matching contribution. RSA matching contributions would also be excluded from income when deposited. A taxpayer's RSA individual contributions and matching contributions would offset the taxpayer's $2,000 IRA contribution limit. Like excess IRA contributions, individual RSA contributions in excess of $1,000 ($500 from 2002 to 2004) would be subject to an annual excise tax.

[452] Earnings on contributions would accumulate on a tax- deferred basis and distributions would be taxable. Preretirement withdrawals of limited amounts to be used for the purchase of a first home, a medical emergency, or education expenses, would be permitted after 5 years. Except in the case of death or disability, distribution of all other amounts would be prohibited before the account holder reaches retirement age.

[453] RSAs held by financial institutions would be subject to the prohibited transaction rules, including the prohibition against loans, and the investment restrictions applicable to IRAs. As with employer plan benefits and traditional IRAs, the transfer of RSA amounts upon divorce would not create immediate tax consequences to the transferor, and the transferred interest would be treated as held by the transferee.

[454] To facilitate efficient administration of the RSA program, participation by financial institutions would be limited to Federally insured depository institutions and certain other financial institutions as specified by Treasury regulations. To assist with account administration requirements, an on-line database of eligible taxpayers and spouses and available government matching contributions would be maintained. It is anticipated that the provisions of the Code dealing with confidentiality and disclosure of returns and return information (sec. 6103) would be expanded to permit employers and financial institutions to access this database to determine if plan participants and account holders requesting a government matching contribution are eligible.

[455] Effective date. -- The proposal would be effective for taxable years beginning after 2001, with initial eligibility for government matching contributions based on 2001 individual income tax returns.

Analysis

[456] Although the favorable tax treatment of contributions to IRAs and employer-sponsored retirement plans has helped produce expanded retirement-savings opportunities for many individuals, many lower-and moderate-income workers do not benefit from these opportunities. Some statistics indicate that only half of American workers are covered by employer-sponsored retirement plans, and that workers with lower earnings are much less likely than workers with higher earnings to be covered by such plans, to contribute to a 401(k)-type plan offered by employers, or to contribute to an IRA.

[457] Some believe that the reasons for these low levels of participation by lower income workers are that these families, compared to higher-income workers and families (1) tend to have less access to credit and financial markets, (2) must devote a high proportion of their disposable income to necessities such as food, clothing, housing, and medical care, leaving little or no income for retirement saving, (3) are less likely to have experience with financial institutions and their investment products or the benefits of long-term saving on a tax-preferred basis, and (4) are likely to receive little or no tax subsidy on their IRA or pension contributions.

[458] Proponents of the proposal believe that the proposal would address these impediments to savings by lower-and middle-income families by using a substantial government matching contribution to highlight the benefit of saving and, unlike the existing savings incentives provided in the form of deductions and exclusions, providing the greatest tax benefits for those workers with the most modest incomes. Others argue that the proposal would do little to assist lower-income workers, who would continue to be required to choose between paying for necessities and saving for retirement, and would create a new Federal entitlement that would be difficult and expensive to administer.

Prior Action

[459] No prior action.

2. Small business tax credit for qualified retirement plan contributions

Present Law

[460] The timing of an employer's deduction for compensation paid to an employee generally corresponds to the employee's recognition of the compensation. However, an employer that contributes to a qualified retirement plan is entitled to a deduction (within certain limits) for the employer's contribution to the plan on behalf of an employee even though the employee does not recognize income with respect to the contribution until the amount is distributed to the employee.

Description of Proposal

[461] The proposal would provide a nonrefundable income tax credit for small employers equal to 50 percent of certain qualifying employer contributions made to qualified retirement plans on behalf of nonhighly compensated employees. For purposes of the proposal, a small employer would mean an employer with no more than 100 employees who received at least $5,000 of earnings in the preceding year. A nonhighly compensated employee would be defined as an employee who neither (1) was a five-percent owner of the employer at any time during the current year or the preceding year, or (2) for the preceding year, had compensation in excess of $80,000 (indexed for inflation). ¹¹⁴

[462] The proposal would require a small employer to make nonelective contributions equal to at least one percent of compensation to qualify for the credit. The credit would apply to both qualifying nonelective employer contributions or qualifying employer matching contributions, but only up to a total of three percent of the nonhighly compensated employee's compensation. The credit would be available for 50 percent of qualifying benefit accruals under a nonintegrated defined benefit plan if the benefits are equivalent, as defined in regulations, to a three-percent nonelective contribution to a defined contribution plan.

[463] To qualify for the credit, the nonelective and matching contributions to a defined contribution plan and the benefit accruals under a defined benefit plan would be required to vest at least as rapidly as under either a three-year cliff vesting schedule or a graded schedule that provides 20-percent vesting per year for five years. Amounts contributed to qualified plans other than pension plans would be subject to the same distribution restrictions that apply to qualified nonelective employer contributions to a section 401(k) plan (i. e. , distribution only upon separation from service, death, disability, attainment of age 59=, plan termination without a successor plan, or acquisition of a subsidiary or substantially all the assets of a trade or business that employs the participant). Qualifying contributions to pension plans would be subject to the distribution restrictions generally applicable to those plans (i.e., distribution only attainment of normal retirement age, termination of employment, disability, death, or plan termination). However, qualifying contributions to both pension and non pension plans generally would not be distributable upon separation from service or severance from employment within five years after the date of the first contribution to the plan, unless directly transferred to an account with the same distribution restrictions.

[464] The plan to which the small employer makes the qualifying contributions (and any plan aggregated with that plan for nondiscrimination testing purposes) would be required to allocate any nonelective employer contributions proportionally to participants' compensation from the employer (or on a flat-dollar basis) and, accordingly, without the use of permitted disparity or cross-testing.

[465] Forfeited nonvested qualifying contributions or accruals for which the credit was claimed generally would result in recapture of the credit at a rate of 35 percent. The Secretary of the Treasury would be authorized to issue administrative guidance, including de minimis rules, to simplify or facilitate claiming and recapturing the credit.

[466] The credit would be a general business credit. The 50 percent of qualifying contributions that are effectively offset by the tax credit would not be deductible; the other 50 percent of the qualifying contributions (and other contributions) would be deductible to the extent permitted under present law.

[467] Effective date. -- The credit would be effective for taxable years beginning after December 31, 2001. An employer would not be permitted to claim the credit for more than three taxable years. The credit generally would not be effective for taxable years beginning after December 31, 2009, but an employer that claims the credit for the first time in 2008 or 2009 would be permitted to claim the credit for the remaining one or two taxable years.

Analysis

[468] Small employers may be hesitant or unable to establish a qualified retirement plan that provides nonelective or matching contributions to all employees. Plans that offer only salary reduction contributions often do not benefit many lower-and moderate-income employees. Providing a tax credit for a portion of nonelective contributions and matching contribution may encourage small employers to adopt plans that provide such contributions. On the other hand, it is unclear whether the magnitude of the cost saving provided by the proposed tax credit will provide sufficient additional incentive for small businesses to establish plans. In some cases the credit may be inefficient because it may be claimed by employers who would have established a plan in any event.

Prior Action

[469] No prior action.

3. Small business tax credit for new retirement plan expenses

Present Law

[470] The costs incurred by an employer related to the establishment and maintenance of a retirement plan (e.g., payroll system changes, investment vehicle set-up fees, consulting fees) generally are deductible by the employer as ordinary and necessary expenses in carrying on a trade or business.

Description of Proposal

[471] The proposal would provide a three-year tax credit for 50 percent of the administrative and retirement-education expenses for any small business that adopts a new qualified defined benefit or defined contribution plan (including a section 401(k) plan), SIMPLE plan, simplified employee pension ("SEP"), or payroll deduction IRA arrangement. The credit would apply to 50 percent of the first $2,000 in administrative and retirement-education expenses for the plan or arrangement for the first year of the plan or arrangement and 50 percent of the first $1,000 of administrative and retirement- education expenses for each of the second and third years.

[472] The credit would be available to an employer that did not employ, in the preceding year, more than 100 employees with compensation in excess of $5,000, but only if the employer did not have a retirement plan or payroll deduction IRA arrangement during any part of 1998. In order for an employer to be eligible for the credit, the plan would have to cover at least one nonhighly compensated employee. In addition, if the credit is for the cost of a payroll deduction IRA arrangement, the arrangement would have to be made available to all employees of the employer who have worked with the employer for at least three months.

[473] The credit would be a general business credit. The 50 percent of qualifying expenses that are effectively offset by the tax credit would not be deductible; the other 50 percent of the qualifying expenses (and other expenses) would be deductible to the extent permitted under present law.

[474] Effective date. -- The credit would be effective beginning in the year of enactment and would be available only for plans established after 1998 and on or before December 31, 2009. For example, if an eligible employer adopted a plan in the year 2009, the credit would be available for the years 2009, 2010, and 2011.

Analysis

[475] Establishing and maintaining a qualified plan involves employer administrative costs both for initial start-up of the plan and for on-going operation of the plan. These expenses generally are deductible to the employer as a cost of doing business. The cost of these expenses to the employer is reduced by the tax deduction. By reducing costs, providing a tax credit for the costs associated with establishing a retirement plan may promote the adoption of such plans by small businesses. On the other hand, it is unclear whether the magnitude of the cost saving provided by the proposed tax credit will provide sufficient additional incentive for small businesses to establish plans. In some cases the credit may be inefficient because it may be claimed by employers who would have established a plan in any event.

Prior Action

[476] The proposal is similar to proposals contained in the President's Fiscal Year 1999 and 2000 Budget Proposals.

4. Promote Individual Retirement Account contributions through payroll deduction

Present Law

[477] Under present law, an employer may establish a payroll deduction program to help employees save for retirement through individual retirement arrangements ("IRAs"). Under a payroll deduction program, an employee may contribute to an IRA by electing to have the employer withhold amounts from the employee's paycheck and forward them to the employee's IRA. Payroll deduction contributions are included in the employee's wages for the taxable year but the employee may deduct the contributions on the employee's tax return, subject to the normal IRA deduction limits.

[478] The legislative history of the Taxpayer Relief Act of 1997 provides that employers that choose not to sponsor a retirement plan should be encouraged to set up a payroll deduction system to help employees save for retirement by making payroll deduction contributions to their IRAs. The Secretary of Treasury is encouraged to continue his efforts to publicize the availability of these payroll deduction IRAs.

[479] Under present law, an IRA payroll deduction program may be exempt from the provisions of Title I of the Employee Retirement Income Security Act of 1974, as amended (" ERISA"), which include reporting and disclosure and fiduciary requirements. In general, ERISA regulations provide an exception from the provisions of Title I of ERISA for an IRA payroll deduction program in which no contributions are made by the employer, participation is completely voluntary for employees, the employer does not endorse any part of the program (but may publicize the program, collect contributions, and remit them), and the employer receives no form of consideration other than reasonable compensation for services actually rendered in connection with payroll deductions. A payroll deduction program may be subject to Title I of ERISA if, for example, an employer makes contributions to the program or an employer receives more than reasonable compensation for services rendered in connection with payroll deductions.

Description of Proposal

[480] Under the proposal, contributions of up to $2,000 made to an IRA through payroll deduction generally would be excluded from an employee's income and, accordingly, would not be reported as income on the employee's Form W-2. However, the amounts would be subject to employment taxes (FICA and FUTA), and would be reported as a contribution to an IRA on the employee's W-2. If the full amount of the payroll deduction IRA contributions would not have been deductible had the employee contributed directly to an IRA, the employee would be required to include the amount that would not have been deductible in income.

[481] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2000.

Analysis

[482] The proposal is intended to encourage employers to offer payroll deduction programs to their employees and encourage employees to save for retirement. While present law permits such payroll deduction programs, the proposal is designed to make them more attractive (and more widely utilized) by providing employees with a convenient way to obtain the tax benefits for IRA contributions that will eliminate the need for some employees to report IRA contributions on their tax returns.

[483] It is not clear whether the proposal would have the desired effect. Increased IRA participation may not result because there is no change in the economic incentive to make IRA contributions (that is, the proposal would not change the present-law tax benefits of making IRA contributions). On the other hand, by increasing the convenience of making contributions, some taxpayers may participate who would not otherwise participate and more taxpayers may begin to save on a regular basis. Oppositely, some analysts have noted that under present law many IRA contributions are not made until immediately prior to the date the taxpayer files his or her tax return. Such taxpayers may not be motivated by the long- term economic benefits of an IRA, but rather by a short-term desire to affect the immediate consequence of tax filing. The proposal may or may not affect the psychology of such taxpayers.

[484] For the proposal to be effective, employers must create payroll deduction programs. In order to do so, employers may have to revise current payroll systems. Employers may not be willing to incur the costs of establishing and maintaining a payroll deduction program. The proposal does not create a direct economic incentive for employers to incur such costs, although implementation of the proposal to provide a small business tax credit for new retirement plan expenses may provide such an incentive for some employers. On the other hand, if employees find the payroll deduction program attractive and know such payroll options are available elsewhere, employers may find it to their benefit to extend this payroll deduction option to their employees. In addition, some employers may already have the systems capability to make payroll deduction contributions, for example, if the employer has a section 401(k) plan.

[485] The exclusion provided by the proposal may be confusing for some employees who may mistakenly believe they are entitled to the exclusion when they are not because of the IRA deduction income phase-out rules. In addition, some employees could mistakenly claim both the exclusion and the deduction on their return.

Prior Action

[486] The proposal is similar to proposals contained in the President's Fiscal Year 1999 and 2000 Budget Proposals.

5. The "SMART" plan -- a simplified pension plan for small business

Present Law

[487] Any employer, including a small employer, may adopt a qualified plan for its employees. In addition, present law contains some special plans designed specifically for small employers. Present law provides for a simplified retirement plan for small business employers called the savings incentive match plan for employees (" SIMPLE") retirement plan. SIMPLE plans are not subject to the nondiscrimination rules applicable to qualified plans (including the top-heavy rules). A SIMPLE plan can be either an individual retirement arrangement ("IRA") for each employee or part of a qualified cash or deferred arrangement ("401(k) plan"). SIMPLE plans can be adopted by employers who employ 100 or fewer employees who received at least $5,000 in compensation and who do not maintain another employer-sponsored retirement plan. Under a SIMPLE retirement plan, employees can elect to make pre-tax deferrals of up to $6,000 per year. In general, employers are required to make either a matching contribution of up to 3 percent of the employee's compensation or a nonelective contribution equal to 2 percent of compensation. In the case of a SIMPLE IRA, the employer can elect a lower matching contribution percentage if certain requirements are satisfied. Employees are 100 percent vested in all contributions made to their accounts. A SIMPLE retirement plan cannot be a defined benefit plan.

[488] Alternatively, small business employers may offer their employees a simplified employee pension ("SEP"). SEPs are employer- sponsored plans under which employer contributions are IRAs established by the employees. Contributions under a SEP generally must bear a uniform relationship to the compensation of each employee covered under the SEP (e.g., each employee receives a contribution to the employee's IRA equal to 5 percent of the employee's compensation for the year).

Description of Proposal

In general

[489] The proposal would create a new simplified tax-qualified pension plan for small business employers called the Secure Money Annuity or Retirement Trust ("SMART") Plan. The SMART Plan would combine the features of both a defined benefit plan and a defined contribution plan. As is the case with other qualified retirement plans, contributions to the SMART Plan would be excludable from income, earnings would accumulate tax-free, and distributions would be subject to income tax (unless rolled over). SMART plans would not be subject to many of the rules generally applicable to qualified plans, including the nondiscrimination and top-heavy rules.

Employer and employee eligibility and vesting

[490] The SMART Plan could be adopted by an employer who (1) employed 100 or fewer employees who received at least $5,000 in compensation in the prior year, and (2) has not maintained a defined benefit pension plan or money purchase pension plan within the preceding 5 years.

[491] All employees who have completed two years of service with at least $5,000 in compensation would participate in the SMART Plan. An employee's benefit would be 100 percent vested at all times.

Benefits and funding

[492] SMART Plans would provide a fully funded minimum defined benefit. Each year the employee participates, the employee would earn a minimum annual benefit at retirement equal to 1 percent or 2 percent of compensation for that year, as elected by the employer. For example, if an employee participates for 25 years in a SMART Plan, and the employer had elected a 2-percent benefit, and the employee's average salary over the entire period was $50,000, the employee would accrue a minimum benefit of $25,000 per year at age 65. An employer could elect, for each of the first 5 years the SMART Plan is in existence, to provide all employees with a benefit equal to 3 percent of compensation. The maximum compensation that could be taken into account in determining an employee's benefit for a year would be $100,000 (indexed for inflation).

[493] Each year the employer would be required to contribute an amount to the SMART Plan on behalf of each participant sufficient to provide the annual benefit accrued for that year payable at age 65, using specified actuarial assumptions (including a 5-percent annual interest rate). Funding would be provided either through a SMART Plan individual retirement annuity ("SMART Annuity") or through a trust ("SMART Trust"). In the case of a SMART Trust, each employee would have an account to which actual investment returns would be credited. If a participant's account balance were less than the total of past employer contributions credited with 5 percent interest per year, the employer would be required to make up the shortfall. In addition, the employer would be required to contribute an additional amount for the year to make up for any shortfall between the balance in the employee's account and the purchase price for an annuity paying the minimum guaranteed benefit when an employee retires and takes a life annuity. If the investment returns exceed the 5-percent assumption, the employee would be entitled to the larger account balance. SMART Trusts could invest only in readily tradable securities and insurance products regulated by state law.

[494] In the case of a SMART Annuity, each year the employer would be required to contribute the amount necessary to purchase an annuity that provides the benefit accrual for that year on a guaranteed basis.

[495] The required contributions would be deductible under the rules applicable to qualified defined benefit plans. An excise tax would apply if the employer failed to make the required contributions for a year.

Distributions

[496] No distributions would be allowed from a SMART Plan prior to the employee's attainment of age 65, except in the event of death or disability, or if the account balance of a terminated employee does not exceed $5,000. However, an employer could allow a terminated employee who has not yet attained age 65 to directly transfer the individual's account balance from a SMART Trust to either a SMART Annuity or a special individual retirement account ("SMART Account") that is subject to the same distribution restrictions as the SMART Trust. If a terminated employee's account balance did not exceed $5,000, the SMART Plan would be allowed to make a cashout of the account balance. The employee would be allowed to transfer such distribution tax-free to a SMART Annuity, a SMART Account, or a regular IRA.

[497] SMART Plans would be subject to the qualified joint and survivor annuity rules that apply to qualified defined benefit plans. Lump sum payments also could be made available. In addition, an employer could allow the transfer of a terminated employee's account balance from SMART Trust to either a SMART Annuity or a SMART Account.

[498] Distributions from SMART Plans would be subject to tax under the present-law rules applicable to qualified plans. A 20- percent additional tax would be imposed for violating the pre-age 65 distribution restrictions under a SMART Annuity or SMART Account.

PBGC guarantee and premiums

[499] The minimum guaranteed benefit under the SMART Trust would be guaranteed by the Pension Benefit Guarantee Corporation (" PBGC"). Reduced PBGC premiums would apply to the SMART Trust. Neither the PBGC guarantee, nor PBGC premiums, would apply to the SMART Annuity or SMART Account.

Nondiscrimination requirements and benefit limitations

[500] SMART Plans would not be subject to the nondiscrimination or top-heavy rules applicable to qualified retirement plans. SMART Plans also would not be subject to the limitations on contributions and benefits under qualified plans (sec. 415). However, if an employer maintained a SMART Plan, and then terminated it and established a qualified defined benefit plan, the SMART Plan accruals would be taken into account for purposes of the limitations applicable to the defined benefit plan.

Other rules

[501] Other plans maintained by the employer. -- An employer that maintained a SMART Plan could not maintain additional tax- qualified plans, other than a SIMPLE plan, a 401(k) plan, or a 403(b) tax-sheltered annuity plan under which the only contributions that are permitted are elective contributions and employer contributions that are not greater than those provided for under the design-based safe harbor for 401(k) plans.

[502] Reporting and disclosure. -- SMART Plans would be subject to simplified reporting requirements.

[503] Employee contributions. -- No employee contributions would be permitted to a SMART Plan.

[504] IRS model. -- The IRS would be directed to issue model SMART Plan provisions or a model SMART Plan document. Employers would not be required to use the IRS models.

[505] Coordination with IRA deduction rules. -- SMART Plans would be treated as qualified plans for purposes of the IRA deduction phase-out rules. Thus, employees who participated in a SMART Plan and had modified adjusted gross income in excess of the applicable thresholds would be phased out of making deductible IRA contributions. This rule currently applies to SEPs and SIMPLE Plans.

[506] Calendar plan year. -- The plan year for all SMART Plans would be the calendar year, which would be used in applying SMART Plan contribution limits, eligibility, and other requirements.

Effective date

[507] The proposal would be effective for calendar years beginning after 2000.

Analysis

[508] Under present law, small businesses have many options available for providing retirement benefits for their employees, including SIMPLE plans and SEPs not available to larger employers. Nevertheless, retirement plan coverage is lower among smaller employers. There may be a number of reasons for such lower coverage. Some believe the retirement plan coverage for small business employers continues to be inadequate. They argue that the limits on qualified plan benefits are not sufficient to induce owners to establish a plan because the owners will not be able to receive as high a retirement benefit as they would like. Others point out that the limits are high enough to allow significant retirement benefits (the lesser of $135,000 per year or 100 percent of compensation), and that there are other causes for the low small employer plan coverage, such as the administrative burdens and costs, and the unpredictability of funding requirements associated with defined benefit plans that may inhibit small business employers from adopting and maintaining such plans.

[509] The SMART Plan provides another option for small businesses that does not involve many of the administrative burdens of the present-law qualified plan rules. Thus, some small businesses who would not otherwise adopt a plan may adopt a SMART Plan, leading to increased pension coverage. On the other hand, some are concerned that the SMART Plan will primarily benefit the owners of a small business, particularly if the plan is adopted when the owner is nearing retirement age. For example, suppose an owner of a business establishes a SMART Plan when he is age 60. For each of the next 5 years, the contributions under the plan fund a benefit equal to 3 percent of compensation for the year, payable at age 65. Because there are only 5 years to fund the benefit for the owner, the contributions will be significantly larger than for other employees who may have many years until retirement. Thus, the SMART Plan in effect allows employers to weight contributions by age.

[510] The proposal may increase complexity by adding another option for small businesses. Such businesses may explore all available options in an effort to determine which option is most favorable for them.

Prior Action

[511] The proposal is similar to proposals contained in the President's Fiscal Year 1999 and 2000 Budget Proposals.

6. Enhancements to SIMPLE 401(k) plan nonelective contribution alternative

Present Law

[512] A small business may establish a simplified defined contribution retirement plan called a savings incentive match plan for employees ("SIMPLE") retirement plan. An employer is eligible to adopt a SIMPLE plan if the employer employs 100 or fewer employees who received at least $5,000 in compensation during the preceding year and does not maintain another retirement plan.

[513] A SIMPLE plan may be either an individual retirement arrangement for each employee ("SIMPLE IRA") or part of a qualified cash or deferred arrangement (a "SIMPLE 401(k)"). A SIMPLE IRA is not subject to the nondiscrimination rules or top-heavy rules generally applicable to qualified plans. Similarly, a SIMPLE 401(k) is deemed to satisfy the special nondiscrimination tests applicable to 401(k) plans and is not subject to the top-heavy rules. The other qualified plan rules apply to a SIMPLE 401(k), however.

[514] SIMPLE plans are subject to special contribution rules. Employees may elect during the 60-day period preceding a plan year to make elective contributions under a SIMPLE plan of up to $6,000 during the plan year. The $6,000 dollar limit is adjusted for cost- of-living increases in $500 increments.

[515] An employer that maintains a SIMPLE plan generally is required to match each employee's elective contributions on a dollar- for-dollar basis up to 3 percent of the employee's compensation. As an alternative to a matching contribution for any year, an employer may make a nonelective contribution on behalf of each eligible employee equal to 2 percent of the employee's compensation.

[516] Under a SIMPLE IRA, the compensation limit does not apply for purposes of the required employer matching contribution. If the employer satisfies the contribution requirement by making a nonelective contribution, however, the amount of compensation taken into account for each participant to determine the amount of the required employer contribution may not exceed the compensation limit.

[517] Under a SIMPLE 401(k), the compensation limit applies for purposes of the matching contribution as well as the nonelective contribution.

[518] No contributions other than employee elective contributions and required employer contributions may be made to a SIMPLE plan. All contributions under a SIMPLE plan must be fully vested.

Description of Proposal

[519] The proposal would make several modifications of the SIMPLE 401(k) plan nonelective contribution alternative.

[520] First, an employer would have the flexibility to make a nonelective contribution equal to up to 15 percent of compensation for all eligible employees. As under present law, the nonelective contribution rate would be uniform for all employees and contributions would be fully vested when made. In addition, these contributions would be subject to the distribution restrictions applicable to employer contributions under the 401(k) safe harbor rules (i. e., distribution only upon separation from service, death, disability, attainment of age 59-1/2, hardship, plan termination without a successor plan, or acquisition of a subsidiary or substantially all the assets of a trade or business the employs the participant).

[521] Second, the employer would be permitted to wait until as late as December 1 of the year for which a contribution is made to determine the level of nonelective contributions for the year. The level of nonelective contributions would be disclosed in the annual notice provided to employees at the end of the year.

[522] Third, the elective contribution limit for nonhighly compensated employees under the nonelective contribution alternative would be conformed to the limit that generally applies to 401(k) plans ($10,500 for 2000) even when employers make no contributions. The elective contribution limit for highly compensated employees under the SIMPLE 401(k) nonelective contribution alternative would depend on the level of nonelective contributions made on behalf of all eligible employees. If an employer chose (by December 1) to make a nonelective contribution equal to 2 percent of compensation on behalf of all eligible employees, then, as under current law, highly compensated employees would be permitted to contribute up to $6,000 (indexed for inflation) in elective contributions to the SIMPLE 401(k) plan. Alternatively, if an employer chose (by December 1) to make a nonelective contribution equal to 1 percent of compensation, highly compensated employees would be permitted to contribute up to $3,000 (indexed for inflation) in elective contributions to the plan. As a further alternative, if an employer chose (by December 1) to make a nonelective contribution equal to 3 percent of compensation (or more), highly compensated employees would be permitted to contribute up to the maximum 401(k) elective contribution limit ($ 10,500 for 2000). An employer maintaining a SIMPLE 401(k) plan using the nonelective contribution alternative for a year also would have the option to make no nonelective contributions to the plan for a year, in which case highly compensated employees would not be permitted to make elective contributions to the plan for the year.

[523] Finally, elective contributions by nonhighly compensated employees under the SIMPLE 401(k) plan nonelective contribution alternative would not be subject to the percentage-of-pay limit under section 415(c). The deduction limits for contributions to SIMPLE 401(k) plans under section 404 also would be modified to reflect the President's separate proposal relating to the deductibility of elective contributions on behalf of nonhighly compensated employees.

[524] The IRS would be directed to issue model SIMPLE 401(k) plan provisions or a model SIMPLE 401(k) plan document. Vendors and employers would have the option of using their own documents instead of the models.

[525] The proposal would not change the rules applicable to SIMPLE IRA plans or to the SIMPLE 401(k) plan matching contribution alternative, except that the law would be clarified to provide that matching contributions to a SIMPLE 401(k) plan are subject to the same withdrawal restrictions that apply to matching contributions under the section 401(k) safe harbor rules.

[526] Effective date. -- The proposal would be effective for plan years beginning after December 31, 2000.

Analysis

[527] Some statistics indicate that many small employers do not sponsor retirement plans because small businesses tend to have uncertain and fluctuating financial situations that discourage such businesses from making commitments to contribute for a year prior to or soon after the beginning of the year. On the other hand, some small employers that are attracted to the SIMPLE plan as a simplified means of providing 401(k)-type plan coverage may wish to have the flexibility to make nonelective contributions in excess of 2 percent of compensation in more profitable years.

[528] In addition, some argue that while SIMPLE IRA plans provide an important retirement savings alternative for employees of small businesses, small businesses should be encouraged to consider "upgrading" to 401(k) or other qualified plans when they are reasonably able to do so. SIMPLE 401(k) plans, particularly those that offer nonelective contributions, can serve as a useful bridge between SIMPLE IRA plans and 401(k) and other qualified retirement plans.

[529] Some would argue that making the elective contribution limit for highly compensated employees dependent upon the amount of the employer's nonelective contribution would provide an incentive for many employers to make nonelective contributions equal to at least 3 percent of compensation, thereby increasing benefits for nonhighly compensated employees. On the other hand, allowing highly compensated participants in a plan deemed to satisfy the applicable nondiscrimination requirements to contribute up to the maximum 401(k) elective contribution limit in exchange for a nonelective contribution that does not exceed the maximum top-heavy minimum contribution may permit significant contributions by highly compensated employees without comparable participation by rank-and- file employees. This result would be viewed by some as inconsistent with a basic reason for extending favorable tax treatment to employer-provided pension plans.

[530] Although the proposal would provide flexibility for plan sponsors in the design and operation of their plans, the proposal may add additional layers of complexity to an arrangement intended to be a simplified method of providing 401(k)-type plan coverage without increasing retirement savings by rank-and-file employees.

Prior Action

[531] No prior action.

7. Eliminate IRS user fees for initial determination letters for small businesses adopting a qualified retirement plan for the first time

Present Law

[532] An employer that maintains a retirement plan for the benefit of its employees may request from the IRS a determination as to whether the form of the plan satisfies the applicable qualification requirements of section 401(a). In order to obtain from the IRS a determination letter on the qualified status of the plan, the employer must pay a user fee. The user fee may range from $125 to $1,250, depending upon the scope of the request and the type and format of the plan.

Description of Proposal

[533] The proposal would eliminate the IRS user fee for the initial determination letter of one qualified retirement plan maintained by a small business if (1) the employer did not maintain a qualified plan in 1998, (2) the employer had no more than 100 employees who received at least $5,000 of earnings in the preceding year, and (3) the qualified retirement plan covers at least one nonhighly compensated individual. The proposal would apply only to requests by employers for determination letters concerning the qualified retirement plans they maintain. Therefore, a sponsor of a prototype plan would be required to pay a user fee for a request for a notification letter, opinion letter, or similar ruling. A small employer that adopts a prototype plan, however, would not be required to pay a user fee for a determination letter request with respect to the employer's plan.

[534] Effective date. -- The proposal would be effective for determination letter requests made after the date of enactment.

Analysis

[535] One of the factors affecting the decision of an employer to adopt a plan is the level of administrative costs associated with the plan. Some believe that reducing administrative costs, such as IRS user fees for determination letters, will help further the establishment of qualified plans by employers. Others argue that because the IRS user fees for determination letters, especially for employers that adopt prototype plans, are relatively insignificant, the proposal will do little to encourage employers to adopt new plans.

Prior Action

[536] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal, a small employer would not be required to pay a user fee for any determination letter request with respect to the qualified status of a retirement plan that the employer maintains if the determination letter request is made during the first five years of the plan.

8. Simplify prohibited transaction provisions for loans to individuals who are S corporation owners or self-employed

Present Law

[537] The Internal Revenue Code prohibits certain transactions ("prohibited transactions") between a qualified plan and a disqualified person in order to prevent persons with a close relationship to the qualified plan from using that relationship to the detriment of plan participants and beneficiaries. ¹¹⁵ Certain types of transactions are exempted from the prohibited transaction rules, including loans from the plan to plan participants, if certain requirements are satisfied. In addition, the Department of Labor can grant an administrative exemption from the prohibited transaction rules if the exemption is administratively feasible, in the interest of the plan and plan participants and beneficiaries, and protective of the rights of participants and beneficiaries of the plan. Pursuant to this exemption process, the Secretary of Labor grants exemptions both with respect to specific transactions and classes of transactions.

[538] The statutory exemptions to the prohibited transaction rules do not apply to certain transactions in which the plan makes a loan to an owner-employee. Loans to participants other than owner- employees are permitted if loans are available to all participants on a reasonably equivalent basis, are not made available to highly compensated employees in an amount greater than made available to other employees, are made in accordance with specific provisions in the plan, bear a reasonable rate of interest, and are adequately secured. In addition, the Code places limits on the amount of loans and repayment terms.

[539] For purposes of the prohibited transaction rules, an owner-employee means (1) a sole proprietor, (2) a partner who owns more than 10 percent of either the capital interest or the profits interest in the partnership, (3) an employee or officer of a Subchapter S corporation who owns more than 5 percent the corporation, and (4) the owner of an individual retirement arrangement ("IRA"). The term owner-employee also includes certain family members of an owner-employee and certain corporations owned by an owner-employee.

[540] Under the Internal Revenue Code, a two-tier excise tax is imposed on disqualified persons who engage in a prohibited transaction. The first level tax is equal to 15 percent of the amount involved in the transaction. The second level tax is imposed if the prohibited transaction is not corrected within a certain period, and is equal to 100 percent of the amount involved.

Description of Proposal

[541] The prohibited transaction rules would be modified to permit loans from a qualified retirement plan to participants who are S corporation owners or self-employed persons whose ownership interest is less than 20 percent and by permitting loans that were exempted from the prohibited transaction rules when the company was taxable as a C corporation to continue to be exempted for 24 months after the first day of the first plan year beginning with or within the first tax year the company elects to be an S corporation.

[542] Effective date. -- The proposal would be effective for loans first made (including loans refinanced) after December 31, 2000.

Analysis

[543] The prohibited transaction rules protect plan participants and beneficiaries from misdealing by persons close to the plan. In many cases, such transactions would also be violations of general fiduciary responsibilities. However, by identifying certain types of typical transactions that are likely to raise issues of misdealing, the prohibited transaction rules define a specific standard of conduct.

[544] In the case of plans that cover only the owner or owners of a business, the issue is not whether other plan participants may be harmed, but whether the plan is being used for retirement benefits, or to further the individual interests of the owner by providing a means for tax-favored transactions. The prohibited transaction rules help ensure that the owner is not merely using the plan for tax avoidance purposes.

[545] The statutory exemptions to the prohibited transaction rules reflect an understanding that in some cases transactions between a plan and persons close to the plan may be beneficial to plan participants. The administrative exemption process provides further opportunity to demonstrate that an otherwise prohibited transaction will benefit the plan. This process allows the Department of Labor to scrutinize transactions to make sure that the interests of plan participants and beneficiaries are adequately protected. In some cases, the Department of Labor will request that changes be made to a proposed transaction before granting an exemption.

[546] The present-law rules relating to transactions by owner- employees reflect a view that such transactions may raise special questions as to whether they benefit the plan and thus should be reviewed by the Department of Labor before an exemption is granted. Some view the present-law rules as appropriate, because of the particularly close relationship owner-employees have with the plan and the potential for such individuals to misuse plan assets for their own benefit, rather than to provide retirement benefits under the plan. In some cases, the owner-employee may be making the decisions for the plan, as well as for themselves.

[547] Most of the discussion regarding the present-law prohibited transaction rules has focused on the ability to obtain plan loans. Under present law, loans to participants other than owner-employees are permitted if loans are available to all participants on a reasonably equivalent basis, are not made available to highly compensated employees in an amount greater than made available to other employees, are made in accordance with specific provisions in the plan, bear a reasonable rate of interest, and are adequately secured. In addition, the Code places limits on the amount of loans and repayment terms. Some argue that it is appropriate to extend the plan loan exemption to owner-employees, because there are such specific rules regarding plan loans which provide adequate safe guards. Others, including the proponents of the proposal, argue that the historical abuses associated with the use of plan assets by business owners generally involve individuals who are sole owners or who have very substantial ownership control over the business and that the limit on loans to small business owners should be more consistent among the various forms of business and should permit individuals without meaningful control of the business to borrow under the same rules as other employees.

[548] On the other hand, some believe that the present-law rules regarding loans unfairly discriminate against the owners of unincorporated businesses and S corporations. For example, the sole shareholder of a C corporation may take advantage of the statutory exemptions to the prohibited transaction rules for loans. The sole shareholder may also be the only employee of the corporation and the plan trustee, and there may be just as great a possibility for misdealing as with an owner-employee. Some who hold this view argue that the treatment of shareholders of C corporations and unincorporated businesses and S corporation shareholders should be equalized. Others argue that present law should be modified to provide a rule that eliminates the inequities based on form of business, but still denies the statutory cases in appropriate cases. For example, such a rule might take into account whether there are non-owner employees covered by the plan and whether there is an independent plan trustee.

Prior Action

[549] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal, the prohibited transaction rules would be modified to permit loans from a qualified retirement plan to all participants who are S corporation owners or self-employed persons.

9. Provide faster vesting for employer contributions to qualified retirement plans

Present Law

[550] A plan is not a qualified plan unless a participant's employer-provided benefit vests at least as rapidly as under one of two alternative minimum vesting schedules. A plan satisfies the first schedule if a participant acquires a nonforfeitable right to 100 percent of the participant's accrued benefit derived from employer contributions upon the completion of 5 years of service. A plan satisfies the second schedule if a participant has a nonforfeitable right to at least 20 percent of the participant's accrued benefit derived from employer contributions after 3 years of service, 40 percent after 4 years of service, 60 percent after 5 years of service, 80 percent after 6 years of service, and 100 percent after 7 years of service. ¹¹⁶ If a plan is a "top-heavy plan", employer contributions either must be fully vested after the participant has completed 3 years of service, or must become vested in increments of 20 percent for each year beginning after 2 years of service, with full vesting after the participant completes 6 years of service.

Description of Proposal

[551] Under the proposal, employer contributions under defined contribution and defined benefit plans would be required to be fully vested after an employee has 3 years of service, or to become vested in increments of 20 percent for each year of service, with full vesting after the employee has completed 5 years of service. Conforming changes would be made to the top heavy rules and Title I of ERISA.

[552] Effective date. -- The proposal would be effective for plan years beginning after December 31, 2000, with an (unspecified) extended effective date for plans maintained pursuant to a collective bargaining agreement.

Analysis

[553] The general justification for accelerating the vesting of employer contributions focuses on the mobile nature of today's workforce and the substantial risk that many participants will leave employment before fully vesting in employer contributions. Shortening the vesting period is consistent with encouraging retirement savings, proponents argue.

[554] Opponents may counter that in some cases accelerating the vesting schedule of employer contributions may reduce overall retirement savings by making plans more expensive for some employers. Because contributions that are forfeited are generally used by employers to reduce the contributions of the employer in subsequent years, employers may find that the shorter vesting period increases their plan costs. This could cause employers to eliminate or reduce additional contributions such as matching contributions. Reductions in matching contributions may in turn reduce employee participation in 401(k) plans, because employer matching contributions are a significant feature of plans that for many employees may provide the economic incentive to participate in the plan.

[555] Employers may use vesting schedules that are not immediate to promote longer job attachment from employees that may enable the employer and employee to reap benefits of job specific training the employee may have received when initially employed by the employer. Reducing the time to full vesting may cause the employer to make changes in other forms of compensation to balance any increased costs associated with accelerated vesting.

Prior Action

[556] Similar proposals were included in the President's Fiscal Year 1999 and 2000 Budget Proposals and in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under those proposals, the faster vesting requirements would have applied only to employer matching contributions.

10. Count FMLA time toward retirement vesting and participation requirements

Present Law

[557] Under the Family and Medical Leave Act ("FMLA"), eligible workers are entitled to up to 12 weeks of unpaid leave to care for a new child, to care for a family member who has a serious health condition, or because the worker has a serious health condition. The employer must provide continued medical coverage during the unpaid leave. Upon return from leave, the employee must be restored to the position or an equivalent position (i.e., same benefits, pay, and terms and conditions of employment).

[558] Although the employee must generally be restored to the same position, the employer is not required to count the period of unpaid leave for purposes of eligibility to participate in a qualified retirement plan or plan vesting.

Description of Proposal

[559] Leave taken under the FMLA would be taken into account in determining qualified retirement plan eligibility and vesting.

[560] Effective date. -- The proposal would be effective for plan years beginning after December 31, 2000.

Analysis

[561] Individuals who take FMLA may lose service credit for determining plan eligibility or vesting of benefits. The proposal may increase the opportunity for workers taking leave under the FMLA to become eligible for or vest in retirement benefits.

[562] Counting FMLA service under retirement plans may increase employer costs to the extent that workers vest or become eligible for plan benefits that might not otherwise do so. If the additional costs are significant, then employers may adjust plan benefits or other compensation to take into account the additional costs.

Prior Action

[563] The proposal is similar to a proposal contained in the President's Fiscal Year 2000 Budget Proposal.

11. Increase defined contribution plan percentage of pay limitation

Present Law

[564] Section 415 imposes limits on the contributions that may be made to tax-favored retirement plans. In the case of a tax- qualified defined contribution plan, the limit on annual additions that may be made to the plan on behalf of an employee is the lesser of $30,000 (for 2000) or 25 percent of the employee's compensation. Annual additions include employer contributions, including contributions made at the election of the employee (i.e., employee elective deferrals), after-tax employee contributions, and any forfeitures allocated to the employee. For this purpose, compensation means taxable compensation of the employee, plus elective deferrals, and similar salary reduction contributions.

Description of Proposal

[565] The proposal would increase the maximum allowable annual addition, based on a percentage of pay, for defined contribution plans from 25 percent to 35 percent of compensation.

[566] Effective date. -- The proposal would be effective for limitation years beginning after December 31, 2000.

Analysis

[567] The tax benefits provided under qualified plans are a departure from the normally applicable income tax rules. The special tax benefits for qualified plans are generally justified on the ground that they serve an important social policy objective, i.e., the provision of retirement benefits to a broad group of employees. The limits on contributions and benefits, elective deferrals, and compensation that may be taken into account under a qualified plan all serve to limit the tax benefits associated with such plans. The level at which to place such limits involves a balancing of different policy objectives and a judgment as to what limits are most likely to best further policy goals.

[568] The limitations applicable to defined contribution plans is an annual limit on the contributions, not on the ultimate benefit payable. From a retirement income policy perspective, the appropriate limit for such contributions may depend on one's views about the appropriate level of retirement earnings, as well as other factors. In addition, many view defined contribution plans as a supplement to more traditional pension plans, such as defined benefit plans, and question whether it is appropriate to allow employers to place a large reliance on defined contribution plans as the main source of retirement benefits.

[569] Others argue that defined contribution plans are being more and more popular and, in some cases, allow individuals, particularly more mobile workers, to accumulate a larger retirement benefit than they could under a typical plan. It is also argued that the compensation limit has the most impact on relatively nonhighly compensated workers, because it is based on a percentage of compensation. In addition, the limitation may in some cases prevent relatively nonhighly compensated individuals to contribute as much as they would like to a section 401(k) plan. The limitation has no effect on very highly compensated individuals (i.e., those with compensation in excess of $120,000).

[570] Proponents of the proposal argue that increasing the limitation from 25 percent to 35 percent would increase the retirement savings opportunities for lower-and moderate-income workers who are most in need of additional retirement savings and have the ability to increase their retirement savings, while continuing to maintain appropriate limits on the percentage of compensation that an employee is permitted to defer on a tax-favored basis. Others argue that any limitation of less than 100 percent of compensation is not an appropriate limit and continues to adversely affect nonhighly compensated workers. Some argue, however, that as a practical matter it is unlikely that an increase in the percentage limitation will actually benefit many nonhighly compensated workers. Many employers provide for contribution levels well below the 25 percent limitation. They also argue that, to the extent the limitation affects employee deferrals under a section 401(k) plan, it is not clear that lower income individuals would actually take advantage of the increased limits, because they have less income from which to save.

[571] To the extent that the increase allows individuals to increase deferrals under a section 401(k) plan, some argue that it is not appropriate to allow individuals to defer 100 percent of compensation. Individuals who will be able to do so will have income from other sources, e.g., another job, retirement income from former employment, or investment earnings.

Prior Action

[572] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal, the maximum allowable annual addition, based on a percentage of pay, for defined contribution plans would have been increased from 25 percent to 100 percent of compensation.

12. Certain elective contributions not taken into account for purposes of deduction limits

Present Law

[573] Employer contributions to one or more qualified retirement plans are deductible subject to certain limits. In general, the deduction limit depends on the kind of plan.

[574] In the case of a defined benefit pension plan or a money purchase pension plan, the employer generally may deduct the amount necessary to satisfy the minimum funding cost of the plan for the year. If a defined benefit pension plan has more than 100 participants, the maximum amount deductible is at least equal to the plan's unfunded current liabilities.

[575] In the case of a profit-sharing or stock bonus plan, the employer generally may deduct an amount equal to 15 percent of compensation of the employees covered by the plan for the year.

[576] If an employer sponsors both a defined benefit pension plan and a defined contribution plan that covers some of the same employees (or a money purchase pension plan and another kind of defined contribution plan), the total deduction for all plans for a plan year generally is limited to the greater of (1) 25 percent of compensation or (2) the contribution necessary to meet the minimum funding requirements of the defined benefit pension plan for the year (or the amount of the plan's unfunded current liabilities, in the case of a plan with more than 100 participants).

[577] For purposes of the deduction limits, employee elective deferral contributions to a section 401(k) plan are treated as employer contributions and, thus, are subject to the generally applicable deduction limits.

[578] Subject to certain exceptions, nondeductible contributions are subject to a 10-percent excise tax.

Description of Proposal

[579] The proposal would increase the 15-percent deduction limit applicable to profit-sharing and stock bonus plans by the amount of contributions on behalf of nonhighly compensated employees participating in the profit-sharing or stock bonus plan that exceed, in the aggregate, 15 percent of compensation otherwise paid or accrued on behalf of those nonhighly compensated employees. The increased deduction limit would be available only if contributions under the plan other than elective deferral contributions of nonhighly compensated employees would be deductible under the 15- percent deduction limit. Elective contributions that are deductible only as a result of this special rule would be disregarded for purposes of determining the amount deductible under the 25-percent limit applicable when an employee participates in both a defined contribution plan and a defined benefit plan.

[580] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2000.

Analysis

[581] The deduction limits for qualified plans attempt to balance tax policy concerns (including revenue issues) with retirement income security concerns. From a tax policy perspective, the deduction limits for contributions to qualified plans generally serve to limit the tax benefits associated with such plans, and help ensure that the plans are actually used to provide retirement benefits, rather than as a tax-saving mechanism for the employer. An employer may have an incentive to make nondeductible contributions to a plan because such contributions receive tax-free buildup on the earnings. The excise tax on nondeductible contributions provides a disincentive to make such contributions.

[582] The deduction limits also reflect retirement policy objectives. The deduction limits for defined contribution plans result in an additional incentive for employers to sponsor nondiscretionary pensions plans by prescribing greater limits for money purchase and defined benefit pension plans than for profit- sharing or stock bonus plans. On the other hand, subjecting elective deferrals to the normally applicable deduction limits may cause employers to restrict the amount of elective contributions an employee may make or to restrict employer contributions to the plan, thereby reducing participants' ultimate retirement benefits and their ability to save adequately for retirement.

[583] Because the proponents of the proposal believe that these restrictions primarily affect the ability of nonhighly compensated participants to save for retirement, the proposal would increase the applicable deduction limit only to the extent that elective deferrals would otherwise exceed the present-law deduction limit on behalf of nonhighly compensated participants. Others would argue for a broader proposal under which all elective deferral contributions would not be subject to the deduction limits and would not be taken into account for purposes of applying the deduction limits to other contributions. Proponents of a broader proposal believe that such special treatment is appropriate because employers do not have discretion regarding employee elective deferrals. Rather, each employee determines how much to contribute by reducing his or her compensation. While an employer may be able to reduce contributions to other plans so that all contributions are deductible, so doing might impair the funding of the other plans or result in reduced plan benefits. Some would argue that the limits placed on plan participants' elective contributions are sufficient from a tax policy perspective to limit tax-favored saving, and that it is inappropriate to limit employer deductions for what constitutes individual savings. It may also be argued that the proposal would create a "floating" deduction limit, thereby increasing uncertainty and complexity in plan administration.

[584] Some argue that any proposal that increases the deductibility of elective deferrals will further encourage the adoption of section 401(k) plans as primary pension plans, which will place a greater burden for retirement saving on employees.

Prior Action

[585] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal, elective deferral contributions would not be subject to the deduction limits, and the application of a deduction limitation to any other employer contribution to a qualified retirement plan would not take into account elective deferral contributions.

13. Conform definition of compensation for purposes of deduction limits

Present Law

[586] Employer contributions to one or more qualified retirement plans are deductible subject to certain limits. In general, the deduction limit depends on the kind of plan. Subject to certain exceptions, nondeductible contributions are subject to a 10-percent excise tax.

[587] In the case of a defined benefit pension plan or a money purchase pension plan, the employer generally may deduct the amount necessary to satisfy the minimum funding cost of the plan for the year. If a defined benefit pension plan has more than 100 participants, the maximum amount deductible is at least equal to the plan's unfunded current liabilities.

[588] In some cases, the amount of deductible contributions is limited by compensation. In the case of a profit-sharing or stock bonus plan, the employer generally may deduct an amount equal to 15 percent of compensation of the employees covered by the plan for the year.

[589] If an employer sponsors both a defined benefit pension plan and a defined contribution plan that covers some of the same employees (or a money purchase pension plan and another kind of defined contribution plan), the total deduction for all plans for a plan year generally is limited to the greater of (1) 25 percent of compensation or (2) the contribution necessary to meet the minimum funding requirements of the defined benefit pension plan for the year (or the amount of the plan's unfunded current liabilities, in the case of a plan with more than 100 participants).

[590] In the case of an employee stock ownership plan ("ESOP"), principal payments on a loan used to acquire qualifying employer securities are deductible up to 25 percent of compensation.

[591] For purposes of the deduction limits, employee elective deferral contributions to a qualified cash or deferred arrangement ("section 401(k) plan") are treated as employer contributions and, thus, are subject to the generally applicable deduction limits.

[592] For purposes of the deduction rules, compensation generally includes only taxable compensation, and thus does not include salary reduction amounts, such as elective deferrals under a section 401(k) plan or a tax-sheltered annuity ("section 403(b) annuity"), elective contributions under a deferred compensation plan of a tax-exempt organization or a State or local government ("section 457 plan"), and salary reduction contributions under a section 125 cafeteria plan. For purposes of the contribution limits under section 415, compensation does include such salary reduction amounts.

Description of Proposal

[593] Under the proposal, salary reduction amounts that are treated as compensation for purposes of section 415 would be treated as compensation for purposes of applying the limitations of section 404.

[594] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2000.

Analysis

[595] Compensation unreduced by employee elective contributions is a more appropriate measure of compensation for plan purposes, including deduction limits, than the present-law rule. Applying the same definition for deduction purposes as is generally used for other qualified plan purposes will also simplify application of the qualified plan rules.

Prior Action

[596] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President.

14. Improve benefits of nonhighly compensated employees under 401(k) safe harbor plans

Present Law

[597] Under present law, special nondiscrimination tests apply to contributions made to 401(k) plans. In general, the actual deferral percentage ("ADP") test applies to the elective contributions of all employees under the plan and the average contribution percentage ("ACP") test applies to employer matching and after-tax employee contributions. The ADP test is satisfied if the average percentage of elective contributions for highly compensated employees does not exceed the average percentage of elective contributions for nonhighly compensated employees by more than a specified percentage. The ACP test is similar but it tests the average contribution percentages (i.e., employer matching and after- tax employee contributions) of the highly compensated employees and nonhighly compensated employees.

[598] As an alternative to annual testing under the ADP and ACP tests, the Small Business Job Protection Act of 1996 provides two alternative "design-based" 401(k) safe harbors, effective beginning in 1999. Under the safe harbor, if the employees are provided a specified matching or nonelective contribution, ADP and ACP testing of employee elective contributions and employer matching contributions is not required. Under the matching contribution safe harbor, the employer must make nonelective contributions of at least 3 percent of compensation for each nonhighly compensated employee eligible to participate in the plan. Alternatively, under the other safe harbor, the employer must make a 100 percent matching contribution on an employee's elective contributions up to the first 3 percent of compensation and a matching contribution of at least 50 percent on the employee's elective contributions up to the next 2 percent of compensation.

[599] Elective contributions under a section 401(k) plan include contributions made pursuant to an "automatic enrollment" arrangement, i.e., an arrangement under which, in any case in which an employee has an effective opportunity to elect to receive cash and does not affirmatively elect to receive cash, the employee's compensation is reduced by a fixed percentage and that amount is contributed on the employee's behalf to the plan. ¹¹⁷

Description of Proposal

[600] The proposal would modify the matching contribution design-based safe harbor for section 401(k) plans by requiring that, in addition to the matching contribution, the employer either (1) make a nonelective contribution for nonhighly compensated employees equal to 1 percent of compensation, or (2) automatically enroll eligible employees in the plan at a 3-percent of compensation contribution rate. In addition, the proposal would permit an employer to reduce the matching contribution, beginning with matching contributions provided at the highest rate of elective contributions, by the amount of safe harbor nonelective contributions under the plan.

[601] Effective date. -- The proposal would be effective for plan years beginning after December 31, 2000.

Analysis

[602] The special nondiscrimination rules for 401(k) plans are designed to ensure that nonhighly compensated employees, as well as highly compensated employees, actually receive benefits under the plan. The nondiscrimination rules give employers an incentive to make the plan attractive to lower-and middle-income employees (e.g., by providing a match) and to undertake efforts to enroll such employees, because the greater the participation by such employees, the more highly compensated employees can contribute to the plan.

[603] The design-based safe harbors were designed to achieve the same objectives as the special nondiscrimination rules, but in a simplified manner. The nonelective safe harbor ensures a minimum benefit for employees covered by the plan, and it was believed that the required employer match would be sufficient incentive to induce participation by nonhighly compensated employees. It was also hoped that the design-based safe harbors would reduce the complexities associated with qualified plans, and induce more employers to adopt retirement plans for their employees.

[604] Some are concerned that the safe harbors will not have the intended effect, but instead will result in less participation by rank-and-file employees, in part because employers will no longer have a financial incentive to encourage employees to participate.

[605] Requiring employers who use the section 401(k) matching formula safe harbor to make an additional one percent nonelective contribution for each eligible nonhighly compensated employee, whether or not the employee makes elective contributions to the plan, will provide a minimum benefit for employees covered in the plan and also may encourage more employees to contribute to the plan and help ensure that lower-and middle-income employees receive some benefits. On the other hand, some argue that the purpose of the safe harbor formulas is to encourage more employers to sponsor 401(k) plans by eliminating the costs associated with annual testing. Adding a required employer contribution increases costs to employers and may impede the establishment of retirement plans. Some also believe that it is inappropriate to require a contribution to a 401(k) plan if employees do not make any elective deferrals. Under this view, retirement savings is a shared obligation of the employer and employee.

[606] The ability to provide for automatic enrollment in lieu of a mandatory additional nonelective contribution may make the proposal acceptable to some. In fact, some may argue that automatic enrollment constitutes an effective method of increasing employee participation in 401(k) plans and that employers should be encouraged to include automatic enrollment provisions in their plans. Others would argue that automatic enrollment would provide employers with a very attractive alternative to a required additional contribution and would defeat the purpose of providing a minimum benefit to employees.

[607] Permitting plan sponsors to replace a portion of their safe harbor matching contributions with safe harbor nonelective contributions would afford plan design flexibility and possibly encourage the provision of a minimum benefit to employees through nonelective contributions. On the other hand, the option to reduce the level of required matching contributions would add another layer of complexity to the safe harbor without increasing retirement savings by rank-and-file employees.

Prior Action

[608] The proposal is similar to proposals contained in the President's Fiscal Year 1999 and 2000 Budget Proposals, except the prior proposals did not include the options to automatically enroll eligible employees in the plan at a 3-percent of compensation contribution rate or to reduce the level of required matching contributions.

15. Simplify definition of highly compensated employee

Present Law

[609] Under present law, an employee is treated as highly compensated if the employee (1) was a 5-percent owner of the employer at any time during the year or the preceding year or (2) either (a) had compensation for the preceding year in excess of $80,000 (indexed for inflation) or (b) at the election of the employer had compensation for the preceding year in excess of $80,000 (indexed for inflation) and was in the top 20 percent of employees by compensation for such year.

Description of Proposal

[610] The proposal would eliminate the top-paid group election from the definition of highly compensated employee. Under the new definition, an employee would be treated as a highly compensated employee if the employee (1) was a 5-percent owner of the employer at any time during the year or the preceding year, or (2) for the preceding year, had compensation in excess of $80,000 (indexed for inflation).

[611] Effective date. -- The proposal would be effective for plan years beginning after December 31, 2000.

Analysis

[612] The proposal would further simplify the definition of highly compensated employee by eliminating the top-paid group election. Permitting elections that may vary from year to year increases complexity as employers that may benefit from the election may feel it necessary to run tests under both options. In addition, by use of the election, it is possible for employees earning very high compensation (in excess of $80,000) to be treated as nonhighly compensated for testing purposes if the employer has a sufficient percentage of high-paid employees in its workforce (i. e., if employees earning more than $80,000 are in the top paid 20 percent of employees). This would allow some employers to effectively eliminate benefits for low-and moderate-wage workers without violating the nondiscrimination rules. The proposal may help ensure that the simplified definition of highly compensated employee better reflects the purpose of promoting meaningful benefits for low-and moderate- wage workers, not only the high paid. On the other hand, some would argue that the greater flexibility provided to employers under present law is appropriate. Without the flexibility in testing, some employers may reduce plan benefits or choose to terminate plans, reducing aggregate pension coverage and potentially reducing aggregate retirement saving

Prior Action

[613] The proposal is similar to proposals contained in the President's Fiscal Year 1999 and 2000 Budget Proposals.

16. Tax treatment of the division of section 457 plan benefits upon divorce

Present Law

[614] Under present law, benefits provided under a qualified retirement plan for a participant may not be assigned or alienated to creditors of the participant, except in very limited circumstances. One exception to the prohibition on assignment or alienation rule is a qualified domestic relations order ("QDRO"). A QDRO is a domestic relations order that creates or recognizes a right of an alternate payee to any plan benefit payable with respect to a participant, and that meets certain procedural requirements.

[615] Under present law, a distribution from a governmental plan or a church plan is treated as made pursuant to a QDRO if it is made pursuant to a domestic relations order that creates or recognizes a right of an alternate payee to any plan benefit payable with respect to a participant. Such distributions are not required to meet the procedural requirements that apply with respect to distributions from qualified plans.

[616] Under present law, amounts distributed from a qualified plan generally are taxable to the participant in the year of distribution. However, if amounts are distributed to the spouse (or former spouse) of the participant by reason of a QDRO, the benefits are taxable to the spouse (or former spouse). Amounts distributed pursuant to a QDRO to an alternate payee other than the spouse (or former spouse) are taxable to the plan participant.

[617] Section 457 of the Internal Revenue Code provides rules for deferral of compensation by an individual participating in an eligible deferred compensation plan ("section 457 plan") of a tax- exempt or State and local government employer. The QDRO rules do not apply to section 457 plans.

Description of Proposal

[618] The proposal would extend the taxation rules for qualified plan distributions pursuant to a QDRO to distributions from section 457(b) plans made pursuant to a domestic relations order. In addition, a payment from a section 457(b) plan made pursuant to a QDRO would not be treated as violating the restrictions on distributions from such plans.

[619] Effective date. -- The proposal would be effective for payments made after the date of enactment.

Analysis

[620] Many believe that the rules regarding qualified domestic relations orders should apply to all types of employer-sponsored retirement plans. In addition, the proposal may result in simplification of the Federal tax laws by clarifying and standardizing the rules regarding tax treatment of division of retirement benefits upon divorce.

Prior Action

[621] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President.

17. Require joint and seventy-five percent survivor annuity option for pension plans

Present Law

[622] Defined benefit pension plans and money purchase pension plans are required to provide benefits in the form of a qualified joint and survivor annuity ("QJSA") unless the participant and his or her spouse consent to another form of benefit. A QJSA is an annuity for the life of the participant, with a survivor annuity for the life of the spouse which is not less than 50 percent (and not more than 100 percent) of the amount of the annuity payable during the joint lives of the participant and his or her spouse. In the case of a married participant who dies before the commencement of retirement benefits, the surviving spouse must be provided with a qualified preretirement survivor annuity ("QPSA") which provides the surviving spouse with a benefit that is not less than the benefit that would have been provided under the survivor portion of a QJSA.

[623] Defined contribution plans other than money purchase pension plans are not required to provide a QJSA or QPSA if the participant does not elect an annuity as the form of payment (or the plan does not offer an annuity) and the surviving spouse is the participant's beneficiary (unless the spouse consents to designation of another beneficiary).

[624] The participant and his or her spouse may waive the right to a QJSA and QPSA provided certain requirements are satisfied. In general, these conditions include providing the participant with a written explanation of the terms and conditions of the survivor annuity, the right to make, and the effect of, a waiver of the annuity, the rights of the spouse to waive the survivor annuity, and the right of the participant to revoke the waiver. In addition, the spouse must provide a written consent to the waiver, witnessed by a plan representative or a notary public, which acknowledges the effect of the waiver. Similar waiver and election rules apply to the waiver of the right of the spouse to be the beneficiary under a defined contribution plan that is not required to provide a QJSA.

Description of Proposal

[625] Under the proposal, plans subject to the survivor annuity rules would be required to offer a 75-percent joint and survivor annuity as an option. The definition of a QJSA and QPSA would not be modified. For example, the proposal and the QJSA and QPSA rules would be satisfied if a plan offers a 75-percent joint and survivor annuity as its only annuity option for married participants. Under this example, benefits would be paid as a 75-percent QJSA unless the participant and his or her spouse elect another option. The QPSA would be based on the 75-percent joint and survivor annuity. As another example, the proposal and the QJSA and QPSA rules would also be satisfied if a plan offers a 50-percent QJSA and QPSA and, in addition, allows married participants to elect a 75-percent joint and survivor annuity. Under this example, benefits would be paid in the form of a 50-percent QJSA unless the participant and his or her spouse elect otherwise. The QPSA would be based on the 50-percent joint and survivor annuity.

[626] Effective date. -- The proposal would be effective for plan years beginning after December 31, 2000, with an (unspecified) extended effective date for plans maintained pursuant to a collective bargaining agreement.

Analysis

[627] A joint and survivor annuity is generally the actuarial equivalent of an annuity payable over the life of the participant (a single life annuity). Under a joint and survivor annuity, the amount payable during the lifetime of the participant is generally less than the amount that would be paid if the benefit were paid as a single life annuity. Thus, while a joint and survivor annuity offers a survivor benefit, it typically pays a lower benefit during the participant's lifetime. Plans may, but are not required to, provide a fully subsidized joint and survivor annuity that pays the same amount during the participant's lifetime as would have been paid under a single life annuity. Under present law, a plan may provide for a more generous survivor benefit than the 50-percent joint and survivor annuity. In addition, a plan may provide for an optional joint and survivor benefit, e.g., a 50-percent QJSA and a 75-percent or 100- percent joint and survivor annuity option.

[628] The stated rationale for the proposal is that many couples may prefer an option that pays a somewhat smaller benefit to the couple while both are alive but a larger benefit than the present-law 50-percent survivor benefit. It is also argued that a surviving spouse typically has retirement needs that exceed half the retirement needs of a couple. For example, the poverty threshold for an aged individual is almost 80 percent of the threshold for an aged couple. Proponents of the proposal argue that the option would be especially helpful to women, because they tend to live longer than men, and many aged widows have income below the poverty level.

[629] Some plans may already provide options that satisfy the proposal. Other plans, however, would need to be modified to comply. Some employers may wish to restrict the options offered under the plan in order to minimize administrative costs. If an employer wishes to offer only one joint and survivor annuity option, it would have to provide a 75-percent joint and survivor annuity. Some participants prefer the 50-percent joint and survivor annuity, because they do not wish to receive lower benefits during the participant's lifetime. For such participants, the proposal may have the effect of causing the participant to elect a nonannuity form of benefit (if one is available) or a single life annuity. ¹¹⁸

Prior Action

[630] The proposal is similar to a proposal contained in the President's Fiscal Year 2000 Budget Proposal.

18. Encourage pension asset preservation by default rollover to IRAs of involuntary distributions

Present Law

[631] If a qualified retirement plan participant ceases to be employed by the employer that maintains the plan, the plan may distribute the participant's nonforfeitable accrued benefit without the consent of the participant and, if applicable, the participant's spouse, if the present value of the benefit does not exceed $5,000. If such an involuntary distribution occurs and the participant subsequently returns to employment covered by the plan, then service taken into account in computing benefits payable under the plan after the return need not include service with respect to which a benefit was involuntarily distributed unless the employee repays the benefit. ¹¹⁹

[632] Generally, a participant may roll over an involuntary distribution from a qualified plan to an IRA or to another qualified plan.

Description of Proposal

[633] The proposal would make a direct rollover the default option for involuntary cashouts that exceed $1,000 and that are eligible rollover distributions from qualified retirement plans, tax- sheltered section 403(b) annuities, or governmental section 457 plans. The distribution would be directly rolled over to an eligible retirement plan, including an IRA, unless the participant affirmatively elects to receive the distribution in cash or, if applicable, property. The recipient plan or IRA could be designated when the employee is enrolled as a participant in the distributing plan; alternatively, the recipient plan could be designated at termination of employment.

[634] At the election of the plan sponsor, if a participant fails to designate a rollover plan or IRA and does not affirmatively elect to receive the distribution in cash, then involuntary cashout amounts could be retained in the distributing plan or the plan sponsor may designate an institution that will serve as the IRA trustee on behalf of the participant. In either case, the plan administrator would disclose to distributees the plan's choice of a default arrangement for cashout amounts, i.e., retention in the plan or direct rollover to a specified IRA in the participant's name.

[635] Because the assets that are rolled over would constitute plan assets of the distributing plan, the plan sponsor's designation would be subject to ERISA's general fiduciary responsibility provisions (e.g., the requirements that the selection be prudent and solely in the interest of the participant) and the prohibited transaction provisions of ERISA and the Code. A plan sponsor would be permitted to choose an IRA provider that imposes reasonable annual maintenance fees and charges. The Department of Labor would be directed to issue safe harbors under which the designation of an institution and investment of the funds would be deemed to be prudent.

[636] Once assets are rolled over to an IRA, they no longer would be assets of the plan from which they originated, and the plan fiduciary would not have any further responsibility under ERISA with respect to the IRA. Benefits directly rolled over to an IRA designated by the payor would be treated in the same way as any other benefits rolled over to an IRA. For example, the IRA owner could withdraw funds from the IRA at any time, subject to the normal income tax rules, including the additional 10 percent tax on early withdrawals where applicable.

[637] Effective date. -- The proposal would apply to distributions made after December 31, 2001, except that the proposal would not apply prior to January 1, 2003, to distributions from plans sponsored by small employers (i.e., employers with no more than 100 employees). In addition, any plan sponsor would be permitted to amend its plan and voluntarily comply with the proposal at an earlier date.

Analysis

[638] Some statistics indicate that retirement plan distributions, particularly involuntary cashouts, often are not rolled over. Failure to make a rollover can significantly reduce the retirement income that would otherwise be accumulated by workers who change jobs frequently. Some believe that rollovers frequently do not occur because employees lack experience with financial institutions and are not familiar with the process of opening an IRA. Others believe that the proposal would do little to promote accumulation of retirement funds because in many cases employees decide to use retirement plan distributions for necessities or luxuries simply because they have access to the funds. It would likely be argued that the proposal would impose on plan sponsors an unfair administrative burden and additional potential fiduciary liability.

Prior Action

[639] No prior action.

19. Rollovers allowed among various types of plans

Present Law

In general

[640] Present law permits the rollover of funds from a tax- favored retirement plan to another tax-favored retirement plan. The rules that apply depend on the type of plan involved. Similarly, the rules regarding the tax treatment of amounts that are not rolled over depend on the type of plan involved.

Distributions from qualified plans

[641] Under present law, an "eligible rollover distribution" from a tax-qualified employer-sponsored retirement plan may be rolled over tax free to a traditional individual retirement arrangement ("IRA") ¹²⁰ or another qualified plan. ¹²¹ An "eligible rollover distribution" means any distribution to an employee of all or any portion of the balance to the credit of the employee in a qualified plan, except the term does not include (1) any distribution which is one of a series of substantially equal periodic payments made (a) for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and the employee's designated beneficiary, or (b) for a specified period of 10 years or more, (2) any distribution to the extent such distribution is required under the minimum distribution rules, and (3) certain hardship distributions. The maximum amount that can be rolled over is the amount of the distribution includible in income, i.e., after-tax employee contributions cannot be rolled over. Qualified plans are not required to accept rollovers.

Distributions from tax-sheltered annuities

[642] Eligible rollover distributions from a tax-sheltered annuity ("section 403(b) annuity") may be rolled over into an IRA or another section 403(b) annuity. Distributions from a section 403(b) annuity cannot be rolled over into a tax-qualified plan. Section 403(b) annuities are not required to accept rollovers.

IRA distributions

[643] Distributions from a traditional IRA, other than minimum required distributions, can be rolled over into another IRA. In general, distributions from an IRA cannot be rolled over into a qualified plan or section 403(b) annuity. An exception to this rule applies in the case of so-called "conduit IRAs." Under the conduit IRA rule, amounts can be rolled from a qualified plan into an IRA and then subsequently rolled back to another qualified plan if the amounts in the IRA are attributable solely to rollovers from a qualified plan. Similarly, an amount may be rolled over from a section 403(b) annuity to an IRA and subsequently rolled back into a section 403(b) annuity if the amounts in the IRA are attributable solely to rollovers from a section 403(b) annuity.

Distributions from section 457 plans

[644] A "section 457 plan" is an eligible deferred compensation plan of a State or local government or tax-exempt employer that meets certain requirements. In some cases, different rules apply under section 457 to governmental plans and plans of tax-exempt employers. For example, governmental section 457 plans are like qualified plans in that plan assets are required to be held in a trust for the exclusive benefit of plan participants and beneficiaries. In contrast, benefits under a section 457 plan of a tax-exempt employer are unfunded, like nonqualified deferred compensation plans of private employers.

[645] Section 457 benefits can be transferred to another section 457 plan. Distributions from a section 457 plan cannot be rolled over to another section 457 plan, a qualified plan, a section 403(b) annuity, or an IRA.

Rollovers by surviving spouses

[646] A surviving spouse that receives an eligible rollover distribution may roll over the distribution into an IRA, but not a qualified plan or section 403(b) annuity.

Direct rollovers and withholding requirements

[647] Qualified plans and section 403(b) annuities are required to provide that a plan participant has the right to elect that an eligible rollover distribution be directly rolled over to another eligible retirement plan. If the plan participant does not elect the direct rollover option, then withholding is required on the distribution at a 20-percent rate.

Notice of eligible rollover distribution

[648] The plan administrator of a qualified plan or a section 403(b) annuity is required to provide a written explanation of rollover rules to individuals who receive a distribution eligible for rollover. In general, the notice is to be provided within a reasonable period of time before making the distribution and is to include an explanation of (1) the provisions under which the individual may have the distribution directly rolled over to another eligible retirement plan, (2) the provision that requires withholding if the distribution is not directly rolled over, (3) the provision under which the distribution may be rolled over within 60 days of receipt, and (4) if applicable, certain other rules that may apply to the distribution. The Treasury Department has provided more specific guidance regarding timing and content of the notice.

Taxation of distributions

[649] As is the case with the rollover rules, different rules regarding taxation of benefits apply to different types of tax- favored arrangements. In general, distributions from a qualified plan, section 403(b) annuity, or IRA are includible in income in the year received. In certain cases, distributions from qualified plans are eligible for capital gains treatment and averaging. These rules do not apply to distributions from other types of plans. Distributions from a qualified plan, IRA, and section 403(b) annuity generally are subject to an additional 10-percent early withdrawal tax if made before age 59-1/2. There are a number of exceptions to the early withdrawal tax. Some of the exceptions apply to all three types of plans, and others apply only to certain types of plans. For example, the 10-percent early withdrawal tax does not apply to IRA distributions for educational expenses, but does apply to similar distributions from qualified plans and section 403(b) annuities. Benefits under a section 457 plan are generally includible in income when paid or made available. The 10-percent early withdrawal tax does not apply to section 457 plans.

Description of Proposal

[650] The proposal would provide that eligible rollover distributions from qualified plans could be rolled over to another qualified plan, section 403(b) annuity, a governmental section 457 plan, or traditional IRA. Similarly, an eligible rollover distribution from a section 403(b) annuity could be rolled over to another 403(b) annuity, qualified plan, governmental section 457 plan, or traditional IRA. In addition, an eligible rollover distribution from a governmental section 457 plan could be rolled over to another governmental section 457 plan, 403(b) annuity, qualified plan, or traditional IRA.

[651] A special rule would prevent individuals from receiving special capital gains and income averaging treatment available to qualified plan distributions if the individual's account includes any amounts previously held under a section 403(b) annuity or governmental section 457 plan. Benefits under a governmental section 457 plan attributable to a rollover from another type of plan would not be includible in income until paid. A distribution from a governmental section 457 plan of amounts rolled over from another type of plan would be subject to the early withdrawal tax. Governmental section 457 plans would be required to separately account for rollover amounts. In addition, the rules regarding direct rollovers, withholding, and written notification concerning eligible rollover distributions would be extended to distributions from a governmental section 457 plan.

[652] Effective date. -- The proposal would be effective for distributions made after December 31, 2000.

Analysis

[653] Some individuals may accumulate retirement savings in more than one different type of tax-favored retirement saving vehicle. Allowing rollovers between different types of plans will allow individuals to combine their retirement savings in one vehicle. The ability to combine savings may be administratively easier for individuals, and may also affect investment choices and returns.

[654] In general, the rationale for not permitting rollovers among qualified plans, section 403(b) annuities, and governmental section 457 plans has been that benefits under such plans are taxed differently. The key differences are the application of the additional tax on early withdrawals and the special rules providing capital gains and income averaging treatment for certain qualified retirement plan distributions. These special rules providing capital gains and income averaging treatment have been repealed so that, after the expiration of certain transition rules, these differences in tax treatment between qualified plans and section 403(b) annuities will no longer remain. Furthermore, many believe that it is appropriate to extend the same rollover rules to governmental section 457 plans; like qualified plans, such plans are required to hold plan assets in trust for employees.

[655] The proposal addresses the current differences in tax treatment by requiring that governmental section 457 plans separately account for rollover amounts subject to the early withdrawal tax and by providing that the special rules providing capital gains and income averaging treatment will not apply to section 403(b) annuity and governmental section 457 plan amounts. In order to preserve the availability of averaging or capital gains treatment, it may be necessary for individuals to separately keep track of amounts attributable to section 403(b) annuities and governmental section 457 plans. Individuals may make mistakes, which can result in claiming averaging or capital gains treatment when the individual is not eligible to do so, or in losing the ability to claim such treatment when it is available.

Prior Action

[656] The proposal is similar to proposals contained in the President's Fiscal Year 1999 and 2000 Budget Proposals, except that under those proposals, the rollover rules would not have been extended to governmental section 457 plans. A similar proposal also was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President.

20. Rollovers of after-tax contributions

Present Law

Under present law, a qualified plan may permit individuals to make after-tax contributions to the plan. Present law provides that the maximum amount that can be rolled over to another qualified plan or an IRA is the amount of the distribution that is taxable. That is, employee after-tax contributions cannot be rolled over to another retirement plan or an IRA.

Description of Proposal

[657] The proposal would provide that employee after-tax contributions could be rolled over to another qualified retirement plan or a traditional IRA, provided that the plan or IRA provider agrees to track and report the after-tax portion of the rollover for the individual. ¹²²

[658] Effective date. -- The proposal would be effective for distributions made after December 31, 2000.

Analysis

[659] The proposal may help individuals to save for retirement. By increasing the opportunities to retain after-tax contributions in a tax-favored vehicle, it may help increase retirement security.

[660] The primary rationale for not permitting after-tax contributions to be rolled over has generally been that the record keeping involved is too complex. An individual who rolls over such contributions will need to keep accurate records in order to determine the taxable amount of any subsequent distribution from the IRA or plan. Maintaining such records may be difficult, because they may have to be kept for a long time. In addition, keeping track of the after-tax contributions may be more difficult if new contributions are made to the plan or IRA or amounts are subsequently transferred to another IRA or plan. The proposal addresses this issue by placing the burden of keeping track of such amounts on the financial institution offering the IRA or the plan. However, financial institutions and plans may not want or may not be able to fulfill the responsibility of keeping track of such contributions. It is unclear how many plans will not accept such contributions because they do not want the record keeping burdens. Others argue that the individual who rolls over after-tax contributions, not the financial institution or plan, should be responsible for keeping track of such contributions using forms that IRS should develop. Such forms could, for example, expand Form 8606-Nondeductible IRAs, to include information regarding after-tax contributions.

Prior Action

[661] The proposal is similar to a proposal contained in the President's Fiscal Year 2000 Budget Proposal. A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal, the responsibility for keeping track of after-tax contributions would be imposed on the individual who makes the rollover rather than the financial institution offering the IRA or the plan.

21. Rollovers of regular IRAs into workplace retirement plans

Present Law

[662] In general, amounts in an individual retirement arrangement ("IRA") may not be rolled over into a tax-qualified retirement plan, a section 403(b) tax-sheltered annuity, or a governmental section 457 plan. ¹²³

Description of Proposal

[663] An individual who has a traditional IRA and whose IRA contributions have all been tax deductible would be offered the opportunity to transfer funds from the traditional IRA into a qualified defined contribution retirement plan, section 403(b) tax- sheltered annuity or governmental section 457 plan -- provided that the retirement plan trustee meets the same standards as an IRA trustee. ¹²⁴ A special rule would prevent individuals from receiving special capital gains and income averaging treatment available to qualified plan distributions if the individual's account includes any amounts previously held under a section 403(b) annuity or governmental section 457 plan. In addition, amounts distributed from a governmental section 457 plan would be subject to the early withdrawal tax to the extent the distribution consists of amounts attributable to rollovers from a traditional IRA. Governmental section 457 plans would be required to separately account for such amounts.

[664] Effective date. -- The proposal would be effective for distributions made after December 31, 2000.

Analysis

[665] Like the proposal relating to rollovers among various types of plans, allowing rollovers from IRAs into qualified plans, section 403(b) annuities, or governmental section 457 plans will allow individuals to combine their retirement savings in one vehicle. The ability to combine savings may be administratively easier for individuals, and may also affect investment choices and returns.

Prior Action

[666] The proposal is similar to a proposal contained in the President's Fiscal Year 1999 Budget Proposal, except that under that proposal, rollovers to governmental section 457 plans would not be allowed. A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President.

22. Facilitate the purchase of service credits in governmental defined benefit plans

Present Law

[667] Under present law, limits are imposed on the contributions and benefits under qualified pension plans (Code sec. 415). In the case of a defined contribution plan, the limit on annual additions is the lesser of $30,000 (for 2000) or 25 percent of compensation. Annual additions include employer contributions, as well as after- tax employee contributions. In the case of a defined benefit pension plan, the limit on the annual retirement benefit is the lesser of (1) 100 percent of compensation or (2) $135,000 (for 2000). The 100 percent of compensation limitation does not apply in the case of State and local governmental pension plans.

[668] Present law provides special rules with respect to contributions by a participant in a State or local governmental plan to purchase permissive service credits under a governmental defined benefit plan. Such contributions are subject to one of two limits. Either (1) the accrued benefit derived from all contributions to purchase permissive service credit must be taken into account in determining whether the defined benefit pension plan limit is satisfied, or (2) all such contributions must be taken into account in determining whether the $30,000 limit on annual additions is met for the year (taking into account any other annual additions of the participant). These limits may be applied on a participant-by- participant basis. That is, contributions to purchase permissive service credits by all participants in the same plan do not have to satisfy the same limit.

[669] Permissive service credit means credit for a period of service recognized by the governmental plan only if the employee voluntarily contributes to the plan an amount (as determined by the plan) which does not exceed the amount necessary to fund the benefit attributable to the period of service and which is in addition to the regular employee contributions, if any, under the plan. Section 415 is violated if more than 5 years of permissive service credit is purchased for "nonqualified service". In addition, section 415 is violated if nonqualified service is taken into account for an employee who has less than 5 years of participation under the plan. Nonqualified service is service other than service (1) as a Federal, State, or local government employee, (2) as an employee of an association representing Federal, State or local government employees, (3) as an employee of an educational institution which provides elementary or secondary education, or (4) for military service. Service under (1), (2) or (3) is not qualified if it enables a participant to receive a retirement benefit for the same service under more than one plan.

[670] Under present law, benefits in a section 403(b) tax- sheltered annuity or under a governmental section 457 plan cannot be rolled over or transferred in a tax-free transfer to a governmental defined benefit plan.

[671] Benefits under section 403(b) annuities and section 457 plans are subject to certain distribution restrictions. Benefits under a section 403(b) annuity cannot be distributed prior to age 59- 1/2, separation from service, hardship, death or disability. Benefits under a section 457 plan cannot be distributed prior to the earliest of age 70-1/2, hardship, or separation from service.

Description of Proposal

[672] Governmental employees would be able to transfer funds from a section 403(b) plan or a section 457 plan in a tax-free transfer in order to purchase permissive service credits under a governmental defined benefit plan or to repay contributions and earnings with respect to an amount previously refunded under a forfeiture of service credit under the plan (or another plan maintained by a State or local government employer within the same State). A transfer could be made even if the individual could not take a distribution from the transferee plan. Transferred funds would be subject to the present-law rules regarding permissive service credit.

[673] Effective date. -- The proposal would be effective with respect to transfers made after December 31, 2000.

Analysis

[674] Permitting tax-free transfers as under the proposal will make it easier for State and local government employees to purchase permissive service credit, thereby allowing such employees to increase their retirement benefits. Some question whether it is appropriate to provide such special rules only for employers of certain types of entities.

Prior Action

[675] Similar proposals were included in the President's Fiscal Year 2000 Budget Proposal and in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President.

23. Thrift Savings Plan portability proposals

Present Law

[676] The Thrift Savings Plan ("TSP") is a retirement savings and investment plan for Federal and Postal employees. It offers employees the same type of before-tax savings and tax-deferred investment earnings that many private corporations offer their employees under section 401(k) plans.

[677] A newly-hired Federal employee is first allowed to contribute to the FERS Thrift Savings Plan (TSP) in the second semi- annual election period -- six to twelve months after being hired. Rehired employees become eligible in the first election period following their rehire and thus wait up to six months. When an employee becomes eligible to participate in the TSP, the employing agency will automatically contribute 1 percent of pay to the employee's account. If the employee contributes, the agency makes certain matching contributions. Employee contributions to the TSP are limited to salary reduction amounts, precluding rollover contributions from a qualified trust.

Description of Proposal

[678] All waiting periods for employee elective contributions and agency contributions to the TSP would be eliminated for new hires and rehires. In addition, an employee would be allowed to roll over an "eligible rollover distribution" from a qualified trust sponsored by a previous employer to the employee's TSP account.

[679] Effective date. -- The proposal would be effective after December 31, 2000.

Analysis

[680] New and rehired Federal employees should be provided the same retirement savings opportunities as current employees. Eliminating waiting periods for employee contributions would reduce gaps in savings opportunities for new and rehired Federal employees. Eliminating waiting periods for agency matching and automatic contributions would increase retirement savings and enhance employees' incentives to contribute.

[681] Allowing tax-free rollovers to the TSP from qualified trusts sponsored by previous employers would make it easier for TSP participants to consolidate their retirement savings. Changing these rules would conform TSP practices to those followed by many private employer plans.

Prior Action

[682] A similar proposal was included in H. R. 208, a bill to amend Title 5, United States Code, to allow for the contribution of certain rollover distributions to accounts in the Thrift Savings Plan, to eliminate certain waiting-period requirements for participating in the Thrift Savings Plan, and for other purposes, as passed by the House of Representatives on April 20, 1999.

24. Permit accelerated funding of defined benefit plans

Present Law

[683] Defined benefit pension plans are subject to minimum funding requirements designed to ensure that pension plans have sufficient assets to pay benefits. A defined benefit pension plan is funded using one of a number of acceptable actuarial cost methods.

[684] No contribution is required under the minimum funding rules in excess of the full funding limit. The full funding limit is generally defined as the excess, if any, of (1) the lesser of (a) the accrued liability under the plan (including normal cost) or (b) 155 percent of the plan's current liability, over (2) the value of the plan's assets (sec. 412(c)(7)). ¹²⁵ In general, current liability is all liabilities to plan participants and beneficiaries accrued to date, whereas the accrued liability full funding limit is based on projected benefits. The current liability full funding limit is scheduled to increase as follows: 160 percent for plan years beginning in 2001 or 2002, 165 percent for plan years beginning in 2003 and 2004, and 170 percent for plan years beginning in 2005 and thereafter. ¹²⁶ In no event is a plan's full funding limit less than 90 percent of the plan's current liability over the value of the plan's assets.

[685] An employer sponsoring a defined benefit pension plan generally may deduct amounts contributed to satisfy the minimum funding standard for the plan year. Contributions in excess of the full funding limit generally are not deductible. Under a special rule, an employer that sponsors a defined benefit pension plan (other than a multiemployer plan) which has more than 100 participants for the plan year may deduct amounts contributed of up to 100 percent of the plan's unfunded current liability. In addition, in the case of a single employer plan terminating under a standard termination, contributions are currently deductible up to the level of the benefits guaranteed by the PBGC under Title IV of ERISA.

Description of Proposal

[686] The full funding limitation based on current liability would be phased up more quickly than under present law, so that it would be 170 percent of current liability for years beginning after December 31, 2002. In addition, the 10 percent excise tax on nondeductible contributions would not apply to the extent a contribution is nondeductible solely as a result of the current liability full funding limit.

[687] Finally, the special deduction rule for terminating plans under section 404(g) would be modified so that all contributions needed to satisfy the plan's liabilities upon plan termination would be immediately deductible. In the case of a plan with fewer than 100 participants, liabilities attributable to recent benefit increases for highly compensated employees would be disregarded for this purpose.

Conforming changes would be made to Title I of ERISA.

[688] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2000.

Analysis

[689] The deduction limits for qualified plans attempt to balance tax policy concerns (including revenue issues) with retirement income security concerns. From a tax policy perspective, the deduction limits for contributions to qualified plans generally serve to limit the tax benefits associated with such plans, and help ensure that the plans are actually used to provide retirement benefits, rather than as a tax-saving mechanism for the employer. An employer may have an incentive to make nondeductible contributions to a plan because such contributions receive tax-free buildup on the earnings. The excise tax on nondeductible contributions provides a disincentive to make such contributions.

[690] The deduction limits also reflect retirement policy objectives. Thus, the minimum funding cost of a defined benefit plan and the amount necessary to fully fund a defined benefit plan (i.e., eliminate unfunded current liabilities) are always deductible. Exceptions to the nondeductible excise tax ensure that, even though certain contributions are not deductible, the employer is not penalized for making such contributions.

[691] Some employers are concerned that the current liability full funding limit may put their employees at risk by forcing funding to be deferred into the future. Permitting an employer to contribute amounts which are currently nondeductible as a result of the current liability full funding limit, without applying the excise tax on nondeductible contributions, may provide more security for employees while restricting employers' ability to use excessive pension funding as a tax shelter.

Prior Action

[692] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal, the current liability full funding limit would be repealed for plan years beginning in 2004 and thereafter, and up to 100 percent of a plan's unfunded termination liability, determined as if the plan terminated at the end of the plan year, would be deductible.

25. Benefit limits for multiemployer plans under section 415

Present Law

[693] In general, under present law, annual benefits under a defined benefit pension plan are limited to the lesser of $135,000 (for 2000) or 100 percent of average compensation for the 3 highest years. Reductions in these limits are generally required if the employee has fewer than 10 years of service or plan participation. If benefits under a defined benefit plan begin before social security retirement age, the dollar limit must be actuarially reduced to compensate for the early commencement. A special rule applies to defined benefit plans maintained by governmental or tax-exempt employers and qualified merchant marine plans. In the case of such plans, the dollar limit is reduced in the case of retirement before age 62 and increased in the case of retirement after age 65. In addition, there is a floor on early retirement benefits. Pursuant to this floor, the minimum benefit payable at age 55 is $75,000.

[694] For purposes of section 415, all plans maintained by an employer and related entities are combined, except that a multiemployer plan may disregard benefits provided by the same employer through other multiemployer plans. Thus, aggregation of benefits within a multiemployer plan that are attributable to service with a specific employer and a single-employer plan maintained by the same or a related employer is required.

Description of Proposal

[695] Under the proposal, the 100-percent-of-compensation limit on defined benefit plan benefits would not apply to multiemployer plans. Also, the rule requiring aggregation of benefits provided from a single employer for purposes of section 415 would be modified to eliminate aggregation between a multiemployer defined benefit plan and a single employer defined benefit plan for purposes of the 100- percent-of-compensation limit. In addition, the special early retirement rules that apply under present law to defined benefit plans sponsored by governmental or tax-exempt employers and qualified merchant marine plans would apply to multiemployer plans.

[696] Effective date. -- The proposal would be effective for years beginning after December 31, 2000.

Analysis

[697] The limits on benefits under qualified plans were designed to limit the tax benefits and revenue loss associated with such plans, while still ensuring that adequate retirement benefits could be provided. The 100-percent-of-compensation limitation reflects Congressional judgment that a replacement rate of 100-percent-of- compensation is an adequate retirement benefit.

[698] The stated rationale for the proposal is that the qualified plan limitations present significant administrative problems for many multiemployer plans which base benefits on years of credited service rather than compensation. In addition, it is argued that, because pension benefits under multiemployer plans are typically based upon factors other than compensation, the 100-percent of compensation rule produces an artificially low limit for employees in certain industries, such as building and construction, where wages vary significantly from year to year. Furthermore, some argue that multiemployer plans should be permitted to provide for higher early retirement benefits because participants in such plans often need to retire early due to the physical stress of the work they perform.

[699] Others argue that the limits on benefits under qualified plans create administrative problems for all plan sponsors, and that these problems are no greater for multiemployer plans than for any other plan. In addition, it is argued that there is no justification for higher benefit limitations, including higher early retirement benefits, for multiemployer plans, as persons affected by these limits are not all participants in multiemployer plans. Providing a special rule for such plans would merely create inequities among plan participants based upon the type of plan in which they are a participant. For example, many individuals work in industries where wages may vary significantly from year to year, but not all of those employees are participants in multiemployer plans. To the extent that the qualified plan limits are deemed to inappropriately reduce benefits in such (or similar) cases, it is argued that it would be more equitable to provide an across the board rule that is not based upon the type of plan. If it is believed that a 100-percent of compensation limitation or an early retirement reduction is not appropriate, it is not clear why only participants in multiemployer plans should receive the benefit of a higher limit.

Prior Action

[700] Similar proposals were included in the Taxpayer Relief Act of 1997, as passed by the Senate. Similar proposals were also included in the Administration's 1995 Pension Simplification Proposal, ¹²⁷ in the Small Business Job Protection Act of 1996 as passed by the Senate, and in the President's Fiscal Year 1999 and 2000 Budget Proposals, except that those proposals would not eliminate the aggregation of benefits between multiemployer and other plans or extend to multiemployer plans the special rules regarding early retirement benefits.

26. Full funding limit for multiemployer plans

Present Law

[701] Under present law, employer deductions for contributions to a defined benefit pension plan cannot exceed the full funding limit. In general, the full funding limit is the lesser of a plan's accrued liability and 155-percent of current liability. The 155- percent of current liability limit is scheduled to increase gradually, until it is 170 percent in 2005 and thereafter.

[702] Defined benefit pension plans are required to have an actuarial valuation no less frequently than annually.

Description of Proposal

[703] Under the proposal, the current liability full funding limit would not apply to multiemployer plans. In addition, such plans would be required to have an actuarial valuation at least once every three years. Changes would be made to the corresponding provisions of title I of the Employee Retirement Income Security Act of 1974, as amended.

[704] Effective date. -- The proposal would be effective for taxable years beginning after December 31, 2000.

Analysis

[705] The current liability full funding limit was enacted as a balance between differing policy objectives. On one hand is the concern that defined benefit pension plans should be funded so as to provide adequate benefit security for plan participants. On the other hand is the concern that employers should not be entitled to make excessive contributions to a defined benefit pension plan to fund liabilities that it has not yet incurred. Such use of a defined benefit plan was believed to be equivalent to a tax-free savings account for future liabilities, and inconsistent generally with the treatment of unaccrued liabilities under the Internal Revenue Code. The current liability full funding limit as initially enacted was 150 percent of current liability. It was increased to the present-law level by the Taxpayer Relief Act of 1997 because the Congress believed that the 150-percent limit unduly restricted funding of defined benefit pension plans.

[706] Proponents of the proposal argue that employers have no incentive to make excess contributions to a multiemployer plan, because the amount an employer contributes to the plan is set by a collective bargaining agreement and a particular employer's contributions are not set aside to pay benefits solely to the employees of that employer.

[707] Others would argue that it is inappropriate to provide special rules based on the type of plan. While many multiemployer plans restrict the ability of the employer to obtain reversions of excess plan assets on termination of the plan, not all do, so that an employer may still have an incentive to fund unincurred liabilities in order to obtain tax benefits. Also, many plans that are not multiemployer plans restrict the ability of employers to obtain excess assets, limiting any incentive to make excess contributions.

Prior Action

[708] Similar proposals were included in the Administration's 1995 Pension Simplification Proposal ¹²⁸ and in the President's Fiscal Year 1999 and 2000 Budget Proposals.

27. Increase disclosure for pension amendments that reduce the future rate of benefit accrual

Present Law

[709] Section 204(h) of Title I of ERISA provides that a defined benefit pension plan or a money purchase pension plan may not be amended so as to provide for a significant reduction in the rate of future benefit accrual, unless, after adoption of the plan amendment and not less than 15 days before the effective date of the plan amendment, the plan administrator provides a written notice ("section 204(h) notice"), setting forth the plan amendment (or a summary of the amendment written in a manner calculated to be understood by the average plan participant) and its effective date. The plan administrator must provide the section 204(h) notice to each plan participant, each alternate payee under an applicable qualified domestic relations order ("QDRO"), and each employee organization representing participants in the plan. The applicable Treasury regulations provide, however, that a plan administrator need not provide the section 204(h) notice to any participant or alternate payee whose rate of future benefit accrual is reasonably expected not to be reduced by the amendment, nor to an employee organization that does not represent a participant to whom the section 204(h) notice must be provided. In addition, the regulations provide that the rate of future benefit accrual is determined without regard to optional forms of benefit, early retirement benefits, retirement-type subsidiaries, ancillary benefits, and certain other rights and features.

[710] A covered amendment generally will not become effective with respect to any participants and alternate payees whose rate of future benefit accrual is reasonably expected to be reduced by the amendment but who do not receive a section 204(h) notice. An amendment will become effective with respect to all participants and alternate payees to whom the section 204(h) notice was required to be provided if the plan administrator (1) has made a good faith effort to comply with the section 204(h) notice requirements, (2) has provided a section 204(h) notice to each employee organization that represents any participant to whom a section 204(h) notice was required to be provided, (3) has failed to provide a section 204(h) notice to no more than a de minimis percentage of participants and alternate payees to whom a section 204(h) notice was required to be provided, and (4) promptly upon discovering the oversight, provides a section 204(h) notice to each omitted participant and alternate payee.

[711] The Internal Revenue Code does not require any notice concerning a plan amendment that provides for a significant reduction in the rate of future benefit accrual.

Description of Proposal

[712] The proposal would require that the notice of a significant reduction of the rate of future benefit accrual summarize the important terms of the plan amendment, including identification of the effective date, a statement that the amendment is expected to significantly reduce the rate of future benefit accrual, a general description of how the amendment significantly reduces the rate of future benefit accrual, and a description of the class or classes of participants to whom the amendment applies. Participants would receive the notice at least 45 days before the effective date of the plan amendment.

[713] For a plan with 100 or more active participants, the plan administrator would also be required to provide affected participants an enhanced advance notice of the amendment that describes, and illustrates using specific examples, the impact of the amendment on representative affected participants, to make available the formulas and factors used in those examples in order to permit similar calculations to be made, and to make available a follow-up individualized benefit statement estimating the participant's projected retirement benefits. Certain amendments, such as amendments that do not make a fundamental change in a plan's formula, could be to the extent provided by Treasury regulations.

[714] In the case of an egregious failure to comply with the notice requirements (for example, a failure to provide the required information to most affected participants or an intentional failure to provide notice to any affected participant), the amendment would be prohibited from going into effect for all affected participants, and the employer would be subject to excise taxes. In the case of a failure that is not an egregious failure, the employer would be subject to excise taxes (which could be waived in certain cases), but the amendment would be permitted to take effect, provided the notice is promptly furnished to the affected participants who did not previously receive it.

[715] Effective date. -- The proposal would be effective for plan amendments taking effect after the date of enactment, with special transition rules in certain circumstances.

Analysis

[716] Significant publicity has been given recently to conversions of traditional defined benefit pension plans to "cash balance" plans, with particular focus on the impact such conversions have on affected workers. Many believe that the limited notice requirement under present law does not provide pension plan participants with clear, adequate, and timely information about pension plan amendments that may result in reductions of future benefit accruals and therefore hinders the ability of participants to plan for retirement. Proponents of the proposal argue that participants cannot understand certain types of plan amendments without (1) a notice that includes examples showing how the change affects future benefits for illustrative participants, (2) the ability to obtain plan documents in order to do their own calculations regarding future pension benefits, and (3) the ability to obtain individualized projections of the effect of the change on their own future pensions.

[717] Some are concerned that the proposal fails to strike a balance between providing meaningful disclosure and avoiding the imposition of unnecessary administrative burdens on employers. Others are concerned that the proposal would not adequately protect the interests of plan participants, and therefore support proposals that would require employers to permit affected participants to choose between pre-amendment and post-amendment benefit formulas, require employers to take measures to mitigate the impact of amendments on future benefit accrual, or restrict the ability of employers to amend plans.

Prior Action

[718] A similar proposal was included in the Taxpayer Refund and Relief Act of 1999, as passed by the Congress and vetoed by the President, except that under that proposal, an employer that amends a pension plan with 100 or more participants to provide for a significant reduction in the rate of future benefit accrual generally would be subject to an excise tax for failure to provide within a reasonable time before the effective date of the amendment (except as provided in Treasury regulations) a notice written in a manner calculated to be understood by the average plan participant and providing sufficient information (as determined in accordance with Treasury regulations) to allow participants to understand the effect of the plan amendment.