Menu
Tax Notes logo

Full Text: Senate Budget Committee Releases Print On Tax Expenditures.

DEC. 1, 1994

S. Prt. 103-101

DATED DEC. 1, 1994
DOCUMENT ATTRIBUTES
  • Institutional Authors
    U.S. Senate
    Budget Committee
    Congressional Research Service
  • Cross-Reference
    Text of this 568-page committee print may be ordered from Tax

    Analysts' Access Service as Doc 95-340; call our customer service

    department at (800) 955-2444 for assistance.
  • Index Terms
    tax expenditures
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-340 (568 pages)
  • Tax Analysts Electronic Citation
    95 TNT 8-35
Citations: S. Prt. 103-101
====== SUMMARY ======

The Senate Budget Committee has released a report prepared by the Congressional Research Service that provides a comprehensive description of over 120 tax expenditures.

In "Tax Expenditures: Compendium of Background Material on Individual Provisions" (S. Prt. 103-101), a committee print dated December 1994, the Budget Committee fulfills a requirement of the Congressional Budget and Impoundment and Control Act of 1974 to examine tax expenditures in the process of developing a budget resolution.

"The CRS has produced an extraordinarily useful document which incorporates not only a description of each provision and an estimate of its revenue cost, but also a discussion of its impact, a review of its underlying rationale, and a set of bibliographic references," former Budget Chairman Jim Sasser, D-Tenn., wrote in an accompanying letter of transmittal to the committee.

====== FULL TEXT ======

TAX EXPENDITURES

 

COMPENDIUM OF BACKGROUND MATERIAL

 

ON INDIVIDUAL PROVISIONS

COMMITTEE ON THE BUDGET

 

UNITED STATES SENATE

DECEMBER 1994

PREPARED BY THE

 

CONGRESSIONAL RESEARCH SERVICE

LETTER OF TRANSMITTAL

November 30, 1994

UNITED STATES SENATE

 

COMMITTEE ON THE BUDGET

 

WASHINGTON, DC

To the Members of the Committee on the Budget:

The Congressional Budget and Impoundment and Control Act of 1974 (as amended) requires the Budget Committees to examine tax expenditures as they develop the Congressional Budget Resolution. There are over 120 separate tax expenditures in current law. These provisions confer benefits on individuals and institutions that are comparable to direct Federal spending. They have a substantial impact on the level of Federal receipts and are seldom reviewed with the same scrutiny given to the direct spending or mandatory programs about which so much has recently been written.

Tax expenditures are becoming increasingly important when considering the budget. They are generally enacted as permanent legislation and are thus comparable to continuing direct spending on entitlement programs. They cause significant revenue losses and are often less efficient than related outlay programs. In some cases, they cause economic distortion and result in higher inflation and interest rates and in less growth.

This print was prepared by the Congressional Research Service (CRS) and was coordinated by David Williams of the Senate Budget Committee staff. All tax code changes through the end of the 103rd Congress are included.

The CRS has produced an extraordinarily useful document which incorporates not only a description of each provision and an estimate of its revenue cost, but also a discussion of its impact, a review of its underlying rationale, and a set of bibliographic references. Nothing in this print should be interpreted as representing the views or recommendations of the Budget Committee or any of its members.

Jim Sasser

 

Chairman

* * *

LETTER OF SUBMITTAL

CONGRESSIONAL RESEARCH SERVICE

 

THE LIBRARY OF CONGRESS

 

Washington, D.C.,

 

November 28, 1994

Honorable Jim Sasser

 

Chairman, Committee on the Budget

 

U.S. Senate

 

Washington, DC 20510

Dear Mr. Chairman:

I am pleased to submit a revision of the November 1992 Committee Print on Tax Expenditures.

As in earlier versions, each entry includes an estimate of the revenue cost, the legal authorization, a description, the impact of the provision, the rationale at the time of adoption, an assessment, and bibliographic citations. The impact section includes quantitative data on the distribution of tax expenditures across income classes where relevant and where data are available. The rationale section contains some detail about the historical development of each provision. The assessment section summarizes the issues surrounding each tax expenditure.

The revision was written under the general direction of Jane G. Gravelle, Senior Specialist in Economic Policy. Contributors of individual entries include Jane G. Gravelle and Donald W. Kiefer of the Office of Senior Specialists; James M. Bickley, David L. Brumbaugh, Gregg A. Esenwein, Salvatore Lazzari, Linda Levine, Gerald E. Mayer, Nonna A. Noto, Louis A. Talley, Jack H. Taylor, and Dennis Zimmerman of the Economics Division; and Velma W. Burke, Geoffrey C. Kollman, Robert F. Lyke, Joseph I. Richardson, Raymond Schmitt, and James R. Storey of the Education and Public Welfare Division. Thomas A. Holbrook provided editorial assistance and prepared the document for publication.

DANIEL P. MULHOLLAN, Director

CONTENTS

Letter of Transmittal

 

Letter of Submittal

 

Introduction

 

National Defense

 

Exclusion of Benefits and Allowances

 

to Armed Forces Personnel

Exclusion of Military Disability Benefits

International Affairs

Exclusion of Income Earned Abroad by U.S. Citizens

 

Exclusion of Certain Allowances

 

for Federal Employees Abroad

 

Exclusion of Income of Foreign Sales Corporations (FSCS)

 

Deferral of Income of Controlled Foreign Corporations

 

Inventory Property Sales Source-Rule Exception

 

Interest Allocation Rules Exception for Certain Nonfinancial

 

Institutions

General Science, Space, and Technology

Credit for Increasing Research Activities

 

Expensing of Research and Development Expenditures

Energy

Expensing of Exploration and Development Costs:

 

Oil, Gas, and Other Fuels

 

Excess of Percentage over Cost Depletion:

 

Oil, Gas, and Other Fuels

 

Credit for Enhanced Oil Recovery Costs

 

Nonconventional Fuel Production Credit

 

Alcohol Fuel Credits

 

Exclusion of Interest on State and Local Government Industrial

 

Development Bonds for Energy Production Facilities

 

Expensing of Tertiary Injectants

 

Exclusion of Energy Conservation Subsidies Provided by

 

Public Utilities

 

Credit for Investments in Solar and

 

Geothermal Energy Facilities

 

Credits for Electricity from Wind and Biomass

 

Deductions and Credits for Clean-Fuel Vehicles

 

and Refueling Property

Natural Resources and Environment

Expensing of Exploration and Development Costs:

 

Nonfuel Minerals

 

Excess of Percentage Over Cost Depletion:

 

Nonfuel Minerals

 

Investment Credit and 7-Year Amortization

 

for Reforestation Expenditures

 

Expensing Multiperiod Timber-Growing Costs

 

Exclusion of Interest on State and Local Government

 

Sewage, Water, and Hazardous Waste Facilities

 

Investment Tax Credit for Rehabilitation

 

of Historic Structures

 

Special Rules for Mining Reclamation Reserves

Agriculture

Exclusion of Cost-Sharing Payments

 

Exclusion of Cancellation of Indebtedness Income

 

of Farmers

 

Cash Accounting and Expensing for Agriculture

Commerce and Housing

Bad Debt Reserves of Financial Institutions

 

Exemption of Credit Union Income

 

Exclusion of Investment Income on Life Insurance

 

and Annuity Contracts

 

Exclusion of Investment Income

 

from Structured Settlement Accounts

 

Small Life Insurance Company Taxable Income Adjustment

 

Special Treatment of Life Insurance Company Reserves

 

Deduction of Unpaid Loss Reserves for

 

Property and Casualty Insurance Companies

 

Special Alternative Tax on Small Property and Casualty

 

Insurance Companies

 

Tax Exemption for Certain Insurance Companies

 

Special Deduction for Blue Cross and

 

Blue Shield Companies

 

Deductibility of Mortgage Interest on

 

Owner-Occupied Residences

 

Deductibility of Property Tax on

 

Owner-Occupied Residences

 

Deferral of Capital Gains on Sale of Principal Residence

 

Exclusion of Capital Gains on Sales of Principal Residences

 

for Persons Age 55 and Over ($125,000 Exclusion)

 

Exclusion of Interest on State and Local

 

Government Bonds for Owner-Occupied Housing

 

Exclusion of Interest on State and Local

 

Government Bonds for Rental Housing

 

Depreciation of Rental Housing in Excess of

 

Alternative Depreciation System

 

Low-Income Housing Tax Credit

 

Maximum 28% Tax Rate on Long-Term Capital Gains

 

Depreciation on Buildings Other than Rental Housing

 

in Excess of Alternative Depreciation Systems

 

Depreciation on Equipment in Excess of

 

Alternative Depreciation Systems

 

Expensing up to $17,500 of Depreciable Business Property

 

Exclusion of Capital Gains at Death Carryover Basis of

 

Capital Gains on Gifts

 

Amortization of Business Start-Up Costs

 

Reduced Rates on First $10,000,000 of

 

Corporate Taxable Income

 

Permanent Exemption from Imputed Interest Rules

 

Expensing of Magazine Circulation Expenditures

 

Special Rules for Magazine, Paperback Book,

 

and Record Returns

 

Deferral of Gain on Non-Dealer Installment Sales

 

Completed Contract Rules

 

Cash Method of Accounting, Other than Agriculture

 

Exclusion of Interest on State and Local Government

 

Small-Issue Bonds

 

Deferral of Gain on Like-Kind Exchanges

 

Exception from Net Operating Loss Limitations for

 

Corporations in Bankruptcy Proceedings

 

Deferral of Gain from Sale or Exchange of Broadcasting

 

Facilities to Minority Owned Businesses

Transportation

Deferral of Tax on Capital Construction Funds

 

of Shipping Companies

 

Employer-Paid Transportation Benefits

 

Exclusion of Interest on State and Local Government Bonds

 

for High-Speed Inter-Urban Rail Facilities

Community and Regional Development

Investment Credit for Rehabilitation of Structures,

 

Other than Historic Structures

 

Exclusion of Interest on State and Local Government Bonds

 

for Private Airports, Docks,

 

and Mass Commuting Facilities

 

Regional Economic Development Incentives:

 

Empowerment Zones, Enterprise Communities,

 

and Indian Investment Incentives

Education, Training, Employment, and Social Services

 

Exclusion of Scholarship and Fellowship Income

 

Parental Dependency Exemption for Students Ages 19-23

 

Exclusion of Interest on State and Local Government

 

Student Loan Bonds

 

Exclusion of Interest on State and Local Government

 

Bonds for Private Nonprofit Educational Facilities

 

Deductibility of Charitable Contributions for

 

Educational Institutions

 

Exclusion of Interest on Education Savings Bonds

 

Exclusion for Employer-Provided

 

Educational Assistance Benefits

 

Exclusion of Employee Meals and Lodging

 

(Other than Military)

 

Special Tax Provisions for

 

Employee Stock Ownership Plans (ESOPs)

 

Exclusion of Benefits Provided under Cafeteria Plans

 

Exclusion of Rental Allowances for Ministers' Homes

 

Exclusion of Miscellaneous Fringe Benefits

 

Exclusion of Employee Awards

 

Exclusion of Income Earned by Voluntary

 

Employees' Beneficiary Associations

 

Targeted Jobs Tax Credit

 

Deductibility of Charitable Contributions, Other than for

 

Education and Health

 

Credit for Child and Dependent Care Services

 

Exclusion for Employer-Provided Child Care

 

Exclusion for Certain Foster Care Payments

 

Expensing Costs of Removing Architectural Barriers

 

Tax Credit for Disabled Access Expenditures

Health

Exclusion of Employer Contributions for Medical Insurance

 

Premiums and Medical Care

 

Exclusion of Medical Care and CHAMPUS Health

 

Insurance for Military Dependents

 

Deductibility of Medical Insurance Premiums by the

 

Self-Employed

 

Deductibility of Medical Expenses

 

Exclusion of Interest on State and Local Government Bonds

 

for Nonprofit Hospital Facilities

 

Tax Credit for Orphan Drug Research

 

Deductibility of Charitable Contributions

 

to Health Organizations

Medicare

Hospital Insurance (Part A)

 

Supplementary Medical Insurance (Part B)

Income Security

Exclusion of Workers' Compensation Benefits

 

Exclusion of Special Benefits For Disabled Coal Miners

 

Exclusion of Public Assistance Benefits

 

Net Exclusion of Pension Contributions and Earnings Plans

 

for Employees and Self-Employed Individuals (Keoghs)

 

Individual Retirement Plans (Exclusion of Contributions

 

and Earnings)

 

Exclusion of Other Employee Benefits: Premiums on

 

Group Term Life Insurance

 

Exclusion of Other Employee Benefits: Premiums on

 

Accident and Disability Insurance

 

Exclusion for Employer-Provided Death Benefits

 

Additional Standard Deduction for the Blind and Elderly

 

Tax Credit for the Elderly and Disabled

 

Deductibility of Nonbusiness Casualty and Theft Losses

 

Earned Income Tax Credit

Social Security and Railroad Retirement

Exclusion of Untaxed Social Security and

 

Railroad Retirement Benefits

Veterans' Benefits and Services

Exclusion of Veterans' Benefits and Services

 

Exclusion of Interest on State and Local Government

 

Veterans' Housing Bonds

General Purpose Fiscal Assistance

Exclusion of Interest on Public Purpose

 

State and Local Debt

 

Deduction of Nonbusiness State and Local Government

 

Income and Personal Property Taxes

 

Tax Credit for Section 936 Income

Interest

Deferral of Interest on Savings Bonds

Appendix

Forms of Tax Expenditures

INTRODUCTION

This compendium gathers basic information concerning 127 Federal tax provisions currently treated as tax expenditures. They include those listed in Tax Expenditure Budgets prepared for fiscal years 1993-1997 by the Joint Committee on Taxation, /1/ although certain separate items that are closely related and are within a major function may be combined.

In addition, certain provisions that have expired, but which may be reinstated, are also included. Certain special capital gains provisions (e.g., timber, coal and iron ore royalties) that were formerly listed separately are now discussed in the general capital gains rate differential item.

With respect to each tax expenditure, this compendium provides:

The Federal revenue loss associated with the provision for

 

individual and corporate taxpayers, for fiscal years 1995-1999,

 

as estimated by the Joint Committee on Taxation;

The legal authorization for the provision (e.g., Internal

 

Revenue Code section, Treasury Department regulation, or

 

Treasury ruling);

A description of the tax expenditure, including an example of

 

its operation where this is useful;

A brief analysis of the impact of the provision, including

 

information on its distribution where data are available;

A brief statement of the rationale for the adoption of the tax

 

expenditure where it is known, including relevant legislative

 

history;

An assessment, which addresses the arguments for and against

 

the provision; and

References to selected bibliography.

The information presented for each tax expenditure is not intended to be exhaustive or definitive. Rather, it is intended to provide an introductory understanding of the nature, effect, and background of each provision. Good starting points for further research are listed in the selected bibliography following each provision.

Defining Tax Expenditures

Tax expenditures are revenue losses resulting from Federal tax provisions that grant special tax relief designed to encourage certain kinds of behavior by taxpayers or to aid taxpayers in special circumstances. These provisions may, in effect, be viewed as spending programs channeled through the tax system. They are, in fact, classified in the same functional categories as the U.S. budget.

Section 3(a)(3) of the Congressional Budget and Impoundment Control Act of 1974 specifically defines tax expenditures as:

. . . those revenue losses attributable to provisions of the

 

Federal tax laws which allow a special exclusion, exemption, or

 

deduction from gross income or which provide a special credit,

 

a preferential rate of tax, or a deferral of tax

 

liability; . . . .

In the legislative history of the Congressional Budget Act, provisions classified as tax expenditures are contrasted with those provisions which are part of the "normal structure" of the individual and corporate income tax necessary to collect government revenues.

The listing of a provision as a tax expenditure in no way implies any judgment about its desirability or effectiveness relative to other tax or non-tax provisions that provide benefits to specific classes of individuals and corporations. Rather, the listing of tax expenditures, taken in conjunction with the listing of direct spending programs, is intended to allow Congress to scrutinize all Federal programs relating to the same goals--both non-tax and tax-- when developing its annual budget. Only when tax expenditures are considered will congressional budget decisions take into account the full spectrum of Federal programs.

Because any qualified taxpayer may reduce tax liability through use of a tax expenditure, such provisions are comparable to entitlement programs under which benefits are paid to all eligible persons. Since tax expenditures are generally enacted as permanent legislation, it is important that, as entitlement programs, they be given thorough periodic consideration to see whether they are efficiently meeting the national needs and goals for which they were established.

Tax expenditure budgets which list the estimated annual revenue losses associated with each tax expenditure first were required to be published in 1975 as part of the Administration budget for fiscal year 1976, and have been required to be published by the Budget Committees since 1976. The tax expenditure concept is still being refined, and therefore the classification of certain provisions as tax expenditures continues to be discussed. Nevertheless, there has been widespread agreement for the treatment as tax expenditures of most of the provisions included in this compendium. /2/

As defined in the Congressional Budget Act, the concept of tax expenditure refers to the corporation and individual income taxes. Other parts of the Internal Revenue Code--excise taxes, employment taxes, estate and gift taxes--also have exceptions, exclusions, refunds and credits (such as a gasoline tax exemptions for non- highway uses) which are not included here because they are not parts of the income tax.

Administration Fiscal Year 1993 Tax Expenditure Budget

There are several differences between the tax expenditures shown in this publication and the tax expenditure budget found in the Administration's FY93 budget document. The Joint Committee on Taxation provides estimates for a broader set of tax expenditures than those reported in the Administration's list, and in some cases tax expenditures are combined in one list, but not in the other.

Major Types of Tax Expenditures

Tax expenditures may take any of the following forms:

(1) exclusions, exemptions, and deductions, which reduce taxable income;

(2) preferential tax rates, which apply lower rates to part or all of a taxpayer's income;

(3) credits, which are subtracted from taxes as ordinarily computed;

(4) deferrals of tax, which result from delayed recognition of income or from allowing in the current year deductions that are properly attributable to a future year.

The amount of tax relief per dollar of each exclusion, exemption, and deduction increases with the taxpayer's tax rate. A tax credit is subtracted directly from the tax liability that would otherwise be due; thus the amount of tax reduction is the amount of the credit -- which does not depend on the marginal tax rate. (See Appendix A for further explanation.)

Order of Presentation

The tax expenditures are presented in an order which generally parallels the budget functional categories used in the congressional budget, i.e., tax expenditures related to "national defense' are listed first, and those related to "international affairs" are listed next. In a few instances, two or three closely related tax expenditures derived from the same Internal Revenue Code provision have been combined in a single summary to avoid repetitive references even though the tax expenditures are related to different functional categories. This parallel format is consistent with the requirement of section 301(d)(6) of the the Budget Act, which requires the tax expenditure budgets published by the Budget Committees as parts of their April 15 reports to present the estimated levels of tax expenditures "by major functional categories."

Impact (Including Distribution)

The impact section includes information on the direct effect of the provisions and, where available, the distributional effect across individuals. Unless otherwise specified, distributional tables showing the share of the tax expenditure received by income class are calculated from data in the Joint Committee on Taxation's committee print on tax expenditures for 1995-1999. This distribution uses an expanded income concept that is composed of adjusted gross income (AGI), plus (1) tax-exempt interest, (2) employer contributions for health plans and life insurance, (3) employee share of FICA tax, (4) worker's compensation, (5) nontaxable social security benefits, (6) insurance value of Medicare benefits, (7) corporate income tax liability passed on to shareholders, (8) alternative minimum tax preferences, and (9) excluded income of U.S. citizens abroad.

The following table shows the distribution of returns by income class, for comparison with those tax expenditure distributions:

           Distribution by Income Class of Tax Returns at

 

                1994 Tax Rates and 1994 Income Levels

____________________________________________________________________

     Income Class                                 Percentage

 

     (in thousands of $)                         Distribution

 

____________________________________________________________________

       Below $10                                     18.5

 

       $10 to $20                                    19.1

 

       $20 to $30                                    15.9

 

       $30 to $40                                    12.8

 

       $40 to $50                                     9.1

 

       $50 to $75                                    13.8

 

       $75 to $100                                    5.7

 

       $100 to $200                                   4.1

 

       $200 and over                                  1.1

 

____________________________________________________________________

These estimates were made for nine tax expenditures. For other tax expenditures, a distributional estimate or information on distributional impact is provided, when such information could be obtained.

Many tax expenditures are corporate and thus do not directly affect the taxes of individuals. Most analyses of capital income taxation suggest that such taxes are likely to be borne by capital given reasonable behavioral assumptions. /3/ Capital income is heavily concentrated in the upper-income levels. For example, the Congressional Budget Office /4/ reports that 36.2 percent of capital income is received by the top one percent of the population, 53.7 percent is received by the top 5 percent, and 62.3 percent is received by the top 10 percent. The distribution across the first nine deciles is: 0.3, 0.8, 1.7, 2.8, 3.8, 4.8, 6.2, 7.1, and 9.8. Corporate tax expenditures would, therefore, tend to benefit higher- income individuals.

Rationale

Each tax expenditure item contains a brief statement of the rationale for the adoption of the expenditure, where it is known. They are the principal rationales publicly given at the time the provisions were enacted. The rationale also chronicles subsequent major changes in the provisions and the reasons for the changes. /5/

Assessment

The assessment section summarizes the arguments for and against the tax expenditures and the issues they raise. These issues include effects on economic efficiency, on fairness and equity, and on simplicity and tax administration. Further information can be found in the bibliographic citations.

Estimating Tax Expenditures

The revenue losses for all the listed tax expenditures are those estimated by the Joint Committee on Taxation.

In calculating the revenue loss from each tax expenditure, it is assumed that only the provision in question is deleted and that all other aspects of the tax system remain the same. In using the tax expenditure estimates, several points should be noted.

First, in some cases, if two or more items were eliminated, the combination of changes would probably produce a lesser or greater revenue effect than the sum of the amounts shown for the individual items. Thus, the arithmetical sum of all tax expenditures (reported below) may be different from the actual revenue consequences of eliminating all tax expenditures.

Second, the amounts shown for the various tax expenditure items do not take into account any effects that the removal of one or more of the items might have on investment and consumption patterns or on any other aspects of individual taxpayer behavior, general economic activity, or decisions regarding other Federal budget outlays or receipts.

Finally, the revenue effect of new tax expenditure items added to the tax law may not be fully felt for several years. As a result, the eventual annual cost of some provisions is not fully reflected until some time after enactment. Similarly, if items now in the law were eliminated, it is unlikely that the full revenue effects would be immediately realized.

These tax expenditure estimating considerations are, however, similar to estimating considerations involving entitlement programs. Like tax expenditures, annual budget estimates for each transfer and income-security program are computed separately. However, if one program, such as veterans pensions, were either terminated or increased, this would affect the level of payments under other programs, such as welfare payments.

Also, like tax expenditure estimates, the elimination or curtailment of a spending program, such as military spending or unemployment benefits, would have substantial effects on consumption patterns and economic activity that would directly affect the levels of other spending programs. Finally, like tax expenditures, the budgetary effect of terminating certain entitlement programs would not be fully reflected until several years later because the termination of benefits is usually only for new recipients, with persons already receiving benefits continued under "grandfather" provisions.

All revenue loss estimates are based upon the tax law enacted as of December 31, 1993. All estimates have been rounded to the nearest $0.1 billion.

          SUM OF TAX EXPENDITURE ITEMS BY TYPE OF TAXPAYER,

 

                       FISCAL YEARS 1995-1999

                      [In billions of dollars]

____________________________________________________________________

   Fiscal year       Individuals       Corporations       Total

 

____________________________________________________________________

        1995                393.3          59.7           453.0

 

        1996                419.8          60.6           480.4

 

        1997                448.7          61.0           509.7

 

        1998                475.4          61.9           537.3

 

        1999                506.4          62.1           568.5

 

____________________________________________________________________

Note: These totals are the mathematical sum of the estimated fiscal year effect of each of the tax expenditure items included in this publication. The limitations on the use of the totals are explained in the text. Source: Computed from data supplied by the Joint Committee on Taxation.

Selected Bibliography

Bosworth, Barry P. Tax Incentives and Economic Growth. Washington, DC: The Brookings Institution, 1984.

Brannon, Gerard M. "Tax Expenditures and Income Distribution: A Theoretical Analysis of the Upside-Down Subsidy Argument," The Economics of Taxation, ed. Henry J. Aaron and Michael J. Boskin. Washington, DC: The Brookings Institution, 1980, pp. 87-98.

Browning, Jacqueline, M. "Estimating the Welfare Cost of Tax Preferences," Public Finance Quarterly, v. 7, no. 2. April 1979, pp. 199-219.

Edwards, Kimberly K. "Reporting for Tax Expenditure and Tax Abatement," Government Finance Review, v. 4. August 1988, pp. 13-17.

Freeman, Roger A. Tax Loopholes: The Legend and the Reality. Washington, DC: American Enterprise Institute for Public Policy Research, 1973.

Goode, Richard. The Individual Income Tax. Washington, DC: The Brookings Institution, 1976.

Hildred, William M., and James V. Pinto. "Estimates of Passive Tax Expenditures, 1984," Journal of Economic Issues, v. 23. March 1989, pp. 93-106.

King, Ronald F. "Tax Expenditures and Systematic Public Policy: An Essay on the Political Economy of the Federal Revenue Code," Public Budgeting and Finance, v. 4. Spring 1984, pp. 14-31.

Klimschot, JoAnn. The Untouchables: A Common Cause Study of the Federal Tax Expenditure Budget. Washington, DC: Common Cause, 1981.

Ladd, Helen. The Tax Expenditure Concept After 25 Years. Presidential Address to the National Tax Association. Forthcoming, in 1994 Proceedings of the National Tax Association.

McLure, Charles E., Jr. Must Corporate Income Be Taxed Twice? Washington, DC: The Brookings Institution, 1979.

Noto, Nonna A. "Tax Expenditures: The Link Between Economic Intent and the Distribution of Benefits Among High, Middle, and Low Income Groups." Library of Congress, Congressional Research Service Multilith 80-99E. Washington, DC: May 22, 1980.

Pechman, Joseph A., ed. Comprehensive Income Taxation. Washington, DC: The Brookings Institution, 1977.

--. Federal Tax Policy: Revised Edition. Washington, DC: The Brookings Institution, 1980.

--. What Should Be Taxed: Income or Expenditures? Washington, DC: The Brookings Institution, 1980.

--. Who Paid the Taxes, 1966-85. Washington, DC: The Brookings Institution, 1985.

Schick, Allen. "Controlling Nonconventional Expenditure: Tax Expenditures and Loans," Public Budgeting and Finance, v. 6. Spring 1986, pp. 3-19.

Schroeher, Kathy. Gimme Shelters: A Common Cause Study of the Review of Tax Expenditures by the Congressional Tax Committees. Washington, DC: Common Cause, 1978.

Simon, Karla, "The Budget Process and the Tax Law," Tax Notes, v. 40. August 8, 1988, pp. 627-637.

Steuerle, Eugene, and Michael Hartzmark. "Individual Income Taxation, 1947-79," National Tax Journal, v. 34, no. 2. June 1981, pp. 145-166.

Sunley, Emil M. "The Choice Between Deductions and Credits," National Tax Journal, v. 30, no. 3. September 1977, pp. 243-247.

Surrey, Stanley S. Pathways to Tax Reform. Cambridge, Mass.: Harvard University Press, p. 3.

Surrey, Stanley S., and Paul R. McDaniel. "The Tax Expenditure Concept and the Legislative Process," The Economics of Taxation, ed. Henry J. Aaron and Michael J. Boskin. Washington, DC: The Brookings Institution, 1980, pp. 123-144.

--. Tax Expenditures, Cambridge Mass., Harvard University Press, 1985.

Thuronyi, Victor. "Tax Expenditures: A Reassessment," Duke Law Journal. December 1988, pp. 1155-1206.

U.S. Congress, Congressional Budget Office. Reducing the Federal Budget.- Strategies and Examples, Fiscal Years 1982-1986. 1981.

--. Tax Expenditures: Current Issues and Five-Year Budget Projections, 1984-1988. 1983.

--. Tax Expenditures: Current Issues and Five-Year Budget Projections for Fiscal Years 1982-1986. 1981.

--. The Effects of Tax Reform on Tax Expenditures (Pearl Richardson). 1988.

U.S. Congress, Joint Committee on Taxation. An Analysis of Proposals Relating to Broadening the Base and Lowering the Rates of the Income Tax. Sept. 24, 1982.

--. Estimates of Federal Tax Expenditures for Fiscal Years 1995- 1998. Prepared for the Committee on Ways and Means and the Committee on Finance. Committee Print, 103d Congress, 2nd session. November 9, 1994.

U.S. Congress, Senate Committee on the Budget. Tax Expenditure Limitation and Control Act of 1981 (S. 193). Hearing, 97th Congress, 1st session. Nov. 24, 1981.

--. Tax Expenditures: Compendium of Background Material on Individual Provisions. November 1992.

U.S. Department of the Treasury. Blueprints for Basic Tax Reform. January 17, 1977.

--. The President's 1978 Tax Program: Detailed Descriptions and Supporting Analyses of the Proposals. January 30, 1978.

--. Tax Reform for Fairness, Simplicity, and Economic Growth. November 1984.

U.S. General Accounting Office. Tax Expenditures: A Primer. PAD 80-26, 1979.

--. Tax Expenditures Deserve More Scrutiny. GAO/GGD/AIMD-92- 122, 1994.

U.S. Office of Management and Budget. "Tax Expenditures," Budget of the United States Government Fiscal Year 1995, Analytical Perspectives. 1994.

Wagner, Richard E. The Tax Expenditure Budget. An Exercise in Fiscal Impressionism. Washington, DC: Tax Foundation, 1979.

Weidenbaum, Murray L. The Case for Tax Loopholes. St. Louis: Center for the Study of American Business, Washington University, 1978.

Witte, John F. "The Distribution of Federal Income Tax Expenditures." Policy Journal Studies, v. 12. September 1983, pp. 131-153.

                          National Defense

                EXCLUSION OF BENEFITS AND ALLOWANCES

 

                      TO ARMED FORCES PERSONNEL

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals      Corporations    Total

 

____________________________________________________________________

        1995             2.1               --          2.1

 

        1994             2.1               --          2.1

 

        1995             2.1               --          2.1

 

        1996             2.2               --          2.2

 

        1997             2.3               --          2.3

 

____________________________________________________________________

Authorization

Sections 112 and 134 /6/ and court decisions [see Jones v. United States, 60 Ct. Cl. 552 (1925)].

Description

Military personnel are provided with a variety of in-kind benefits (or cash payments given in lieu of such benefits) that are not taxed. These benefits include medical and dental benefits, group term life insurance, professional education and dependent education, moving and storage, premiums for survivor and retirement protection plans, mustering-out payments, subsistence allowances, uniform allowances, housing allowances, overseas cost-of-living allowances, evacuation allowances, family separation allowances, travel for consecutive overseas tours, emergency assistance, family counseling and defense counsel, burial and death services, travel of dependents to a burial site, and a number of less significant items. Other benefits include certain combat-zone compensation and combat-related benefits. (Medical benefits for dependents are discussed subsequently under the Health function.)

Impact

Many military benefits qualify for tax exclusion. That is to say, the value of the benefit (or cash payment made in lieu of the benefit) is not included in gross income. Since these exclusions are not counted in income, the tax savings are a percentage of the amount excluded, dependent upon the marginal tax bracket of the recipient.

An individual in the 15-percent tax bracket (Federal tax law's lowest tax bracket) would not pay taxes equal to $15 for each $100 excluded. Likewise, an individual in the 39.6-percent tax bracket (Federal law's highest tax bracket) would not pay taxes of $39.60 for each $100 excluded. Hence, the same exclusion can be worth different amounts to different military personnel, depending on their marginal tax bracket. By providing military compensation in a form not subject to tax, the benefits have greater value for members of the armed services with high income than for those with low income.

Rationale

In 1925, the United States Court of Claims in Jones v. United States, 60 Ct. Cl. 552 (1925), drew a distinction between the pay and allowances provided military personnel. The court found that housing and housing allowances were reimbursements similar to other non- taxable expenses authorized for the executive and legislative branches.

Prior to this court decision, the Treasury Department had held that the rental value of quarters, the value of subsistence, and monetary commutations were to be included in taxable income. This view was supported by an earlier income tax law, the Act of August 27, 1894, (later ruled unconstitutional by the Courts) which provided a two-percent tax "on all salaries of officers, or payments to persons in the civil, military, naval, or other employment of the United States."

The principle of exemption of armed forces benefits and allowances evolved from the precedent set by Jones v. United States, through subsequent statutes, regulations, or long-standing administrative practices.

The Tax Reform Act of 1986 consolidated these rules so that taxpayers and the Internal Revenue Service could clearly understand and administer the tax law consistent with fringe benefit treatment enacted as part of the Deficit Reduction Act of 1984.

For some benefits, the rationale was a specific desire to reduce tax burdens of military personnel during wartime (as in the use of combat pay provisions); other allowances were apparently based on the belief that certain types of benefits were not strictly compensatory, but rather intrinsic elements in the military structure.

Assessment

Some military benefits are akin to the "for the convenience of the employer" benefits provided by private enterprise, such as the allowances for housing, subsistence, payment for moving and storage expenses, overseas cost-of-living allowances, and uniforms. Other benefits are equivalent to employer-provided fringe benefits such as medical and dental benefits, education assistance, group term life insurance, and disability and retirement benefits.

Some see the provision of compensation in a tax-exempt form as an unfair substitute for additional taxable compensation. The tax benefits that flow from an exclusion do provide the greatest benefits to high- rather than low-income military personnel. Administrative difficulties and complications could be encountered in taxing some military benefits and allowances that currently have exempt status; for example, it could be difficult to value meals and lodging when the option to receive cash is not available. However, by eliminating exclusions and adjusting military pay scales accordingly, a result might be to simplify decision-making about military pay levels and make "actual" salary more apparent and satisfying to armed forces personnel.

Selected Bibliography

Binkin, Martin. The Military Pay Muddle. Washington, DC: The Brookings Institution, April 1975.

Camm, Frank A. Housing demand and Department of Defense policy on Housing Allowances. Santa Monica, CA: Rand, 1990.

Owens, William L. "Exclusions From, and Adjustments to, Gross Income," Air Force Law Review, v. 19. Spring 1977, pp. 90-99.

U.S. General Accounting Office. Military Commissaries: Justification as Fringe Benefit Needed -- Consolidation Can Reduce Dependence on Appropriations; Report to the Congress by the Comptroller General of the United States, FPCD-80-1. Washington, DC: January 9, 1980.

U.S. Congress, House Committee on Veterans' Affairs, Subcommittee on Education, Training and Employment. Transition Assistance Program, Hearing, 102nd Congress, 2nd session, Serial no. 102-31. Washington, DC: U.S. Government Printing Office, March 19, 1992.

--, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington, DC: U.S. Government Printing Office, 1987, pp. 828-830.

--, Senate Committee on Armed Services, Subcommittee on Manpower and Personnel. Bonuses and Special Pay, Hearing, 97th Congress, 1st session. Washington, DC: U.S. Government Printing Office, November 19, 1981.

U.S. Dept. of the Treasury, Office of the Secretary. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. Washington, DC: November 1984, pp. 47-48.

FOOTNOTES

/1/ U.S. Congress, Joint Committee on Taxation. Estimates of Federal Tax Expenditures for Fiscal Years 1995-1999, Joint Committee Print. Washington, DC: U.S. Government Printing Office, November 9, 1994.

/2/ For a discussion of the conceptual problems involved in defining tax expenditures, see The Budget of the United States Government, Fiscal Year 1995, Analytical Perspectives, "Tax Expenditures," pp. 53- 77.

/3/ See Jane G. Gravelle, Corporate Tax Integration: Issues and Options, Library of Congress, Congressional Research Service Report 91-482, June 14, 1991, pp. 31-39.

/4/ U.S. Congress, Congressional Budget Office. The Changing Distribution of Federal Tax Rates: 1975-1990, October 1987, p. 65.

/5/ Major tax legislation is referred to by year or title. For public law numbers, see Louis Alan Talley, A Concise History of U.S. Federal Taxation, Library of Congress, Congressional Research Service Report 90-295 E, June 14, 1990.

/6/ The word "Section" denotes a section of the Internal Revenue Code of 1986, as amended unless otherwise noted.

END OF FOOTNOTES

                          National Defense

 

              EXCLUSION OF MILITARY DISABILITY BENEFITS

 

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year    Individuals    Corporations        Total

 

____________________________________________________________________

1995               0.1             -              0.1

 

1996               0.1             -              0.1

 

1997               0.1             -              0.1

 

1998               0.1             -              0.1

 

1999               0.1             -              0.1

 

____________________________________________________________________

Authorization

Section 104(a)(4) and 104(b).

Description

Members of the armed forces on or before September 24, 1975, are eligible for exclusion of disability pay. The payment from the Department of Defense is based either on the percentage-of-disability or years-of-service methods.

In the case of the percentage-of-disability method, the pension is the percentage of disability multiplied by the terminal monthly basic pay. These disability pensions are excluded from gross income.

In the years-of-service method, the terminal monthly basic pay is multiplied by the number of service years times 2.5. Only that portion that would have been paid under the percentage-of-disability method is excluded.

Members of the United States armed forces joining after September 24, 1975, and who retire on disability, may exclude from gross income Department of Defense disability payments equivalent to disability payments they could have received from the Veterans Administration. Otherwise, Department of Defense disability pensions may be excluded only if the disability is directly attributable to a combat-related injury.

Impact

Disability pension payments that are exempt from tax provide more net income than taxable pension benefits at the same level. The tax benefit of this provision increases as the marginal tax rate increases, and is greater for higher-income individuals.

Rationale

Typically, the Acts which provided for disability pensions for American veterans also provided that these payments would be excluded from income tax. In 1942, the provision was broadened to include disability pensions furnished by other countries (many Americans had joined the Canadian armed forces). It was argued that disability payments, whether provided by the United States or by Canadian governments, were made for essentially the same reasons and that a veteran's disability benefits were similar to compensation for injuries and sickness, which was already excludable under Internal Revenue Code provisions.

In 1976, the exclusion was repealed, except in certain instances. Congress sought to eliminate abuses by armed forces personnel who were classified as disabled shortly before becoming eligible for retirement in order to obtain tax-exempt treatment for their pension benefits. After retiring from military service, most of these individuals would earn income from other employment while receiving tax-free military pensions. Since present armed forces personnel may have joined or continued their service because of the expectation of tax-exempt disability benefits, Congress deemed it equitable to limit changes in the tax treatment of disability payments to future personnel.

Assessment

The exclusion of disability benefits paid by the Federal Government alters the distribution of net payments to favor higher income individuals. If individuals had no other outside income, distribution could be altered either by changing the structure of disability benefits or by changing the tax treatment.

The exclusion causes the true cost of providing for the military to be understated in the budget. Under present rules, however, most of these tax benefits do not accrue to new members of the armed forces, and the benefit will eventually be confined to a small group, barring a major military engagement which produces substantial combat-related disabilities.

Selected Bibliography

Binkin, Martin. The Military Pay Muddle. Washington, DC: The Brookings Institution, April 1975.

Bittker, Boris I. "Tax Reform and Disability Pensions -- the Equal Treatment of Equals," Taxes, v. 55. June 1977, pp. 363-367.

Ogloblin, Peter K. Military Compensation Background Papers: Compensation Elements and Related Manpower Cost Items, Their Purposes and Legislative Backgrounds. Washington, DC: U.S. Government Printing Office, November 1991, pp. 479-490.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1976 (H.R. 10612, 94th Congress; Public Law 94-455). Washington, DC: U.S. Government Printing Office, 1976, pp. 129-131.

U.S. Dept. of the Treasury, Office of the Secretary. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. Washington, DC: November, 1984, pp. 51-57.

U.S. General Accounting Office. Disability Benefits: Selected Data on Military and VA Recipients; Report to the Committee on Veterans' Affairs, House of Representatives. Washington, DC: August, 1992.

--. Disability Compensation: Current Issues and Options for Change. Washington, DC: 1982.

                        International Affairs

                  EXCLUSION OF INCOME EARNED ABROAD

 

                          BY U.S. CITIZENS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

___________________________________________________________________

 

Fiscal year    Individuals    Corporations        Total

 

___________________________________________________________________

1995               1.6             -              1.6

 

1996               1.6             -              1.6

 

1997               1.7             -              1.7

 

1998               1.8             -              1.8

 

1999               1.9             -              1.9

 

___________________________________________________________________

Authorization

Section 911.

Description

U.S. citizens are generally subject to U.S. taxes on their foreign-source income. To alleviate double-taxation, they may credit foreign taxes they pay against U.S. taxes they would otherwise owe. Also, section 911's foreign earned income exclusion permits U.S. citizens who live abroad to exclude up to $70,000 of income earned from private-sector employment overseas.

Qualifying individuals can also exclude certain expenditures for overseas housing. (Foreign tax credits, however, cannot be claimed for foreign taxes paid on excluded income.) To qualify for either exclusion, a person must be a U.S. citizen, must have their tax home in a foreign country, and must either be a bona fide resident of a foreign country or have lived abroad for at least 330 days of any 12 consecutive months. Qualified income must be "earned" income rather than investment income. If a person qualifies for the exclusion for only part of the tax year, only part of the exclusion can be claimed. The housing exclusion is designed to approximate the extra housing costs of living abroad; it is equal to the excess of actual foreign housing costs over 16 percent of the salary for a Federal employee at the GS-14, step 1 level. While a taxpayer can claim both the housing and the income exclusion, the combined exclusions cannot exceed total foreign earned income, including housing allowances.

Impact

The exclusion's impact depends partly on whether foreign taxes paid are higher or lower than U.S. taxes. If an expatriate pays high foreign taxes, the exclusion has little importance; the U.S. person can use foreign tax credits to offset any U.S. taxes in any case. For expatriates who pay little or no foreign taxes, however, the exclusion reduces or eliminates U.S. taxes. Available data suggest that U.S. citizens who work abroad have higher real incomes, on average, than persons working in the United States. Thus, where it does reduce taxes the exclusion reduces tax progressivity.

The exclusion's effect on horizontal equity is more complicated. Because foreign countries have costs of living that differ from that of the United States, the tax liabilities of U.S. persons working abroad differ from the tax burdens of persons with identical real incomes living in the United States. A person working in a high-cost country needs a higher nominal income to match the real income of a person in the United States; an expatriate in a low-cost country needs a lower nominal income. Since tax brackets, exemptions, and the standard deduction are expressed in terms of nominal dollars, persons living in low-cost countries generally have lower tax burdens than persons with identical real incomes living in the United States. Similarly, if not for the foreign earned income exclusion, U.S. citizens working in high-cost countries would pay higher taxes than their U.S. counterparts.

Because the maximum income exclusion is not linked to the actual cost of living, the provision overcompensates for the cost of living abroad in some cases. Indeed, some have argued that because the tax code does not take into account variations in living costs within the United States, the appropriate equity comparison is between expatriates and a person living in the highest cost area within the United States. In this case, the likelihood that the exclusion reduces rather than improves horizontal equity is increased.

Rationale

The Revenue Act of 1926 provided an unlimited exclusion of earned income for persons residing abroad for an entire tax year. Supporters of the exclusion argued that the provision would bolster U.S. trade performance, since it would provide tax relief to U.S. expatriates engaged in trade promotion.

The subsequent history of the exclusion shows a continuing attempt by policymakers to find a balance between the provision's perceived beneficial effects on U.S. trade and economic performance and perceptions of tax equity. In 1962, the Kennedy Administration recommended eliminating the exclusion in some cases and scaling it back in others in order to "support the general principles of equity and neutrality in the taxation of U.S. citizens at home and abroad." The final version of the Revenue Act of 1962 simply capped the exclusion in all cases at $20,000. The Tax Reform Act of 1976 pared the exclusion further (to $15,000), again for reasons of tax equity.

However, the Foreign Earned Income Act of 1978 completely revamped the exclusion so that the 1976 provisions never went into effect. The 1978 Act sought to provide tax relief more closely tied to the actual costs of living abroad. It replaced the single exclusion with a set of separate deductions that were linked to various components of the cost of living abroad, such as the excess cost of living in general, excess housing expenses, schooling expenses, and home-leave expenses.

In 1981, however, the emphasis again shifted to the perceived beneficial effects of encouraging U.S. employment abroad; the Economic Recovery Tax Act (ERTA) provided a large flat exclusion and a separate housing exclusion. ERTA's income exclusion was $75,000 for 1982, but was to increase to $95,000 by 1986. However, concern about the revenue consequences of the increased exclusion led Congress to temporarily freeze the exclusion at $80,000 under the Deficit Reduction Act of 1984; annual $5,000 increases were to resume in 1988. In 1986, as part of its general program of broadening the tax base, the Tax Reform Act fixed the exclusion at the current $70,000 level.

Assessment

The foreign earned income exclusion has the effect of increasing the number of Americans working overseas in countries where foreign taxes are low. This effect differs across countries. As noted above, without section 911 or a similar provision, U.S. taxes would generally be high and employment abroad would be discouraged in countries where living costs are high. While the flat $70,000 exclusion eases this distortion in the case of some countries, it also overcompensates in others, thereby introducing new distortions.

The foreign earned income exclusion has been defended on the grounds that it helps U.S. exports; it is argued that U.S. persons working abroad play an important role in promoting the sale of U.S. goods abroad. The impact of the provision is uncertain. If employment of U.S. labor abroad is a complement to investment by U.S. firms abroad -- for example, if U.S. multinationals depend on expertise that can only be provided by U.S. managers or technicians -- then it is possible that the exclusion has the indirect effect of increasing flows of U.S. capital abroad.

The increased flow of investment abroad, in turn, could trigger exchange-rate adjustments that would increase U.S. net exports. On the other hand, if the exclusion's increase in U.S. employment overseas is not accompanied by larger flows of investment, it is likely that exchange rate adjustments negate any possible effect section 911 has on net exports. Moreover, there is no obvious economic rationale for promoting exports.

Selected Bibliography

Association of the Bar of the City of New York, Committee on Taxation of International Transactions. "The Effect of Changes in the Type of United States Tax Jurisdiction Over Individuals and Corporations: Residence, Source and Doing Business," Record of the Association of the Bar of the City of New York, v. 46. December 1991, pp. 914-925.

Brumbaugh, David L. Federal Taxation of Americans Who Work Abroad. Library of Congress, Congressional Research Service Report 87-452 E. Washington, DC: 1987.

Hrechak, Andrew, and Richard J. Hunter, Jr. Several Tax Breaks Available for those Working Abroad. Taxation for Accountants, v. 52. May, 1994, pp. 282-286.

Papahronis, John. "Taxation of Americans abroad under the ERTA: An Unnecessary Windfall," Northwestern Journal of International Law and Business, v. 4. Autumn 1982, pp. 556-600.

Sobel, Renee Judith. "United States Taxation of Its Citizens Abroad: Incentive or Equity?" Vanderbilt Law Review, v. 38. January 1985, pp. 101-160.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Economic Recovery Tax Act of 1981. Joint Committee Print, 97th Congress, 1st session, December 29, 1981, pp. 41-48.

U.S. Department of the Treasury. Taxation of Americans Working Overseas: the Operation of the Foreign Earned Income Exclusion in 1987. Washington, DC: 1993.

Gravelle, Jane G., and Donald W. Kiefer. U.S. Taxation of Citizens Working in Other Countries: An Economic Analysis. Library of Congress, Congressional Research Service Report 78-91 E. Washington, DC: 1978.

                        International Affairs

 

                   EXCLUSION OF CERTAIN ALLOWANCES

 

                    FOR FEDERAL EMPLOYEES ABROAD

 

___________________________________________________________________

 

Fiscal year    Individuals    Corporations        Total

 

___________________________________________________________________

1995               0.2             -              0.2

 

1996               0.2             -              0.2

 

1997               0.2             -              0.2

 

1998               0.2             -              0.2

 

1999               0.2             -              0.2

 

___________________________________________________________________

Authorization

Section 912.

Description

U.S. Federal civilian employees who work abroad are allowed to exclude from income certain special allowances that are generally linked to the cost of living. They are not eligible for the $70,000 foreign earned income exclusion. (Like other U.S. citizens, they are subject to U.S. taxes and can credit foreign taxes against their U.S. taxes. Federal employees are, however, usually exempt from foreign taxes).

Specifically, section 912 excludes certain amounts received under the Foreign Service Act of 1980, the Central Intelligence Act of 1949, the Overseas Differentials and Allowances Act, and the Administrative Expenses Act of 1946. The allowances are primarily for the general cost of living abroad, housing, education, and travel. Special allowances for hardship posts are not eligible. Section 912 also excludes cost-of-living allowances received by Federal employees stationed in U.S. possessions, Hawaii, and Alaska. In addition, travel, housing, food, clothing, and certain other allowances received by members of the Peace Corps are excluded.

Impact

Federal employees abroad may receive a significant portion of their compensation in the form of housing allowances, cost-of-living differentials, and other allowances. Section 912 can thus reduce taxes significantly. Since the available data suggest real incomes for Federal workers abroad are generally higher than real incomes in the United States, section 912 probably reduces the tax system's progressivity.

Section 912's impact on horizontal equity (the equal treatment of equals) is more ambiguous. Without it or a similar provision, Federal employees in high-cost countries would likely pay higher taxes than persons in the United States with identical real incomes, because the higher nominal incomes necessary to offset higher living costs would place these employee stationed abroad in a higher tax bracket and would reduce the value of personal exemptions and the standard deduction.

The complete exemption of cost-of-living allowances, however, probably overcompensates for this effect. It is thus uncertain whether the relative treatment of Federal workers abroad and their U.S. counterparts is more or less uneven with section 912.

Some have argued that because no tax relief is provided for persons in high cost areas in the United States, horizontal equity requires only that persons abroad be taxed no more heavily than a person in the highest-cost U.S. area. It might also be argued that the cost of living exclusion for employees in Alaska and Hawaii violates horizontal equity, since private-sector persons in those areas do not receive a tax exclusion for cost-of-living allowances.

Rationale

Section 912's exclusions were first enacted with the Revenue Act of 1943. The costs of living abroad were apparently rising, and Congress determined that because the allowances merely offset the extra costs of working abroad and since overseas personnel were engaged in "highly important" duties, the Government should bear the full burden of the excess living costs, including any taxes that would otherwise be imposed on cost-of-living allowances.

The Foreign Service Act of 1946 expanded the list of excluded allowances beyond cost-of-living allowances to include housing, travel, and certain other allowances. In 1960, exemptions were further expanded to include allowances received under the Central Intelligence Agency Act and in 1961 certain allowances received by Peace Corps members were added.

Assessment

The benefit is largest for employees who receive a large part of their incomes as cost-of-living, housing, education, or other allowances. Beyond this, the effects of the exclusions are uncertain. For example, it might be argued that because the Federal Government bears the cost of the exclusion in terms of foregone tax revenues, the measure does not change the Government's demand for personnel abroad and has little impact on the Government's work force overseas.

On the other hand, it could be argued that an agency that employs a person who claims the exclusion does not bear the exclusion's full cost. While the provision's revenue cost may reduce Government outlays in general (particularly in this era of continuing budget deficits) an agency that employs a citizen abroad probably does not register a cut in its budget equal to the full amount of tax revenue loss that the employee generates. If this is true, section 912 may enable agencies to employ additional U.S. citizens abroad.

Selected Bibliography

Field, Marcia, and Brian Gregg. "U.S. Taxation of Allowances Paid to U.S. Government Employees," Essays in International Taxation: 1976 (U.S. Department of the Treasury). Washington, DC: U.S. Government Printing Office, 1976, pp. 128-150.

                       International  Affairs

                         EXCLUSION OF INCOME

 

                OF FOREIGN SALES CORPORATIONS (FSCs)

                       Estimated Revenue Loss

 

                      [In billions of dollars]

       Fiscal year     Individuals      Corporations       Total

          1995              -               1.4             1.4

 

          1996              -               1.5             1.5

 

          1997              -               1.5             1.5

 

          1998              -               1.5             1.5

 

          1999              -               1.6             1.6

Authorization

Sections 921-927 and 991-997.

Description

The tax code's Foreign Sales Corporation (FSC) provisions permit U.S. exporters to exempt a portion of their export income from U.S. taxation. Enacted in 1984, FSC largely replaces the Domestic International Sales Corporation (DISC) provisions that provided exporters an indefinite tax deferral for part of their export income.

To qualify for the FSC benefit, exports must be sold through specially defined corporations (FSCs) that are organized in a qualifying foreign country or U.S. possession and that meet certain other requirements designed to ensure a minimal presence in a foreign location.

One way the FSC provisions can work is for a U.S. exporting firm to form a subsidiary corporation that qualifies as a FSC. A portion of the FSC's own export income is exempt from taxes, and the FSC can pass on the tax savings to its parent because domestic corporations are allowed a 100-percent dividends-received deduction for income distributed from a FSC.

Alternatively, a FSC can sell tax-favored exports on a commission basis. The FSC foreign presence requirements are relaxed in the case of relatively small exporters. Alternatively, a small exporter can choose to sell its exports through a DISC. Unlike under prior law, however, firms that use the present-law version of DISCs are assessed an interest charge on their deferred taxes.

Impact

FSC's tax exemption for exports increases the after-tax return on investment in export-producing property. In the long run, however, the burden of the corporate income tax (and the benefit of corporate tax exemptions) probably spreads far beyond corporate stockholders to owners of capital in general.

Thus the FSC benefit is probably shared by U.S. capital in general, and probably disproportionately benefits upper-income individuals. To the extent that the FSC exemption results in lower prices for U.S. exports, a part of the FSC benefit probably accrues to foreign consumers of U.S. products.

Rationale

The DISC benefit that preceded FSC was enacted with the Revenue Act of 1971. The provision was intended to increase U.S. exports. DISC was also designed to provide a tax incentive for firms to locate their operations in the United States rather than abroad, and thus provided a counterweight to the tax code's deferral tax incentive to invest abroad.

DISC was subsequently modified by The Tax Reduction Act of 1975, which placed restrictions on the benefit for the export of products in short domestic supply. The Tax Reform Act of 1976 implemented changes designed to improve DISC's cost-effectiveness by linking the tax benefit with increases in a firm's exports. The Tax Equity and Fiscal Responsibility Act of 1982 reduced the DISC benefit slightly as part of the Act's general concern with raising tax revenue and improving tax equity.

A number of major U.S. trading partners voiced objections to DISC almost from its inception, arguing that the provision was an export subsidy and so violated the General Agreement on Tariffs and Trade (GATT), a multilateral trade agreement to which the United States is signatory.

In response to the complaints, the Deficit Reduction Act of 1984 largely replaced DISC with FSC, which contains a number of features (including its foreign-presence requirements) designed to ensure GATT legality. Despite the differences between DISC and FSC, the size of FSC's tax exemption approximates the benefit that was available under DISC's indefinite tax deferral. The basic structure of FSC has remained essentially unchanged since 1984. However, the Omnibus Budget Reconciliation Act of 1993 denied the FSC benefit to exports of raw lumber.

Assessment

Because FSC increases the after-tax return from investment in exporting, it poses a tax incentive to export. FSCs supporters argue that the provision indeed boosts U.S. exports and thus has a beneficial effect on U.S. employment.

Economic analysis, however, suggests that FSC's effects are not what might be expected from a provision designed to improve U.S. trade performance. For example, FSC triggers exchange-rate adjustments that ensure that U.S. imports expand along with any increase FSC might cause in exports; it therefore probably produces no improvement in the U.S. balance of trade.

Indeed, to the extent that FSC increases the Federal budget deficit, it may actually expand the U.S. trade deficit. In addition, FSC probably reduces U.S. economic welfare by interfering in the efficient allocation of the economy's resources and by transferring part of its tax benefit to foreign consumers.

The size of the FSC benefit for individual firms varies, depending on the method an exporter uses to allocate income to its FSC subsidiary. Under the current rules, a corporation that exports can effectively exempt at least 15 percent, and up to 30 percent, of export income from taxes.

It should be noted, however, that some firms may be able to exempt a larger share of their exports from taxes by another tax benefit -- the so-called "export source rule" instead of FSC. Recent estimates place the tax revenue loss from the export source rule at about four times that of FSC.

Selected Bibliography

Baldwin, Robert E. "Are Economist's Traditional Trade Policy Views Still Valid?" Journal of Economic Literature, v. 30. June 1992, pp. 804-829.

Bernet, Blake A. "The Foreign Sales Corporation Act: Export Incentive for U.S. Business," International Lawyer, v. 25. Spring 1991, pp. 223-249.

Brumbaugh, David L. Can Tax Policy Improve Economic Competitiveness? Library of Congress, Congressional Research Service Report 93-80 E.

--. Exports and Taxes: DISCs and FSCs. Library of Congress, Congressional Research Service Issue Brief IB83122 (Archived). Washington, DC: 1985.

The Omnibus Budget Reconciliation Act of 1993 and Repeal of Tax Benefits for Log Exports. Library of Congress, Congressional Research Service Report 93-896 E.

--. Tax Policy and the U.S. Trade Balance, 1981-91. Library of Congress, Congressional Research Service Report 92-161 E. Washington, DC: 1983.

Krugman, Paul R., and Maurice Obstfeld. International Economics: Theory and Policy, 2nd ed. New York: Harper Collins, 1991, pp. 110- 112, 193-195.

U.S. Congress, Congressional Budget Office. Curtail Tax Subsidies for Exports. in Reducing the Deficit: Spending and Revenue Options. Washington: U.S. Govt. Print. Off., 1994, pp. 315-316.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. December 31, 1984, pp. 1037-1070.

U.S. Department of the Treasury. The Operation and Effect of the Foreign Sales Corporation Legislation: January 1, 1985 to June 30, 1988. Washington, 1993. 33 p.

                       International  Affairs

                  DEFERRAL OF INCOME OF CONTROLLED

 

                        FOREIGN CORPORATIONS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

     Fiscal year      Individuals      Corporations       Total

 

     ___________      ___________      ____________       _____

       1995                -               1.1             1.1

 

       1996                -               1.1             1.1

 

       1997                -               1.1             1.1

 

       1998                -               1.2             1.2

 

       1999                -               1.2             1.2

Authorization

Sections 11(d), 882, and 951-964.

Description

The United States taxes firms incorporated in the United States on their worldwide income but taxes foreign-chartered corporations only on their U.S.-source income. Thus, when a U.S. firm earns foreign-source income through a foreign subsidiary, U.S. taxes apply to the income only when it is repatriated to the U.S. parent firm as dividends or other income; the income is exempt from U.S. taxes as long as it remains in the hands of the foreign subsidiary. At the time the foreign income is repatriated, the U.S. parent corporation can credit foreign taxes the subsidiary has paid on the remitted income against U.S. taxes, subject to certain limitations. Because the deferral principle permits U.S. firms to delay any residual U.S. taxes that may be due after foreign tax credits, it provides a tax benefit for firms that invest in countries with low tax rates.

Subpart F of the Internal Revenue Code (sections 951-964) provides an exception to the general deferral principle. Under its provisions, certain types of income earned by foreign corporations controlled by U.S. shareholders is deemed to be distributed whether or not it actually is, and U.S. taxes are assessed on a current basis rather than deferred. Income subject to Subpart F is generally income related to passive investment rather than income from active business operations. Also, certain types of sales, services, and other income whose geographic source is relatively easily shifted is included in Subpart F.

Impact

Deferral provides an incentive for U.S. firms to invest in active business operations in low-tax foreign countries rather than the United States, and thus probably reduces the stock of capital located in the United States. Because the U.S. capital-labor ratio is therefore probably lower than it otherwise would be and U.S. labor has less capital with which to work, deferral likely reduces the general U.S. wage level. At the same time, U.S. capital and foreign labor probably gain from deferral.

Rationale

Deferral has been part of the U.S. tax system since the origin of the corporate income tax in 1909. While deferral was subject to little debate in its early years, it later became controversial. In 1962, the Kennedy Administration proposed a substantial scaling-back of deferral in order to reduce outflows of U.S. capital. Congress, however, was concerned about the potential effect of such a step on the position of U.S. multinationals vis a vis firms from other countries and on U.S. exports. Instead of repealing deferral, the Subpart F provisions were adopted in 1962, and were aimed at taxpayers who used deferral to accumulate funds in so-called "tax haven" countries. (Hence, Subpart F's concern with income whose source can be easily manipulated.)

In 1975, Congress again considered eliminating deferral, and in 1978 President Carter proposed its repeal, but on both occasions the provision was left essentially intact. Subpart F, however, was broadened by the Tax Reduction Act of 1975, the Tax Reform Act of 1976, the Tax Equity and Fiscal Responsibility Act of 1982, the Deficit Reduction Act of 1984, the Tax Reform Act of 1986, and the Omnibus Reconciliation Act of 1993 (OBRA93). OBRA93's changes came after deferral received a certain amount of adverse publicity and criticism during the 1992 Presidential campaign. The Act expanded Supart F to include foreign earnings that firms retain abroad and invest in passive assets beyond a certain threshold. While OBRA93 and the other measures expanded the amount of foreign-source income subject to current U.S. taxation, the deferral principle generally remains applicable to income from active foreign business operations.

Assessment

The U.S. method of taxing overseas investment, with its worldwide taxation of branch income, limited foreign tax credit, and the deferral principle, can pose either a disincentive, an incentive, or be neutral towards investment abroad, depending on the form and location of the investment. For its part, deferral provides an incentive to invest in countries with tax rates that are lower than those of the United States.

Defenders of deferral argue that the provision is necessary to allow U.S. multinationals to compete with firms from foreign countries; they also maintain that the provision boosts U.S. exports. However, economic theory suggests that a tax incentive such as deferral does not promote the efficient allocation of investment. Rather, capital is allocated most efficiently -- and world economic welfare is maximized -- when taxes are neutral and do not distort the distribution of investment between the United States and abroad. Economic theory also holds that while world welfare may be maximized by neutral taxes, the economic welfare of the United States would be maximized by a policy that goes beyond neutrality and poses a disincentive for U.S. investment abroad.

Selected Bibliography

Arnold, Brian J. The Taxation of Controlled Foreign Corporations: An International Comparison. Toronto: Canadian Tax Foundation, 1986.

Ault, Hugh J., and David F. Bradford. "Taxing International Income: An Analysis of the U.S. System and Its Economic Premises," Taxation in the Global Economy, ed. Assaf Razin and Joel Slemrod. Chicago: Univ. of Chicago Press, 1990, pp. 11-52.

Bergsten, C. Fred, Thomas Horst, and Theodore H. Moran. American Multinationals and American Interests. Washington, DC: The Brookings Institution, 1977, pp. 165-212.

Brumbaugh, David L. Does the U.S. Tax System Encourage Firms to Invest Overseas Rather than in the United States? Library of Congress, Congressional Research Service Report Washington, DC: 1993. 6 p.

--. International Tax Provisions of the 1993 Budget Act. Library of Congress, Congressional Research Service Report 93-909 E.

--. Taxation of Overseas Investment Income: Subpart F and the Tax Reform Act of 1986. Library of Congress, Congressional Research Service Report 87-167 E. Washington, DC: 1987.

--. U.S. Taxation of Overseas Investment: Selected Issues in the 102nd Congress. Library of Congress, Congressional Research Service Report 91-682 E. Washington, DC: 1991.

Findlay, Christopher C. "Optimal Taxation of International Income Flows," Economic Record, v. 62. June 1986, pp. 208-214. Frisch, Daniel J. "The Economics of International Tax Policy: Some Old and New Approaches," Tax Notes, v. 47. April 30, 1990, pp. 581- 591.

Gordon, Richard A., Fogarasi, Andre P., Renfroe, Diane L., Tuerff, T. Timothy, and John Venuti. The International Provisions of the Revenue Reconciliation Act of 1993. Tax Notes International. August 30, 1993. pp. 589-600.

Hartman, David G. "Deferral of Taxes on Foreign Source Income," National Tax Journal, v. 30. December 1977, pp. 457-462.

--. "Tax Policy and Foreign Direct Investment," Journal of Public Economics, v. 26. Pp. 107-121.

Slemrod, Joel. "Effect of Taxation with International Capital Mobility," Uneasy Compromise, Problems of a Hybrid Income- Consumption Tax, ed. Henry J. Aaron, Harvey Galper, and Joseph Pechman. Washington, DC: The Brookings Institution, 1988.

U.S. Congress, Joint Committee on Taxation. Factors Affecting the International Competitiveness of the United States. May 30, 1991.

--. General Explanation of the Tax Reform Act of 1986. May 4, 1987.

                        International Affairs

                INVENTORY PROPERTY SALES SOURCE-RULE

 

                              EXCEPTION

                       Estimated Revenue Loss

 

                      [In billions of dollars]

      Fiscal year      Individuals      Corporations       Total

 

      ___________      ___________      ____________       ____

         1995                -                3.5           3.5

 

         1996                -                3.6           3.6

 

         1997                -                3.7           3.7

 

         1998                -                3.7           3.7

 

         1999                -                3.8           3.8

Authorization

Sections 861, 862, 863, and 865.

Description

The tax code's rules governing the source of inventory sales interact with its foreign tax credit provisions in a way that can effectively exempt a portion of a firm's export income from U.S. taxation.

In general, the United States taxes U.S. corporations on their worldwide income. The United States also permits firms to credit foreign taxes they pay against U.S. taxes they would otherwise owe.

Foreign taxes, however, are only permitted to offset the portion of U.S. taxes due on foreign-source income. Foreign taxes that exceed this limitation are not creditable and become so-called "excess credits." It is here that the source of income becomes important: firms that have excess foreign tax credits can use these credits to reduce U.S. taxes if they can shift income from the U.S. to the foreign operation. This treatment effectively exempts such income from U.S. taxes.

The tax code contains a set of rules for determining the source ("sourcing") of various items of income and deduction. In the case of sales of personal property, gross income is generally sourced on the basis of the residence of the seller. U.S. exports covered by this general rule thus generate U.S. -- rather than foreign -- source income.

The tax code provides an important exception, however, in the case of sales of inventory property. Inventory that is purchased and then resold is governed by the so-called "title passage" rule: the income is sourced in the country where the sale occurs. Since the country of title passage is generally quite flexible, sales governed by the title passage rules can easily be arranged so that the income they produce is sourced abroad.

Inventory that is both manufactured and sold by the taxpayer is treated as having a divided source. Unless an independent factory price can be established for such property, half of the income it produces is assigned a U.S. source and half is governed by the title passage rule. As a result of the special rules for inventory, up to 50 percent of the combined income from export manufacture and sale can be effectively exempted from U.S. taxes. A complete tax exemption can apply to export income that is solely from sales activity.

Impact

When a taxpayer with excess foreign credits is able to allocate an item of income to foreign rather than domestic sources, the amount of foreign taxes that can be credited is increased and the effect is identical to a tax exemption for a like amount of income. The effective exemption that the source rule provides for inventory property thus increases the after-tax return on investment in exporting. In the long run, however, the burden of the corporate income tax (and the benefit of corporate tax exemptions) probably spreads beyond corporate stockholders to owners of capital in general.

Thus, the source-rule benefit is probably shared by U.S. capital in general, and therefore probably disproportionately benefits upper- income individuals. To the extent that the rule results in lower prices for U.S. exports, a part of the benefit probably accrues to foreign consumers of U.S. products.

Rationale

The tax code has contained rules governing the source of income since the foreign tax credit limitation was first enacted as part of the Revenue Act of 1921. Under the 1921 provisions, the title passage rule applied to sales of personal property in general; income from exports was thus generally assigned a foreign source if title passage occurred abroad. In the particular case of property both manufactured and sold by the taxpayer, income was treated then, as now, as having a divided source.

The source rules remained essentially unchanged until the advent of tax reform in the 1980s. In 1986, the Tax Reform Act's statutory tax rate reduction was expected to increase the number of firms with excess foreign tax credit positions and thus increase the incentive to use the title passage rule to source income abroad.

Congress was also concerned that the source of income be the location where the underlying economic activity occurs. The Tax Reform Act of 1986 thus provided that income from the sale of personal property was generally to be sourced according to the residence of the seller. Sales of property by U.S. persons or firms were to have a U.S. source.

Congress was also concerned, however, that the new residence rule would create difficulties for U.S. businesses engaged in international trade. The Act thus made an exception for inventory property, and retained the title passage rule for purchased-and- resold items and the divided-source rule for goods manufactured and sold by the taxpayer.

More recently, the Omnibus Budget Reconciliation Act of 1993 repealed the source rule exception for exports of raw timber.

Assessment

Like other tax benefits for exporting, the inventory source-rule exception probably increases exports. At the same time, however, exchange rate adjustments probably ensure that imports increase also. Thus, while the source rule probably increases the volume of U.S. trade, it probably does not improve the U.S. trade balance. Indeed, to the extent that the source rule increases the Federal budget deficit, the provision may actually expand the U.S. trade deficit by generating inflows of foreign capital and their accompanying exchange rate effects.

In addition, the source-rule exception probably reduces U.S. economic welfare by transferring part of its tax benefit to foreign consumers.

Selected Bibliography

Hammer, Richard M., and James D. Tapper. "The Foreign Tax Credit Provisions of the Tax Reform Act of 1986," Tax Adviser, v. 18. February 1987, pp. 76-80, 82-89.

Krugman, Paul R., and Maurice Obstfeld. International Economics: Theory and Policy. 2nd ed. New York: Harper Collins, 1991, pp. 110-112, 193-195.

Maloney, David M., and Terry C. Inscoe. "A Post-Reformation Analysis of the Foreign Tax Credit Limitations," The International Tax Journal, v. 13. Spring 1987, pp. 111-127.

U.S. Congress, Joint Committee on Taxation. Factors Affecting the International Competitiveness of the United States. Joint Committee Print, 98th Congress, 2nd session. May 30, 1991, pp. 143- 152.

--. General Explanation of the Tax Reform Act of 1986. Joint Committee Print, 100th Congress, 1st session. May 4, 1987, pp. 916- 923.

Brumbaugh, David L. Can Tax Policy Improve Economic Competitiveness? Library of Congress, Congressional Research Service Report 93-80 E.

--. The Omnibus Budget Reconciliation Act of 1993 and Repeal of Tax Benefits for Log Exports. Library of Congress, Congressional Research Service Report 93-896 E.

--. Tax Policy and the U.S. Trade Balance, 1981-91. Library of Congress, Congressional Research Service Report 92-161 E. Washington, DC: 1983.

U.S. Department of the Treasury. Report to the Congress on the Sales Source Rules. Washington, 1993. 33 p.

--. Tax Reform for Fairness, Simplicity and Economic Growth: the Treasury Department Report to the President. Volume 2: General Explanation of the Treasury Department Proposals. Washington, DC: November, 1984, pp. 364-368.

                        International Affairs

                 INTEREST ALLOCATION RULES EXCEPTION

 

                FOR CERTAIN NONFINANCIAL INSTITUTIONS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

     Fiscal year      Individuals      Corporations       Total

        1995              --               0.2             0.2

 

        1996              --               0.2             0.2

 

        1997              --               0.2             0.2

 

        1998              --               0.2             0.2

 

        1999              --               0.2             0.2

Authorization

Section 864.

Description

In general, U.S. individuals and corporations are permitted to credit against their U.S. taxes foreign income taxes they pay. A limitation on the credit is imposed by section 904 of the Internal Revenue Code: foreign taxes may only offset the portion of a taxpayer's U.S. taxes that apply to foreign rather than domestic taxable income. Foreign taxes that exceed the limitation cannot be credited in the current year and become so-called "excess credits."

To calculate the limitation, taxpayers who claim foreign tax credits must separate gross income and deductions into those with foreign and domestic sources. If a taxpayer is in an excess-credit position and a deduction is allocated to foreign rather than domestic income, the deduction reduces the portion of income that is from foreign sources and thus reduces the amount of foreign taxes that can be credited. The effect is the same as denial of the deduction for U.S. tax purposes.

Section 864 of the Internal Revenue Code provides rules for allocating interest expense. In general, a taxpayer is required to divide interest deductions between U.S. and foreign sources based on the proportion of its total assets in each location. In order to prevent taxpayers from defeating the purpose of the rules by concentrating interest deductions in particular subsidiary corporations without foreign assets, section 864 generally requires a single-interest allocation to be made for consolidated groups as a whole rather than on a subsidiary-by-subsidiary basis.

An exception to this rule is made for banks whose primary business is neither with related corporations nor their customers. The tax expenditure at hand is a special rule contained in the Tax Reform Act of 1986 that classifies a finance subsidiary of the Ford Motor Company as a financial institution for purposes of the allocation rules, notwithstanding the other requirements set forth in section 864.

Impact

By permitting the affected firm's subsidiary to qualify as a bank and calculate its interest allocation separately, the firm may be able to increase the part of its interest expense that is deducted from U.S. income for foreign tax credit purposes.

As a result, the amount of foreign tax credits that can be claimed by the affected firm may be increased in years when the firm is in an excess-foreign-tax-credit position. The provision therefore probably reduces the firm's U.S. taxes.

Economic theory, however, suggests that the burden of the corporate income tax -- and the benefit from reductions in the tax -- spreads in the long run beyond the stockholders of the immediately affected corporation. (See the related discussion in the Introduction.)

Rationale

The rationale for the interest-allocation-rule exception is not mentioned in the Committee reports accompanying the Tax Reform Act of 1986. The rules requiring allocation on the basis of consolidated groups, however, have been criticized as placing U.S. corporations at a disadvantage with foreign-owned firms.

It is argued, for example, that foreign companies that operate in the United States can in many cases deduct from U.S. taxable income interest on debt they incur in the United States. It should be pointed out, however, that the Omnibus Budget Reconciliation Act of 1989 placed some restrictions on the deductibility of interest paid by U.S. subsidiaries to foreign parent corporations.

Assessment

Underlying the general rules for allocating interest is the principle that investment funds are fungible; that even if a firm's borrowing is linked to specific investments in the United States, it also finances foreign investments because it frees the firm's other capital to go abroad.

If investment funds are indeed fungible and part of the affected firm's domestic borrowing finances foreign investment, then deducting the interest exclusively from U.S. income breaches the foreign tax credit limitation. In effect, in this case, foreign taxes can offset U.S. taxes on U.S. source income. In some cases, this may provide the affected firm with a tax incentive to invest overseas.

Selected Bibliography

Andrus, Joseph L. "Allocating Interest Expense for the Foreign Tax Credit," Tax Notes. December 5, 1988, pp. 1105-1129.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, JCS-10-87. 1987, pp. 944-948.

General Science, Space, and Technology

                             CREDIT FOR

 

                   INCREASING RESEARCH ACTIVITIES

                      Estimated Revenue Loss  /*/

 

                      [In billions of dollars]

     Fiscal year        Individuals       Corporations     Total

       1995                  --                --            --

 

       1996                  --                --            --

 

       1997                  --                --            --

 

       1998                  --                --            --

 

       1999                  --                --            --

                          FOOTNOTE TO TABLE

     /*/ This provision will expire in mid-1995; if reinstated its

 

cost would be approximately $2.2 billion by FY 1998.

                           END OF FOOTNOTE

Authorization

Section 30.

Description

A nonrefundable, 20-percent income tax credit is allowed for certain research expenditures paid or incurred in carrying on a trade or business of the taxpayer. The credit applies only to the extent that the taxpayer's qualified research expenditures for the taxable year exceed the average amount of the taxpayer's yearly qualified base research expenditures. The base is computed by multiplying a fixed ratio, average research expenditures divided by gross receipts in 1984-1988, by average gross receipts for the past four years. The base amount must be at least half of current expenditures. Start-up corporations are assigned an initial fixed ratio of 0.03 of gross receipts, which is gradually converted into the same type of ratio as allowed ongoing firms.

The credit provision adopts the definition of research used for purposes of the special deduction rules under section 174, but subject to certain exclusions. The amount of the section 174 deduction is reduced by the amount of the credit (the "basis adjustment").

Research expenditures eligible for the incremental credit consist of

(1) in-house expenditures by the taxpayer for research wages and supplies used in research;

(2) certain time-sharing costs for computers used in research, and

(3) 65 percent of amounts paid by the taxpayer for contract research conducted on the taxpayer's behalf.

If the taxpayer is a corporation, cash expenditures (including grants or contributions) paid for university basic research in excess of a fixed based are eligible for the credit. Expenditures are reduced by any reduction in other contributions to universities compared to the base period (adjusted by inflation).

Impact

The credit has the effect of reducing the net cost to a business of incurring qualified research expenditures in excess of its research expenditures in a base period. Because of the basis adjustment, a corporate firm saves about 13.2 percent of the cost, since it loses the deduction for twenty percent of eligible expenditures (i.e., 13.2 = 20-.34*.20).

The credit does not provide a benefit to some firms whose research expenditures are declining relative to gross receipts. Firms can, however, benefit from the credit when their level of research activities and other activities (in constant dollars) remains the same because the latest four years' gross receipts are not corrected for inflation. Firms with rapidly growing research expenditures receive larger benefits, but no more than 50 percent of otherwise qualifying current year expenditures can be eligible for the credit, even if the base period amount is less than 50 percent of current expenditures.

Individuals to whom the credit is properly allocable from a partnership or other business may use the credit in a particular year only to offset the amount of tax attributable to that portion of the individual's taxable income derived from that business. For example, an individual cannot use pass-throughs of the credit from a research partnership to offset tax on income from the other sources.

The credit largely accrues to corporations and its direct tax benefits accrue largely to higher-income individuals (see discussion in the Introduction).

Rationale

Section 30 was enacted as part of the Economic Recovery Tax Act of 1981. At that time the credit rate was 25 percent, there was no basis adjustment, and the base was the average of the past three years of expenditures. The reason cited was that a substantial tax credit for incremental research expenditures was needed to overcome the reluctance of many ongoing companies to bear the significant costs of staffing and supplies, and certain equipment expenses such as computer charges, which must be incurred to initiate or expand research programs in a trade or business.

The original credit was scheduled to expire after 1985, in order to allow an evaluation of its effect. The credit was extended (retroactively by the Tax Reform Act of 1986) through 1988. In the Technical and Miscellaneous Revenue Act of 1988, it was extended another year and a half basis adjustment (deductions reduced by half the credit) enacted.

The Omnibus Reconciliation Act of 1989 extended it for another year, and allowed the base to increase in pace with gross receipts rather than research expenditures, increasing the incentive at the margin. It also allowed the credit to apply to R&D associated with a prospective as well as a current line of business and provided for the full basis adjustment. The Omnibus Reconciliation Act of 1989 extended the credit for another year and Tax Extension Act of 1991 extended it through June 1992. The Omnibus Budget Reconciliation Act of 1993 extended the credit through June, 1995.

Assessment

There is widespread agreement that investment in research and development is under-provided in a market economy, since firms cannot obtain the full return from their investment (due to appropriation of the innovation by other firms). There is some evidence that the social returns to R&D are very high. These observations suggest a strong case for subsidizing R&D investments, since they are more profitable to society than most other investments.

Despite these strong reasons to support the credit, there are several criticisms. It is not clear that a tax subsidy is the best means of subsidizing R&D since an open ended subsidy cannot target those investments that are most desirable socially. Funds might be better allocated to targeted investment or to government financed research. Moreover, it is difficult in practice to ensure that firms are properly identifying research and experimental costs.

One criticism of the credit is that the continual expiration and restoration interferes with planning and that a decision should be made as to whether to retain the credit on a permanent basis.

Selected Bibliography

Altschuler, Rosanne. "A Dynamic Analysis of the Research and Experimentation Credit," National Tax Journal, v. 41. December 1988, pp. 453-466.

Baily, Martin Neil, and Robert Z. Lawrence. "Tax Policies for Innovation and Competitiveness," Paper Commissioned by the Council on Research and Technology. April 1987.

Bernstein, Jeffry I. and M. Ishaq Nadiri. "Interindustry R&D Spillovers, Rates of Return, and Production in High Tech Industries," American Economic Review, v. 76. June 1988, pp. 429-434.

Brown, Kenneth M., ed. The R&D Tax Credit. Issues in Tax Policy and Industrial Innovation. Washington, DC: American Enterprise Institute for Public Policy, 1984.

Cordes, Joseph. "Tax Incentives for R&D Spending: A Review of the Evidence," Research Policy, v. 18. 1989, pp. 119-133.

Eisner, Robert. "The New Incremental Tax Credit for R&D: Incentive or Disincentive?" National Tax Journal, v. 37. June 1984, pp. 171-183.

Gravelle, Jane G. The Tax Credit for Research and Development: An Analysis. Library of Congress, Congressional Research Service Report 85-6. Washington, DC: January 25, 1985.

Hall, Bronwyn H. "R & D Tax Policy During the 1980s," in Tax Policy and the Economy 7, ed. James M. Poterba. Cambridge, MA: MIT Press, 1993.

Kiley, Michael T. Social and Private Rates of Return to Research and Development in Industry. Library of Congress, Congressional Research Service Report 93-770. Washington, DC: August 27, 1993.

Landau, Ralph, and Bruce Hannay, eds. Taxation, Technology and the US Economy. NY: Pergamon Press, 1981. See particularly George Carlson, "Tax Policy and the U.S. Economy," (a version of which was published as Office of Tax Analysis Paper 45, U.S. Treasury Department, January 1981), pp. 63-86, and Joseph Cordes, "Tax Policies for Encouraging Innovation: A Survey," pp. 87-99.

Mansfield, Edwin, et al. "Social and Private Rates of Return from Industrial Innovations," Quarterly Journal of Economics, v. 41. March 1977, pp. 221-240.

U.S. Congress, Congressional Budget Office. Federal Support for R&D and Innovation. April 1984.

U.S. Congress, House Committee on Ways and Means. Research and Experimentation Tax Credit Hearing, 98th Congress, 2nd session. August 2, 1984.

U.S. Congress, Joint Committee on Taxation. Description and Analysis of Tax Provisions Expiring in 1992. January 27, 1992: pp. 59-68.

U.S. Congress, Joint Economic Committee. The R&D Tax Credit: An Evaluation of Evidence on Its Effectiveness, 99th Congress, 1st Session. Senate Report 99-73, August 23, 1985.

U.S. General Accounting Office. The Research Tax Credit Has Stimulated Some Additional Research Spending. September 1989.

General Science, Space, and Technology

                            EXPENSING OF

 

                RESEARCH AND DEVELOPMENT EXPENDITURES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

      Fiscal year       Individuals       Corporations       Total

        1995                 /1/              2.0             2.0

 

        1996                 /1/              2.1             2.1

 

        1997                 /1/              2.1             2.1

 

        1998                 /1/              2.2             2.2

 

        1999                 /1/              2.3             2.3

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 174.

Description

As a general rule, business expenditures to develop or create an asset which has a useful life that extends beyond the taxable year, such as expenditures to develop a new consumer product or improve a production process, must be capitalized and cannot be deducted in the year paid or incurred. These costs usually may be recovered through depreciation or amortization deductions over the useful life of the asset, or on a disposition or abandonment of the asset.

Under section 174, however, a taxpayer may elect to deduct currently the amount of certain research or experimental expenditures incurred in connection with the taxpayer's trade or business. In the case of research expenditures resulting in property which does not have a determinable useful life (such as secret processes or formulae), the taxpayer alternatively may elect to deduct the costs ratably over a period of not less than 60 months. Treasury regulations define expenditures eligible for the deduction elections as "research and development costs in the experimental or laboratory sense."

Expenditures for the acquisition or improvement of land, or expenditures for the acquisition or improvement of depreciable or depletable property to be used in connection with research, are not eligible for the deduction elections. However, research expenditures which may be expensed or amortized under section 174 include depreciation (cost recovery) or depletion allowances with respect to depreciable or depletable property used for research. Expenditures to ascertain the existence, location, extent, or quality of mineral deposits, including oil and gas, are not eligible for section 174 elections.

The amount of deduction allowed under section 174 is reduced by the amount, if any, of the credit provided under section 30 for certain incremental research or experimental expenditures.

Impact

The accelerated deduction allowed for research expenditures operates, as does accelerated capital cost recovery, to defer tax liability.

For example, if a corporation incurs expenditures of $1 million in the taxable year for research wages, supplies, and depreciation allowances, the corporation may currently deduct that amount from its taxable income, producing a cash flow (at a 34-percent marginal tax rate) of $340,000. The value to the corporation of current expense treatment is the amount by which the present value of the immediate deduction exceeds (for example) the present value of periodic deductions which otherwise could be taken over the useful life of the asset, such as a patent, resulting from the research expenditures. Expensing is, in fact, equivalent to eliminating tax entirely: the after-tax and pre-tax return on the investment are the same.

The direct beneficiaries of this provision are businesses that undertake research. Mainly, these are large manufacturing corporations or high-technology firms. As a corporate tax deduction, benefits accrue to higher-income individuals (see discussion in the Introduction).

Rationale

Section 174 was enacted as part of the Internal Revenue Code of 1954. The purposes cited for the provision were to encourage research expenditures and to eliminate difficulties and uncertainties under prior law in distinguishing trade or business expenditures from research expenditures.

Assessment

There is relatively little controversy over this provision. It simplifies tax compliance, since it is difficult to isolate expenditures that are associated with R&D or to assign useful lives to them. In addition, there is widespread agreement that investment in research and development is under-provided in a market economy, since firms cannot obtain the full return from their investment (due to appropriation of the innovation by other firms). There is some evidence that the social returns to R&D are very high.

These observations suggest a strong case for subsidizing R&D investments, since they are more profitable to society than most other investments. A tax benefit, however, does not precisely target those investments with the largest spillover effects.

Selected Bibliography

Baily, Martin Neil, and Robert Z. Lawrence. "Tax Policies for Innovation and Competitiveness, Paper Commissioned by the Council on Research and Technology. April 1987.

Bernstein, Jeffry I., and M. Ishaq Nadiri. "Interindustry R&D Spillovers, Rates of Return, and Production in High Tech Industries," American Economic Review, v. 76. June 1988, pp. 429-434.

Cordes, Joseph. "Tax Incentives for R&D Spending: A Review of the Evidence," Research Policy, v. 18. 1989, pp. 119-133.

Landau, Ralph, and Bruce Hannay, eds. Taxation, Technology and the U.S. Economy. New York: Pergamon Press, 1981. See particularly George Carlson, "Tax Policy and the U.S. Economy" (a version of which was published as Office of Tax Analysis Paper 45, U.S. Treasury Department, January 1981), pp. 63-86, and Joseph Cordes, "Tax Policies for Encouraging Innovation: A Survey," pp. 87-99.

Hall, Bronwyn H. "R & D Tax Policy During the 1980s," in Tax Policy and the Economy 7, ed. James M. Poterba. Cambridge, MA: MIT Press, 1993.

Kiley, Michael T. Social and Private Rates of Return to Research and Development in Industry. Library of Congress, Congressional Research Service Report 93-770. Washington, DC: August 27, 1993.

Mansfield, Edwin, et al. "Social and Private Rates of Return from Industrial Innovations," Quarterly Journal of Economics, v. 41. March 1977, pp. 221-240.

U.S. Congress, Congressional Budget Office. Federal Support for R&D and Innovation, April 1984.

Energy

EXPENSING OF EXPLORATION

 

AND DEVELOPMENT COSTS:

 

OIL, GAS, AND OTHER FUELS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

 

               Individuals       Corporations            Total

 

               ___________       ____________            _____

 

Fiscal year  Oil and   Other   Oil and    Other     Oil and   Other

 

               Gas     Fuels      Gas      Fuels      Gas     Fuels

 

____________________________________________________________________

 

   1995       /1/      /1/       0.5       /1/        0.5       /1/

 

   1996       /1/      /1/       0.5       /1/        0.5       /1/

 

   1997       /1/      /1/       0.5       /1/        0.5       /1/

 

   1998       /1/      /1/       0.5       /1/        0.5       /1/

 

   1999       /1/      /1/       0.5       /1/        0.5       /1/

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 263(c), 291, 616-617, 57(2), and 1254.

Description

Firms engaged in production of oil, gas, geothermal, or other fuels are permitted to expense (to deduct in the year paid or incurred) rather than capitalize (i.e., recover such costs through depletion or depreciation) certain intangible drilling and development costs (IDCs). This is an exception to general tax rules.

Amounts paid for fuel, labor, repairs, hauling, supplies, and site preparation are IDCs. Amounts paid for casings, valves, pipelines, and other tangible equipment cannot be expensed, but must be capitalized, recoverable either through depletion or depreciation.

The option to expense IDCs applies to domestic properties; IDCs on foreign properties must be either amortized (deducted in equal amounts) over 10 years or added to the adjusted cost basis and recovered through depletion or depreciation. Corporate taxpayers can only expense 70 percent of the IDCs -- the remaining 30 percent must be amortized over a five-year period.

The excess of expensed IDCs over the capitalized value is a tax preference item that is subject to the alternative minimum tax to the extent that it exceeds 65 percent of the net income from the property. Independent producers include only 70 percent of their IDCs as a tax preference item. Instead of expensing, a taxpayer may choose to amortize over a 10-year period and avoid the alternative minimum tax.

Impact

IDCs and other intangible exploration and development costs represent a major portion of the costs of finding and developing a mineral reserve. In the case of oil and gas, which historically accounted for 99 percent of the revenue loss from this provision, IDCs typically account for between 75 and 90 percent of the costs of creating a mineral asset.

Historically, expensing of IDCs was a major tax subsidy for the oil and gas industry, and, combined with other tax subsidies, reduced effective tax rates significantly below tax rates on other industries. These subsidies provided incentives to increase investment, exploration, and output, especially for oil and gas.

Oil and gas output, for example, rose from 16 percent of total energy production in 1920 to 71.1 percent of total in 1970 (the peak year). The cutbacks in expensing, reductions in income tax rates, and the contraction in the oil and gas industry have reduced the value of this subsidy.

Moreover, the alternative minimum tax, and introduction of new excise taxes, have raised effective tax rates for oil and gas, although the subsidy still keeps effective marginal tax rates on oil and gas (especially for independent producers) below the marginal effective tax rates on other industries.

These taxes arguably contributed to the decline in domestic oil exploration and production, which recently dropped to a 30-year low, but the major cause of these declines is the decline in oil prices.

Unlike percentage depletion, this tax expenditure is largely claimed by corporate oil and gas producers. The at-risk, recapture, and minimum tax restrictions that have since been placed on the use of the provision have primarily limited the ability of high-income taxpayers to shelter their income from taxation through investment in mineral exploration.

Rationale

Expensing of IDCs was originally established in a 1916 Treasury regulation (T.D. 45, article 223), with the rationale that such costs were ordinary operating expenses.

In 1931, a court ruled that IDCs were capital costs, but permitted expensing, arguing that the 15-year precedent gave the regulation the force of a statute. In 1942, Treasury recommended that expensing be repealed, but the Congress did not take action. A 1945 court decision invalidated expensing, but the Congress upheld it (on the basis that it reduced uncertainty and stimulated mineral exploration) and codified it as section 263(c) in 1954.

Continuation of expensing has been based on the need to stimulate exploratory drilling, which could increase domestic oil reserves, reduce imported petroleum, and enhance energy security.

The Tax Reform Act of 1976 added expensing of IDCs as a tax preference item subject to the minimum tax. Expensing of IDCs for geothermal wells was added by the Energy Tax Act of 1978. The Tax Equity and Fiscal Responsibility Act of 1982 limited expensing for integrated oil companies to 85 percent; the remaining 15 percent of IDCs had to be amortized over 3 years.

The Deficit Reduction Act of 1984 limited expensing for integrated producers to 80 percent. This was further limited to 70 percent by the Tax Reform Act of 1986, which also repealed expensing on foreign properties.

In 1990, a special energy deduction was introduced, against the alternative minimum tax, for a portion of the IDCs and other oil and gas industry tax preference items. The Energy Policy Act of 1992 limited the amount of IDCs subject to the alternative minimum tax to 70 percent, and suspended the special energy deduction through 1998.

Assessment

IDCs are generally recognized to be capital costs which, according to standard economic principles, should be recovered using depletion (cost depletion adjusted for inflation). Lease bonuses and other exploratory costs (survey costs, geological and geophysical costs) are properly treated as capital costs, although they may be recovered through percentage rather than cost depletion.

Immediate expensing of IDCs provides a tax subsidy for capital invested in the mineral industry, especially for oil and gas producers, with a relatively larger subsidy for independents.

By expensing rather than capitalizing these costs, taxes on income are effectively set to zero. As a capital subsidy, however, expensing is inefficient because it makes investment decisions based on tax considerations rather than inherent economic considerations.

There is very little, if any, economic justification for this nonneutral tax treatment of IDCs. The depressed state of oil and gas drilling activity in the United States is largely attributable to recent declines in oil prices, although cutbacks in IDCs and other factors have probably played a role.

To the extent that IDCs stimulate drilling of successful wells, they reduce dependence on imported oil in the short run, but contribute to a faster depletion of the Nation's resources. Arguments have been made over the years to justify expensing on grounds of unusual risks, national security, uniqueness of oil as a commodity, the industry's lack of access to capital, and protection of small producers.

Volatile oil prices make oil and gas investments very risky, but this would not necessarily justify expensing. The corporate income tax does have efficiency distortions, but income tax integration may be a more appropriate policy to address this issue. Many economists believe that expensing is a costly and inefficient way to increase oil and gas output and enhance energy security, which might be better addressed through an oil stockpile program such as the Strategic Petroleum Reserve.

Selected Bibliography

Brannon, Gerard M. Energy Taxes and Subsidies. Cambridge, Mass.: Ballinger Publishing Co., 1975, pp. 23-45.

Cox, James C., and Arthur W. Wright. "The Cost Effectiveness of Federal Tax Subsidies for Petroleum Reserves: Some Empirical Results and Their Implications," Studies in Energy Tax Policy, ed. Gerard M. Brannon. Cambridge, Mass.: Ballinger Publishing Co., 1975, pp. 177- 197.

Edmunds, Mark A. "Economic Justification for Expensing IDC and Percentage Depletion Allowance," Oil & Gas Tax Quarterly, v. 36. September, 1987, pp. 1-11.

Gravelle, Jane G. "Effective Federal Tax Rates on Income from New Investments in Oil and Gas Extraction," The Energy Journal, v.6. 1985, pp. 145-153.

Guerin, Sanford M. "Oil and Gas Taxation: A Study in Reform," Denver Law Journal, v. 56. Winter 1979, pp. 127-177.

Harberger, Arnold G. Taxation and Welfare. Chicago: Univ. of Chicago Press, 1974, pp. 218-226.

Lucke, Robert, and Eric Toder. "Assessing the U.S. Federal Tax Burden on Oil and Gas Extraction," The Energy Journal, v. 8. October 1987, pp. 51-64.

Muscelli, Leonard W. "The Taxation of Geothermal Energy Resources," Law and Water Review, v. 19, No. 1. 1984, pp. 25-41.

U.S. Congress, House Committee on Interior and Insular Affairs. An Analysis of the Federal Tax Treatment of Oil and Gas and Some Policy Alternatives, Committee Print, 93rd Congress, 2nd session. Washington, DC: U.S. Government Printing Office, 1974.

U.S Congress, Senate Committee on Finance. Tax treatment of Producers of Oil and Gas, Hearings, 98th Congress, 1st session. Washington, DC: U.S. Government Printing Office, May 5 and 6, 1983.

U.S. General Accounting Office. Additional Petroleum Production Tax Incentives Are of Questionable Merit, GAO/GGD-90-75. July 1990. Washington, DC: U.S. Government Printing Office, July 1990.

U.S. Treasury Department. Tax Reform for Fairness, Simplicity, and Economic Growth, v. 2. November 1984, Washington, DC: 1984, pp. 229-231.

Zlatkovich, Charles P., and Karl B. Putnam. "Economic Trends in the Oil and Gas Industry and Oil and Gas Taxation," Oil and Gas Quarterly, v. 41. March, 1993, pp. 347-365.

Energy

              EXCESS OF PERCENTAGE OVER COST DEPLETION:

 

                      OIL, GAS, AND OTHER FUELS

                       Estimated Revenue Loss*

 

                      [In billions of dollars]

 

____________________________________________________________________

 

              Individuals         Corporations         Total

 

              ___________         ____________         _____

 

Fiscal year Oil and    Other   Oil and    Other     Oil     Other

 

              Gas      Fuels     Gas      Fuels   and Gas   Fuels

 

____________________________________________________________________

 

   1995       0.3       /1/      0.3       0.2      0.6      0.2

 

   1996       0.3       /1/      0.3       0.2      0.6      0.2

 

   1997       0.3       0.1      0.3       0.2      0.6      0.3

 

   1998       0.3       0.1      0.3       0.2      0.6      0.3

 

   1999       0.3       0.1      0.3       0.2      0.6      0.3

                         FOOTNOTES TO TABLE

     /1/ Less than $50 million.

                          END OF FOOTNOTES

Authorization

Sections 611, 612, 613, 613A, and 291.

Description

Firms that extract oil, gas, or other minerals are permitted a deduction to recover their capital investment, which depreciates due to the physical and economic depletion of the reserve as the mineral is recovered (section 611). There are two methods of calculating this deduction: cost depletion and percentage depletion. Cost depletion allows for the recovery of the actual capital investment -- the costs of discovering, purchasing, and developing a mineral reserve -- over the period during which the reserve produces income.

Each year, the taxpayer deducts a portion of the adjusted basis (original capital investment less previous deductions) equal to the fraction of the estimated remaining recoverable reserves that have been extracted and sold. Under this method, the total deductions cannot exceed the original capital investment.

Under percentage depletion, the deduction for recovery of capital investment is a fixed percentage of the "gross income" -- i.e., sales revenue -- from the sale of the mineral. Under this method, total deductions typically exceed the capital invested.

Section 613 states that mineral producers must claim the higher of cost or percentage depletion. The percentage depletion rate for oil and gas is 15 percent and is allowed only for independent producers -- those producing less than 50,000 barrels per day -- and only up to 1,000 barrels of oil output, or its equivalent in gas, per day. In 1990, a higher depletion rate for marginal wells -- oil from stripper wells, and heavy oil -- was enacted. This rate starts at 15 percent, and increases by one percentage point for each $1 that the price of oil falls below $20 per barrel (subject to a maximum rate of 25 percent).

The percentage depletion allowance is available for many other types of fuel minerals, at rates ranging from 10 percent (coal, lignite) to 22 percent (uranium). The rate for regulated natural gas and gas sold under a fixed contract is 22 percent; the rate for geopressured methane gas is 10 percent. Oil shale and geothermal deposits qualify for a 15-percent allowance.

Percentage depletion for oil and gas is limited to 100 percent of net income from each property, and to 65 percent of the taxable income from all properties for each producer. Since 1990, transferred properties have been eligible for percentage depletion. Percentage depletion for coal and other fuels is limited to 50 of the taxable income from the property. Under code section 291, percentage depletion on coal mined by corporations is reduced by 20 percent.

Impact

Historically, generous depletion allowances and other tax benefits reduced effective tax rates in the fuel minerals industry significantly below tax rates on other industries, which provided incentives to increase investment, exploration, and output, especially oil and gas. Oil and gas output, for example, rose from 16 percent of total energy production in 1920 to 71.1 percent of in 1970 (the peak year).

The combination of this subsidy and the deduction of intangible drilling and other costs represented a significant boon to mineral producers who were eligible for both. Three-quarters of the original investment can be "written off" immediately, and then a portion of gross revenues can be written off for the life of the investment. It was possible for cumulative depletion allowances to total many times the amount of the original investment.

The 1975 repeal of percentage depletion for the major integrated oil companies means that only about 1/4 of total oil and gas production benefits from the subsidy. The reduction in the rate of depletion from 27.5 to 15 percent means that independents benefit from it much less than they used to. In addition, cutbacks in other tax benefits, and the introduction of excise taxes have raised effective tax rates in the mineral industries, although independent oil and gas producers continue to be favored.

Undoubtedly, these cutbacks in percentage depletion contributed to the decline in domestic oil production, which peaked in 1970 and recently dropped to a 30-year low. Percentage depletion for other mineral deposits was unaffected by the 1975 legislation. Nevertheless, half of the percent revenue loss is a result, in an average year, of oil and gas depletion. The value of this expenditure to the taxpayer is the amount of tax savings that results from using the percentage depletion method instead of the cost depletion method.

Percentage depletion has little, if any, effect on oil prices, which are determined in the world oil market. It may bid up the price of drilling and mining rights. According to a 1984 Treasury study, "half of the benefits from the depletion allowance accrue to only 90,000 taxpayers with adjusted gross incomes of over $75,000."

Rationale

Provisions for a depletion allowance based on the value of the mine were made under a 1912 Treasury Department regulation (T.D. 1742) but were never implemented. A court case resulted in the enactment, as part of the Tariff Act of 1913, of a "reasonable allowance for depletion" not to exceed five percent of the value of output. This statute did not limit total deductions; Treasury regulation No. 33 limited total deductions to the original capital investment.

This system was in effect from 1913 to 1918, although in the Revenue Act of 1916, depletion was restricted to no more than the total value of output, and in the aggregate no more than capital originally invested or fair market value on March 1, 1913 (the latter so that appreciation occurring before enactment of income taxes would not be taxed).

The 1916 law marked the first time that the tax laws mentioned oil and gas specifically. On the grounds that the newer discoveries that contributed to the war effort were treated less favorably, discovery value depletion was enacted in 1918. Discovery depletion, which was in effect through 1926, allowed deductions in excess of capital investment because it was based on the market value of the deposit after discovery. Congress viewed oil and gas as a strategic mineral, essential to national security, and wanted to stimulate the wartime supply of oil and gas, compensate producers for the high risks of prospecting, and relieve the tax burdens of small-scale producers.

In 1921, because of concern with the size of the allowances, discovery depletion was limited to net income; it was further limited to 50 percent of net income in 1924. Due to the administrative complexity and arbitrariness, and due its tendency to establish high discovery values, which tended to overstate depletion deductions, discovery value depletion was replaced in 1926 by the percentage depletion allowance, at the rate of 27.5 percent.

In 1932, percentage depletion was extended to coal and most other minerals. In 1950, President Truman recommended that the depletion rate be reduced to 15 percent, but Congress disagreed. In 1969, the top depletion rates were reduced from 27.5 to 22 percent, and in 1970 the allowance was made subject to the minimum tax.

The Tax Reduction Act of 1975 eliminated the percentage depletion allowance for major oil and gas companies and reduced the rate for independents to 15 percent for 1984 and beyond. This was in response to the first energy crisis of 1973-74, which caused oil prices to rise sharply. The continuation of percentage depletion for independents was justified by the Congress on grounds that independents had more difficulty in raising capital than the majors, that their profits were smaller, and that they could not compete with the majors.

The Tax Equity and Fiscal Responsibility Act of 1982 limited the allowance for coal and iron ore. The Tax Reform Act of 1986 denied percentage depletion for lease bonuses, advance royalties, or other payments unrelated to actual oil and gas production.

The Omnibus Budget and Reconciliation Act of 1990 raised the depletion rate on marginal production, raised the net income limitation from 50 to 100 percent, and made the allowance available to transferred properties. These liberalizations were based on energy security arguments. The Energy Policy Act of 1992 repealed the minimum tax on percentage depletion.

Assessment

Standard accounting and economic principles state that the appropriate method of capital recovery in the mineral industry is cost depletion adjusted for inflation. The percentage depletion allowance permits independent oil and gas producers, and other mineral producers, to continue to claim a deduction even after all the investment costs of acquiring and developing the property have been recovered. Thus it is a mineral production subsidy rather than an investment subsidy.

As a production subsidy, however, percentage depletion is inefficient, encouraging excessive development of existing properties over exploration for new ones. Although accelerated depreciation for non-mineral assets may lower effective tax rates by speeding up tax benefits, these assets cannot claim depreciation deductions in excess of investment.

Percentage depletion for oil and gas subsidizes independents that are primarily engaged in exploration and production. To the extent that it stimulates oil production, it reduces dependence on imported oil in the short run, but it contributes to a faster depletion of the Nation's resources. Arguments have been made over the years to justify percentage depletion on grounds of unusual risks, the distortions in the corporate income tax, national security, uniqueness of oil as a commodity, the industry's lack of access to capital, and to protect small producers.

Volatile oil prices make oil and gas investments more risky, but this would not necessarily justify percentage depletion or other tax subsidies. The corporate income tax does have efficiency distortions, but income tax integration is a more appropriate policy to address this problem.

Many economists believe that percentage depletion is also a costly and inefficient way to increase oil and gas output and enhance energy security, which might be better addressed through an oil stockpile program such as the Strategic Petroleum Reserve.

Selected Bibliography

Anderson, Robert D., Alan S. Miller, and Richard D. Spiegelman. "U.S. Federal Tax Policy: The Evolution of Percentage Depletion for Minerals," Resources Policy, v. 3. September 1977, pp. 165-176.

Brannon, Gerard M. Energy Taxes and Subsidies. Cambridge, Mass.: Ballinger, 1975, pp. 23-45.

Cox, James C., and Arthur W. Wright. "The Cost Effectiveness of Federal Tax Subsidies for Petroleum Reserves: Some Empirical Results and Their Implications," Studies in Energy Tax Policy, ed. Gerard M. Brannon. Cambridge, Mass.: Ballinger, 1975. pp. 177-197.

Davidson, Paul. "The Depletion Allowance Revisited." Natural Resources Journal, v. 10. January 1970, pp. 1-9.

Edmunds, Mark A. "Economic Justification for Expensing IDC and Percentage Depletion Allowance," Oil & Gas Tax Quarterly, v. 36. September, 1987, pp. 1-11.

Englebrecht, Ted D., and Richard W. Hutchinson. "Percentage Depletion Deductions for Oil and Gas Operations: A Review and Analysis," Taxes, v. 56. January 1978, pp. 48-63.

Frazier, Jessica, and Edmund D. Fenton. "The Interesting Beginnings of the Percentage Depletion Allowance," Oil and Gas Tax Quarterly, v. 38. June 1990, pp. 697-712.

Gravelle, Jane G. "Effective Federal Tax Rates on Income from New Investments in Oil and Gas Extraction," The Energy Journal, v.6. 1985, pp. 145-153.

--. Tax Provisions and Effective Tax Rates in the Oil and Gas Industry, Library of Congress Congressional Research Service Report 78-68E. Washington, DC: November 3, 1977.

Guerin, Sanford M. "Oil and Gas Taxation: A Study in Reform." Denver Law Journal, v. 56. Winter 1979, pp. 127-177.

Harberger, Arnold G. Taxation and Welfare. Chicago: Univ. of Chicago Press, 1974, pp. 218-226.

Lucke, Robert, and Eric Toder. "Assessing the U.S. Federal Tax Burden on Oil and Gas Extraction," The Energy Journal, v. 8. October, 1987, pp. 51-64.

McDonald, Stephen L. "U.S. Depletion Policy: Some Changes and Likely Effects," Energy Policy, v. 4. March 1976, pp. 56-62.

Randall, Gory. "Hard Mineral Taxation-Practical Problems," Idaho Law Review, v. 19. Summer 1983, pp. 487-503.

Tannenwald, Robert. Analysis and Evaluation of Arguments for and Against Percentage Depletion, Library of Congress Congressional Research Service Report 78-68E. Washington, DC: 1978.

U.S Congress, Senate Committee on Finance. Tax treatment of Producers of Oil and Gas, Hearings, 98th Congress, 1st session. Washington, DC: Government Printing Office, May 5-6, 1983.

--. House Committee on Interior and Insular Affairs. An Analysis of the Federal Tax Treatment of Oil and Gas and Some Policy Alternatives, Committee Print, 93rd Congress, 2nd session. Washington, DC: Government Printing Office, 1974.

U.S. General Accounting Office. Additional Petroleum Production Tax Incentives Are of Questionable Merit, GAO/GGD-90-75. Washington, DC: July 1990.

U.S. Treasury Department. Tax Reform for Fairness, Simplicity, and Economic Growth, v. 2. Washington, DC: November, 1984, pp. 229- 231.

                               Energy

               CREDIT FOR ENHANCED OIL RECOVERY COSTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

    Fiscal year      Individuals       Corporations       Total

 

    ___________      ___________       ____________       _____

       1995              --                 /1/            /1/

 

       1996              --                 /1/            /1/

 

       1997              --                 /1/            /1/

 

       1998              --                 /1/            /1/

 

       1999              --                 /1/            /1/

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 43.

Description

Section 43 provides for a 15-percent income tax credit for the costs of recovering domestic oil by a qualified "enhanced-oil- recovery (EOR) method. Qualifying methods apply fluids, gases, and other chemicals into the oil reservoir, and use heat to extract oil that is too viscous to be extracted by conventional primary and secondary waterflooding techniques.

The law provides that nine tertiary recovery methods listed by Department of Energy in section 212.78(c) of their June 1979 regulations qualify for the tax credit. These are miscible fluid displacement, steam-drive injection, microemulsion flooding, in-situ combustion, polymer-augmented water flooding, cyclic steam injection, alkaline (or caustic) flooding, carbonated water flooding, and immiscible carbon dioxide gas displacement. Another technique, immiscible non-hydrocarbon gas displacement, was added as well.

Qualifying EOR costs include the cost of equipment, intangible drilling and development costs (i.e., labor, supplies and repairs), and the costs of the injectants.

The EOR credit is phased out ratably, over a $6-per-barrel range, for oil prices above $28 (the $28 threshold is adjusted for inflation). The EOR credit, like the alcohol fuels tax credits, may not be greater than taxpayer's net income tax in excess of 25 percent of net regular tax liability above $25,000, or the tentative minimum tax.

The cost of the property that may otherwise be deducted is reduced by the amount of the credit. Alternative fuel production credits attributable to the property are also reduced by the EOR credit.

Impact

Conventional oil recovery methods typically succeed in extracting only one-third of a well's oil. Some of the remaining oil can be extracted by unconventional methods, such as EOR methods, but these methods are currently uneconomic at prices below about $28-30 per barrel. The EOR credit reduces the cost of producing oil from abandoned reservoirs relative to the cost of producing oil from new reservoirs. Given that oil prices are not expected to rise above the $28-per-barrel reference price (adjusted for inflation) in the near future, the credit should be fully available.

Rationale

The EOR credit was enacted as part of the Omnibus Budget and Reconciliation Act of 1990, to increase the domestic supply of oil, to reduce the demand for imported oil, to make the United States less dependent upon Persian Gulf producers and other unstable foreign oil producers, and to enhance the energy security of the United States. Undoubtedly, another motive for this provision was to help the oil and gas industry, which has not fully recovered from the 1986 oil price collapse.

Assessment

Oil production in the United States, which peaked in 1970 and recently dropped to a thirty-year low, has been declining at the rate of about four percent per year. Foreign oil supplies now account for over half of U.S. oil demand. The United States, once the world's leading oil producer and exporter, has been depleting its oil resources and is now the high marginal cost oil producer.

United States production of oil by EOR methods increased during the 1980s; between 1990 and 1992 it increased by nearly 14 percent. It is estimated, however, that between 250 and 350 billion barrels of oil remain in abandoned wells, significantly more than the known reserves of oil recoverable by primary and secondary methods. Further, it is estimated that 10 percent of that oil is known recoverable reserves that can be produced with current EOR techniques if the financial incentives were there.

The incentive effect of the EOR credit should, in time, increase the recovery of this oil, which would increase the domestic supply of oil and tend to reduce the level of imported oil.

It is unlikely, however, to reverse the long-term slide in domestic production and growing dependence on imports. The United States is more dependent on imported oil, but is less vulnerable to supply disruptions and oil price shocks, due to the stockpiling of oil under the Strategic Petroleum Reserve, the weakened market power of OPEC, and the increased competitiveness in world oil markets. Increased domestic oil production lessens short-term dependency but it encourages long-term dependency as domestic resources are depleted. EOR oil is more expensive to recover than conventional oil but it is a relatively inexpensive way to add additional oil reserves.

Selected Bibliography

Earnes, Allan, James B. King, Phillip G. Neal, and Richard Rivers. "An Attempt to Spur Tertiary Recovery Methods: The Enhanced Oil Recovery Credit of IRC Section 43," Oil and Gas Tax Quarterly, v. 40. June 1992, pp. 695-703.

Moritis, Guntis. "EOR Increases 24 Percent Worldwide; Claims 10 Percent of U.S. Production," Oil and Gas Journal, v. 90. April 20, 1992, pp. 51-79.

Price, John E. "Accounting for the Cost of Injection Wells and Injectants in Secondary and Tertiary Recovery Efforts," Oil and Gas Tax Quarterly, v. 37. March 1989, pp. 519-534.

U.S. Congress, Senate Committee on Finance. Dependence on Foreign Oil, Hearings, 101st Congress, 2nd session. Washington, DC: U.S. Government Printing Office, July 27, 1990.

Tax Incentives To Boost Energy Exploration, Hearings, 101st Congress, 1st session. Washington, DC: U.S. Government Printing Office, August 3, 1989.

                               Energy

               NONCONVENTIONAL FUEL PRODUCTION CREDIT

                       Estimated Revenue Loss

 

                      [In billions of dollars]

     Fiscal year      Individuals      Corporations       Total

 

     ___________      ___________      ____________       _____

        1995              0.3              0.8             1.1

 

        1996              0.3              0.9             1.2

 

        1997              0.3              0.9             1.2

 

        1998              0.3              0.9             1.2

 

        1999              0.3              0.9             1.2

Authorization

Section 29.

Description

Section 29 provides for a production tax credit of $3 per barrel of oil-equivalent (in 1979 dollars) for certain types of liquid and gaseous fuels produced from alternative energy sources. This credit is also known as the non-conventional fuels credit, or more simply, the "section 29 credit." The full credit is available if oil prices fall below $23.50 per barrel (in 1979 dollars); the credit is phased out as oil prices rise from $23.50 to $29.50 (in 1979 dollars).

Both the credit and the phase-out range are adjusted for inflation since 1979. Currently, the credit is about $5.75 per barrel of liquid fuels and about $1.00 per thousand cubic feet (MCF) for gaseous fuels, and the phase-out range for oil prices is from about $40 to $50 per barrel. Because the current oil price is about $18 per barrel, the credit is now fully in effect.

Qualifying fuels include oil produced from shale or tar sands, synthetic fuels (either liquid, gaseous, or solid) produced from coal, and gas produced from either geopressurized brine, Devonian shale, tight formations, or biomass, and coalbed methane (a colorless and odorless natural gas that permeates coal seams and that is virtually identical to conventional natural gas).

For most qualifying fuels, the production tax credit is available through December 31, 2002, provided that the facilities were placed in service (or wells drilled) by December 31, 1992. For gas produced from biomass, and synthetic fuels produced from coal or lignite, the credit is available through December 31, 2007, provided that the facility is placed in service (or well drilled) before 1996.

The section 29 credit is offset by benefits from Government grants, subsidized or tax-exempt financing, energy investment credits, and the enhanced oil recovery tax credit. Finally, the credit is nonrefundable and it is limited to the excess of a taxpayer's regular tax over several tax credits and the tentative minimum tax.

Impact

In theory, the production tax credit lowers the marginal cost of producing the qualifying alternative fuels, and increases the supply of those fuels, causing a substitution of the alternative fuels for the petroleum fuels, a reduction in the demand for petroleum, and a reduction in imported petroleum (the marginal source of oil).

In practice, however, the credit's effects have, generally, not been sufficient to offset the disincentive effects of low and unstable oil prices, the high cost of alternative fuels production, and taxpayers unawareness of the availability of the new credit. Consequently, there has been little if any increase in the production of alternative fuels since 1980.

In the case of coalbed methane, however, the combined effect of the $1.00 per MCF tax credit (which was at times 100% of natural gas prices) and declining production costs (due to technological advances in drilling and production techniques) was sufficient to offset the decline in oil and natural gas prices, and the resulting decline in domestic conventional natural gas production.

Production of coalbed methane has increased from 0.1 billion MCF in 1980 to over 300 billion MCF in 1991, a large part of it in response to the production tax credits, and virtually all of it at the expense of conventional gas production. The credit for coalbed methane benefits largely oil and gas producers, both independent producers and major integrated oil companies.

Rationale

The original concept for the alternative fuels production tax credit goes back to an amendment by Senator Talmadge to H.R. 5263 (95th Congress), the Senate's version of the Energy Tax Act (P.L. 95- 618), one of five public laws in President Carter's National Energy Plan. H.R. 5263 provided for a $3.00 per barrel tax credit or equivalent for production of shale oil, gas from geopressurized brine, and gas from tight rock formations.

The final version of the Energy Tax Act did not include the production tax credit. The original concept was resuscitated in 1979 by Senator Talmadge as S. 847 and S. 848, which became part of the Crude Oil Windfall Profit Tax Act of 1980 (P.L. 96-223).

The purpose of the credits was to provide incentives for the private sector to increase the development of alternative domestic energy resources because of concern over oil import dependence and national security. The specific event that triggered support for the credits in 1980 was the 1979-80 war between Iran and Iraq, which caused supply shortages and sharp increases in energy prices.

The latter "placed-in-service" rule has been amended several times in recent years. The original 1980 windfall profit tax law established a placed-in-service deadline of December 31, 1989. This was extended by two years to December 31, 1990 by the Technical and Miscellaneous Revenue Act of 1988. That deadline was extended to December 31, 1991 as part OBRA, the Omnibus Budget Reconciliation Act of 1990. The Energy Policy Act of 1992 extended coverage for biomass and fuels produced from coal for facilities through 1997 and extended the credit on production from these facilities through 2007.

Assessment

There has been little, if any, growth in alternative fuels production since 1980, except for alcohol fuels, and that increase is attributable to the excise tax exemptions rather than to production tax credits. Oil imports reached record levels in January, 1990, and now exceed domestic production.

The credits have also greatly increased the production of coalbed methane, which has displaced another domestic energy resource rather than imported oil. Most of the past revenue loss associated with the production tax credits resulted from coalbed methane production. To the extent that the credits stimulate the development of one domestic fuel over another, they are

(1) inconsistent with the policy objective of reducing imported oil;

(2) generating unnecessary losses in Federal tax revenue;

(3) distorting fuel markets, creating inefficiencies in the allocation of resources.

It can be argued that, in the current environment of oil surpluses and low oil prices, such subsidies are not necessary. Economists have questioned the appropriateness of these credits as an energy tax policy to contribute toward energy independence. Both the concept underlying the credits, and the specific fuels that are eligible for the credits, make the tax code the arbiter of which alternative energy resources should and which should not be developed. If there is an external cost to the importation of oil, economic theory suggests a more efficient solution be considered, e.g., a tax on imported petroleum.

Selected Bibliography

Crow, Patrick, and A.D. Koen. "Tight Gas Sands Drilling Buoying U.S. E & D Activity, Oil and Gas Journal, v. 90. November 2, 1992, pp. 21-27.

Ecklund, Eugene E. "Alternative Fuels: Progress and Prospects," Chemtech, v. 19. September, 1989, pp. 549-556; October, 1989, pp. 626-631.

Friedmann, Peter A., and David G. Mayer. "Energy Tax Credits in the Energy Tax Act of 1978 and the Crude Oil Windfall Profit Tax Act of 1980," Harvard Journal on Legislation. Summer 1980, pp. 465-504.

Kriz, Margaret E. "Fuel Duel," National Journal, v. 79. September 19, 1992, pp. 2119-2121.

Kuusbraa, Vello A., and Charles F. Brandenburg. "Coalbed Methane Sparks A New Energy Industry," Oil and Gas Journal, v. 87. October 9, 1989, pp. 49-56.

Lazzari, Salvatore. "The Effects of Federal Tax Policy of Energy Resources: A Comparative Analysis of Oil/Gas and Synthetic Fuels." Library of Congress, Congressional Research Service Report 83-231. Washington, DC: December 30, 1983.

Lemons, Bruce N. "IRS Rulings Further Clarify the Availability of the Nonconventional Fuel Credit," The Journal of Taxation. September 1993, pp. 170-174.

--, and Larry Nemirow. "Maximizing the Section 29 Credit in Coal Seam Methane Transactions," The Journal of Taxation . April 1989, pp. 238-245.

Montgomerie, Bruce. "Federal Income Tax Incentives for the Development and Use of Alternative Energy Resources," Natural Resources Lawyer, v.14. Spring 1981.

Soot, Peet M. "Tax Incentives Spur Development of Coalbed Methane," Oil and Gas Journal, v. 89. June 10, 1991, pp. 40-42.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Crude Oil Windfall Profit Tax Act of 1980, 96th Congress, 2nd session. 1980: pp. 80-84.

Wills, Irene Y, and Norman A. Sunderman. "Section 29 Tax Credit Still Available," Oil and Gas Tax Quarterly, v. 40. December 1991.

                               Energy

                        ALCOHOL FUEL CREDITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

      Fiscal year       Individuals      Corporations       Total

        1995                --                /1/            /1/

 

        1996                --                /1/            /1/

 

        1997                --                /1/            /1/

 

        1998                --                /1/            /1/

 

        1999                --                /1/            /1/

     /1/ Less than $50 million.

Authorization

Section 38, 40, 87.

Description

There are three income tax credits for alcohol-based motor fuels: the alcohol mixtures credit, the pure alcohol fuel credit, and the small ethanol producer credit.

The alcohol mixture (or blender's) credit and the pure alcohol fuel credit is 54 cents per gallon of alcohol of at least 190 proof, and 40 cents for each gallon of alcohol between 150 and 190 proof. No credit is available for alcohol that is less than 150 proof. The alcohol mixtures credit is typically available to the blender, and the pure alcohol credit is typically available to the retail seller.

The small ethanol producer credit is 10 cents per gallon of alcohol produced and sold for use as a transportation fuel. This credit is limited to 15 million gallons of annual alcohol production for each small producer. Only those with a production capacity of under 30 million gallons qualify.

The alcohol fuels tax credits apply to biomass ethanol (alcohol from renewable resources such as vegetative matter), and to methanol derived from biomass, including wood. Alcohol derived from petroleum, natural gas, or coal (including peat) does not qualify for the credits. This limitation excludes most economically feasible methanol, which is derived primarily from natural gas. About 95 percent of current biomass ethanol production is derived from corn.

A 1990 IRS ruling allowed mixtures of gasoline and ETBE (Ethyl Tertiary Butyl Ether) to qualify for the 54-cent blender's credit. ETBE is a compound that results from a chemical reaction between ethanol (which must be produced from renewables under this ruling) and isobutylene. ETBE is technically feasible as a substitute for ethanol or MTBE (Methyl Tertiary Butyl Ether) as a source of oxygen in gasoline regulated under the Clean Air Act.

In lieu of the blender's credit, fuel ethanol blenders may claim the 5.4 cent excise-tax exemption, provided under IRC sections 4041 and 4081 for blends of ethanol and any liquid motor fuel. The 5.4- cent exemption is equivalent to 54 cents per gallon of alcohol.

The alcohol fuels tax credit is a component of the general business credit and is limited to the taxpayer's net income tax in excess of the greater of (a) 25 percent of regular tax liability above $25,000, or the tentative minimum tax. Any unused credits may be carried forward 15 years or back 3 years. Credits must also be included as income under section 87.

All three of the alcohol tax credits expire on January 1, 2001, or in the event that the gasoline tax expires. H.R. 776 (The Comprehensive National Energy Policy Act of 1992) would allow the credits to offset some portion of the alternative minimum tax.

Impact

Consumption of ethanol motor fuel, most of which is a gasoline blend, has increased from about 40 million gallons in 1979 to over one billion gallons. Gasohol accounts for about 8 percent of the transportation fuels market. Virtually all this increase is due to the Federal excise tax exemption, the excise tax exemptions at the State and local level, and to the high oil prices in the late 1970s and early 1980s, rather than to the alcohol fuels tax credits.

Due to restrictions on taking the credit against only portions of income tax liability, and the inclusion of the credit itself in income, blenders prefer to use the excise tax exemption.

Allowing ETBE to qualify for the blender's tax credit is projected to stimulate the production of ethanol for use as an oxygen source for reformulated gasoline, and thus to reduce the production and importation of MTBE, an alternate oxygen source made from natural gas. If this occurs, it would increase the share of US corn crop allocated to ethanol production above the current 4-5 percent. It would also increase Federal revenue losses from the alcohol fuels credits, which heretofore have been negligible due to blender's use of the exemption over the credit.

A recent Environmental Protection Agency mandate that 30 percent of the oxygenate in reformulated gasoline be made from renewables, if implemented, would result in additional revenue losses, especially if ETBE is used to meet the oxygenate requirements under the Clean Air Act during the summer months.

Rationale

The alcohol fuels tax credits were intended to complement the excise-tax exemptions for alcohol fuels enacted in 1978. These exemptions provided the maximum tax benefit when the gasohol mixture is 90% gasoline and 10% alcohol. Recent tax law changes have provided a prorated exemption to blends of 7.7 percent and 5.7 percent alcohol.

The Congress wanted the credits to provide incentives for the production and use of alcohol fuels in mixtures that contained less than 10 percent alcohol. The Congress also wanted to give tax-exempt users (such as farmers) an incentive to use alcohol fuel mixtures instead of tax-exempt gasoline and diesel.

Both the credits and excise-tax exemptions were enacted to encourage the substitution of alcohol fuels produced from renewables for gasoline and diesel. The underlying policy objective is, as with most other energy tax incentives, to reduce reliance on imported petroleum and to contribute to energy independence. In addition, the Congress wanted to help support farm incomes by finding another market for corn, sugar, and other agricultural products that are the basic raw materials for alcohol production.

The alcohol fuels mixture credit and the pure alcohol fuels credit were enacted as part of the Crude Oil Windfall Profit Tax of 1980 (P.L.96-223), at the rate of 40 cents per gallon for alcohol that was 190 proof or more, and 30 cents per gallon for alcohol between 150 and 190 proof. The credits were increased in 1982 and 1984.

The Omnibus Reconciliation Act of 1990 reduced the credits to 54 cents and 40 cents and introduced the new 10-cent-per-gallon small ethanol producer credit.

The Senate version of the Comprehensive National Energy Policy Act of 1992 (H.R. 776) proposed that the credit offset fifty percent of the minimum tax, but this was not part of the final law.

Assessment

The alcohol fuels tax credits were enacted to lower the cost of producing and marketing ethanol fuels that would otherwise not be competitive. They target one specific alternative fuel over many others--such as methanol, liquified petroleum gas, compressed natural gas, or electricity--that could theoretically substitute for gasoline and diesel. Alcohol fuel is not only higher priced, but also requires substantial energy to produce, thereby diminishing the net overall conservation effect.

To the extent that the credits induce a substitution of domestically produced ethanol for petroleum fuels they would reduce petroleum imports and provide some environmental gains, although not necessarily more than other alternative fuels. But it is the excise tax exemptions rather than the credits that have provided these effects so far.

At 54 cents per gallon of alcohol, the subsidy is $23 per barrel of oil displaced, which is $5 per barrel more that the current domestic oil price. Providing tax subsidies for one type of fuel over others could distort market decisions and engender an inefficient allocation of resources, even if doing so produces some energy security and environmental benefits. This occurs when the subsidized fuel is more costly to produce than other fuels, and when other policy approaches are more appropriate to correct for failures in the market to reduce oil imports and to reduce mobile air pollutants.

Substantial losses in Federal tax revenue, and additional economic distortions in fuels markets, are likely to result in the future if there is increased production of ETBE in place of its lower-cost alternative, MTBE. This substitution would reduce imports of MTBE and improve the trade balance, but would not reduce petroleum imports (which is the underlying goal of the credits) since MTBE is made primarily from natural gas.

Selected Bibliography

Kane, Sally, John Reilly, Michael LeBlanc, and James Hrubovcak. "Ethanol's Role: An Economic Assessment," Agribusiness, v.5. September 1989, pp. 505-522.

Lareau, Thomas J. "The Economics of Alternative Fuel Use: Substituting Methanol for Gasoline." Contemporary Policy Issues, v. 8. October 1990, pp. 138-155.

Lazzari, Salvatore. Alcohol Fuels Tax Incentives and EPA's Renewable Oxygenate Requirement, Library of Congress, Congressional Research Service Report 94-785 E. Washington, DC: 1994.

--, Alcohol Fuels Tax Incentives: Current Law and Proposed Options To Expand Current Law, Library of Congress, Congressional Research Service Report 89-343. Washington, DC: 1989.

U.S. Congress, House Committee on Ways and Means. Tax Incentives for the Production and Use of Ethanol Fuels, Hearings, 98th Congress, 2nd session. Washington, DC: U.S. Government Printing Office, July 9, 1984, p. 283.

--, Certain Tax and Trade Alcohol Fuel Initiatives, Hearing, 101st Congress, 2nd session. Washington, DC: U.S. Government Printing Office, February 1, 1990.

--, Joint Committee on Taxation. General Explanation of the Crude Oil Windfall Profit Tax Act of 1980 (H.R. 3919, P.L. 96-233), 96th Congress, 2nd session. Washington, DC: U.S. Government Printing Office.

U.S. General Accounting Office. Importance And Impact of Federal Alcohol Fuel Tax Incentives, GAO/RCED-84-1. June 6, 1984.

Wells, Margaret A., Alan J. Krupnick, and Michael A. Toman. Ethanol Fuel and Non-Market Benefits: Is A Subsidy Justified? (Discussion Paper ENR89-07). Resources for the Future, 1989.

Shurtz, Nancy E. "Promoting Alcohol Fuels Production: Tax Expenditure? Direct Expenditures? No Expenditures?" Southwestern Law Journal, v. 36. June 1982, pp. 597-644

                               Energy

              EXCLUSION OF INTEREST ON STATE AND LOCAL

 

               GOVERNMENT INDUSTRIAL DEVELOPMENT BONDS

 

                  FOR ENERGY PRODUCTION FACILITIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

___________________________________________________________________

  Fiscal year       Individuals    Corporations        Total

 

___________________________________________________________________

     1995              0.1            /1/               0.1

 

     1996              0.1            /1/               0.1

 

     1997              0.1            /1/               0.1

 

     1998              0.1            /1/               0.1

 

     1999              0.1            /1/               0.1

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Sections 103, 141, 142, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance the construction of certain energy facilities is tax exempt. These energy facility bonds are classified as private-activity bonds, rather than as governmental bonds, because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

These bonds may be issued to finance the construction of hydroelectric generating facilities at dam sites constructed prior to March 18, 1979, or at sites without dams that require no impoundment of water. Bonds may also be issued to finance solid waste disposal facilities that produce electric energy.

These exempt facility bonds generally are subject to the State private-activity bond annual volume cap. Bonds issued for government- owned solid waste disposal facilities are not, however, subject to the volume cap.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to provide the services of energy facilities at lower cost.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the energy facilities, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

The Crude Oil Windfall Profits Tax Act of 1980 used tax credits to encourage the private sector to invest in renewable energy sources. Because State and local governments pay no Federal income tax, Congress in this Act authorized governmental entities to use tax-exempt bonds to reduce the cost of investing in hydroelectric generating facilities.

The portion of the facility eligible for tax-exempt financing ranged from 100 percent for 25-megawatt facilities to zero percent for 125-megawatt facilities.

The definition of solid waste plants eligible for tax-exempt financing was expanded by the 1980 Act because the Treasury regulations then existing denied such financing to many of the most technologically efficient methods of converting waste to energy. This expansion of eligibility included plants that generated steam or produced alcohol. Tax exemption for steam generation and alcohol production facilities bonds were eliminated by the 1986 Tax Act.

Assessment

Any decision about changing the status of these two eligible private activities should consider the Nation's need for renewable energy sources to replace fossil fuels, and the importance of solid waste disposal in contributing to environmental goals.

Even if a case can be made for subsidy of these activities, it is important to recognize the costs that accrue. As one of many categories of tax-exempt private-activity bonds, bonds issued for energy facilities have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Lazzari, Salvatore. Federal Tax Provisions Relating to Alcohol Fuels Including Recent Changes Under the Tax Reform Act of 1984. Library of Congress, Congressional Research Service Report 84-194, November 6, 1984.

U.S. Congress, Joint Committee on Internal Revenue Taxation. General Explanation of the Crude Oil Windfall Profits Tax Act of 1980. 96th Congress, 2nd session, 1980.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

                               Energy

                  EXPENSING OF TERTIARY INJECTANTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

___________________________________________________________________

  Fiscal year       Individuals    Corporations        Total

 

___________________________________________________________________

     1995              /1/            /1/              /1/

 

     1996              /1/            /1/              /1/

 

     1997              /1/            /1/              /1/

 

     1998              /1/            /1/              /1/

 

     1999              /1/            /1/              /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 193.

Description

Tertiary recovery projects inject fluids, gases, and other chemicals into the oil or gas reservoir to extract oil too viscous to be extracted by conventional primary and secondary waterflooding techniques.

Nine tertiary recovery methods listed by Department of Energy in section 212.78(c) of its June 1979 regulations qualify for expensing (deducting costs when incurred): 1) miscible fluid displacement, 2) steam-drive injection, 3) microemulsion flooding, 4) in situ combustion, 5) polymer-augmented water flooding, 6) cyclic steam injection, 7) alkaline (or caustic) flooding, 8) carbonated water flooding, and 9) immiscible carbon dioxide gas displacement.

Other tertiary enhanced-recovery projects may qualify if they meet certain criteria. Expensable injectants must not be comprised of a significant amount of a recoverable hydrocarbon. Qualified tertiary injectant expenditures also qualify for a 15-percent income tax credit under code section 43, although the credit must be subtracted from the deduction if both are claimed on the same expenditure.

Impact

Oil production in the United States, which peaked in 1970 and recently dropped to a 30-year low, has been declining at the rate of about four percent per year. Demand for petroleum has been growing, however, and this has caused oil imports to reach record levels. Through September 1994, oil imports averaged 9 million barrels per day, 6.1 percent more than during the comparable period in 1993. Domestic production averaged 6.6 million barrels per day.

The United States, once the world's leading oil producer and exporter, has been depleting its oil resources and is now the high- marginal-cost oil producer. Conventional oil recovery methods typically succeed in extracting only one-third of a well's oil. Some of the remaining oil can be extracted by tertiary recovery methods, but these methods are currently uneconomic at prices below about $28- 30 per barrel.

It is estimated, however, that between 250 and 350 billion barrels of oil remain in abandoned wells, significantly more than the known reserves of oil recoverable by primary and secondary methods. Further, it is estimated that 10 percent of that oil is known recoverable reserves that can be produced with current tertiary oil recovery techniques.

Because oil prices are not expected to rise to $28-$30 per barrel in the near future, tertiary recovery methods are projected to be generally uneconomic without tax incentives. The expensing of tertiary recovery expenditures reduces the cost of producing oil from abandoned reservoirs relative to the cost of producing oil from new reservoirs.

The claiming of both expensing under section 193 and the credit under section 43 results in a partial, rather than a complete, offset of tax benefits. (The tax benefits from both provisions are greater than the tax benefits from each of the provisions separately.) The combined effects of expensing and the credit are equivalent to a net subsidy (a negative tax).

United States production of oil by tertiary oil recovery methods increased during the 1980s; between 1990 and 1992, it increased by nearly 14 percent. The incentive effects of expensing (combined with the credit enacted in 1990) should further increase the recovery of this oil, which would increase domestic supply, and tend to reduce the level of imported oil.

Rationale

Section 193 was added by the Crude Oil Windfall Profit Tax Act of 1980. The Congress wanted to ensure by statute that the costs of injectants would be treated the same as intangible drilling costs, which are expensed under code section 263(c).

In addition, the Congress wanted to encourage the use of tertiary recovery methods in order to increase the domestic supply of oil, reduce the demand for imported oil, make the United States less dependent upon Persian Gulf producers and other unstable foreign oil producers, and enhance the energy security of the United States.

Assessment

In theory, tertiary injectant expenditures are capital expenditures, as are intangible drilling costs, that should be capitalized (depleted) over the income-producing life of the oil or gas property in order to achieve a proper matching of costs and benefits.

Permitting oil and gas producers to expense, instead of capitalizing, injectant expenditures is tantamount to a capital subsidy. As such it may divert capital from other oil and gas activities into production of higher-cost oil and gas. Whether this is an appropriate tax subsidy depends upon the total value (measuring both private and external benefits) of the additional output -- primarily oil -- in comparison to the revenue loss and possible distortions in the oil and gas industry and the economy.

In a market economy, the private benefits from additional oil output would be measured by its price, which is currently about $18 per barrel. The policy question is why the United States should subsidize the production of $30 oil, when it costs only $18 to buy it.

This, in turn, depends on whether there are external costs to high levels of oil import dependence, and the level of these costs. For example, there may be external costs to excessive dependence on unstable foreign oil suppliers. Increased domestic oil production lessens short-term dependency but it encourages long-term dependency as domestic resources are depleted.

However, expensing of tertiary injectant expenditures is unlikely to reverse the long-term slide in domestic production and the growing dependence on imports. The United States is more dependent on imported oil, but is less vulnerable to supply disruptions and oil price shocks, due to the stockpiling of oil under the Strategic Petroleum Reserve, the weakened market power of OPEC, and a more competitive world oil market. If there are social costs to petroleum-import dependency, a better solution may be to impose an oil import tax or to increase strategic reserves.

Selected Bibliography

Karnes, Allan, James B. King, Phillip G. Neal, and Richard Rivers. "An Attempt to Spur Tertiary Recovery Methods: The Enhanced Oil Recovery Credit of IRC Section 43," Oil and Gas Tax Quarterly, v. 40. June 1992, pp. 695-703.

Moritis, Guntis. "EOR Increases 24 Percent Worldwide; Claims 10 Percent of U.S. Production," Oil and Gas Journal, v. 90. April 20, 1992, pp. 51-79.

Price, John E. "Accounting for the Cost of Injection Wells and Injectants in Secondary and Tertiary Recovery Efforts," Oil and Gas Tax Quarterly, v. 37. March 1989, pp. 519-534.

U.S. Congress, Senate Committee on Finance. Tax Incentives To Boost Energy Exploration, Hearings, 101st Congress, 1st session. Washington, DC: U.S. Government Printing Office, August 3, 1989.

--, Joint Committee on Taxation. General Explanation of the Crude Oil Windfall Profit Tax of 1980, Joint Committee Print, 96th Congress. Washington, DC: U.S. Government Printing Office.

                               Energy

             EXCLUSION OF ENERGY CONSERVATION SUBSIDIES

 

                    PROVIDED BY PUBLIC UTILITIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

___________________________________________________________________

  Fiscal year       Individuals    Corporations        Total

 

___________________________________________________________________

     1995              /1/            -                 -

 

     1996              /1/          0.1                0.1

 

     1997              /1/          0.2                0.2

 

     1998              /1/          0.3                0.3

 

     1999              /1/          0.3                0.3

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 136.

Description

Residential customers exclude from income subsidies provided by public utilities for the purchase or installation of an energy- conservation item. Non-residential customers may exclude 40 percent of such subsidies in 1995, 50 percent in 1996, and 65 percent thereafter.

Impact

The exclusion reduces the cost of programs financed by utilities to conserve energy, since, absent such provisions, the value of the subsidy would be included in gross income and subject to tax. Depending on the tax rate, the tax saving could be as much as one- third the value of the subsidy.

Rationale

This provision was adopted as part of the Energy Policy Act of 1992, to encourage customers of public utilities to participate in energy conservation programs.

An exclusion for residential customers had previously been in the law. The Solar Energy and Energy Conservation Act of 1980 amended the National Energy Conservation Act of 1978 to provide that these payments were excluded. This provision expired in mid-1989.

Assessment

Generally, allowing special tax benefits for certain types of investment or consumption results in a misallocation of resources.

Such a program might be justified on the grounds of conservation, if consumption of energy resulted in negative effects on society, such as pollution. In general, however, it is more efficient to directly tax energy fuels than to subsidize a particular method of achieving conservation.

There may also be a market failure in tenant occupied homes, if the tenant pays for electricity separately. In that case, the landlord may have little incentive to undertake conservation expenditures.

Selected Bibliography

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Hassett, Kevin A., and Gilbert E. Metcalf. "Energy Conservation Investment: Do Consumers Discount the Future Correctly?" Energy Policy, v. 21. June 1993, pp. 710-716.

Lazzari, Salvatore. Energy Tax Provisions in the Energy Policy Act of 1992, Library of Congress, Congressional Research Service Report 94-525 E, Washington, DC: June 22, 1994.

Pauley, Patricia, et al. "The Energy Policy Act of 1992: Provisions affecting Individuals, Taxes, February, 1993, pp. 91-96.

U.S. Congress, House. Report to Accompany H.R. 776, the Comprehensive Energy Policy Act. Washington, DC: U.S. Government Printing Office, Report 102-474, Part 6, pp. 35-37.

--, Senate. "Technical Explanation of the Senate Finance committee Amendment to Title XIX of H.R. 776," Congressional Record. Washington, DC: U.S. Government Printing Office, June 18, 1992, pp. 8485-8485.

                               Energy

                 CREDIT FOR INVESTMENTS IN SOLAR AND

 

                    GEOTHERMAL ENERGY FACILITIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

___________________________________________________________________

  Fiscal year       Individuals    Corporations        Total

 

___________________________________________________________________

     1995              -              0.0               0.0

 

     1996              -              0.1               0.1

 

     1997              -              0.1               0.1

 

     1998              -              0.1               0.1

 

     1999              -              0.1               0.1

 

____________________________________________________________________

Authorization

Sections 46 and 48.

Description

Sections 46 and 48 provide for a 10-percent income-tax credit for business investment in solar and geothermal energy equipment. Solar equipment is defined as equipment that generates electricity directly (photovoltaic systems), or that heats, cools, or provides hot water in a building, and equipment that provides solar process heat. Geothermal equipment includes equipment used to produce, distribute, or use energy from a natural underground deposit of hot water, heat, and steam (such as the Geysers of California).

The credits for solar and geothermal equipment are what remain of the business energy tax credits enacted under the Energy Tax Act of 1978, and they are the sole exception to the repeal of the investment tax credits under the Tax Reform Act of 1986.

Impact

The energy tax credits lower the cost of, and increase the rate of return to, investing in solar and geothermal equipment, whose return is typically much lower than conventional energy equipment. Currently low oil prices are unlikely to make investments in solar and geothermal economic even with a 10-percent credit.

Even during the early 1980s, when oil prices were high and effective tax rates on these types of equipment were sometimes negative (due to the combined effect of the energy tax credits, the regular 10 percent investment tax credit, and accelerated depreciation) business investment in these technologies was negligible. It is not clear how much these credits encourage additional investment as opposed to subsidizing investment that would have been made anyway.

The number of solar collector manufacturers, and their shipments of collectors reached a peak in the early 1980s -- commensurate with the peak in oil prices -- and declined thereafter. Shipments of medium-temperature collectors remained high through 1985, declining sharply thereafter. In addition to the 1986 drop in oil prices, this was probably due to the termination of the residential solar credit, which was not reinstated, rather than termination of the business solar credits, which were reinstated.

Most solar collectors are used in heating water and pools in residences. Business applications of solar equipment are still quite insignificant, except for public utilities, which use them to generate electricity. However, public utilities do not qualify for the credit. Very little energy in the United States is generated from solar equipment.

Electricity generated from geothermal deposits, which generated four times as much energy as solar equipment in 1990, increased rapidly from the onset of the energy crisis in 1973 to the collapse of oil prices in 1986, and declined slightly since 1987. Even so, it accounts for 6.2 percent of the energy generated from renewable sources, and 0.4 percent of total U.S. energy consumed in 1990. Most of it is generated by electric utilities, which do not qualify for the tax credit.

Rationale

The business energy tax credits were part of the Energy Tax Act of 1978, which was one of five public laws enacted as part of President Carter's National Energy Plan. The rationale behind the credits was primarily to reduce United States consumption of oil and natural gas by encouraging the commercialization of renewable energy technologies, to reduce dependence on imported oil and enhance national security.

Under the original 1978 law, which also provided for tax credits for solar and geothermal equipment used in residences, several other types of equipment qualified for the tax credits: shale oil equipment, recycling equipment, wind equipment, synthetic fuels equipment, and others. For some types of equipment, the credits expired on December 31, 1982, for others the Crude Oil Windfall Profit Tax Act of 1980 extended the credits through 1985.

The 1980 Act extended the credit for solar and geothermal equipment, raised their credit rates from 10 to 15 percent, repealed the refundability of the credit for solar and wind energy equipment, and extended the credit beyond 1985 for certain long-term projects. The Tax Reform Act of 1986 retroactively extended the credits for solar, geothermal, ocean thermal, and biomass equipment through 1988, at declining rates.

The Miscellaneous Revenue Act of 1988 extended the solar, geothermal, and biomass credits at their 1988 rates -- ocean thermal was not extended. The Omnibus Budget and Reconciliation Act of 1989 extended the credits for solar and geothermal, and reinstated the credit for ocean thermal equipment, through December 31, 1991. The credit for biomass equipment was not extended. The Tax Extension Act of 1991 extended the credits for solar and geothermal through June 30, 1992. The Energy Policy Act of 1992 made the credits, which now apply only to solar and geothermal equipment, permanent.

Assessment

The business energy tax credits encourage investments in technologies that rely on clean, abundant, renewable energy as substitutes for conventional fossil-fuel technologies that pollute the environment and contribute to dependence on imported oil. The major policy question, however, is the cost -- in terms of lost Federal tax revenue and in terms of the distortions to the allocation of resources -- in relation to the small quantities of fossil fuels savings and environmental gains.

The credits lose much Federal tax revenue in relation to the small amounts of fossil energy they save. They also subsidize two specific technologies, at the expense of others that might have more "bang for the buck." The high capital costs for alternative energy technologies, and market uncertainty, are not evidence of energy market failure. If there is a social cost to excessive oil imports, this suggests a tax on imported petroleum.

The environmental problems associated with production and consumption of fossil fuels may be more appropriately addressed with emissions taxes or emissions trading rights (as in the Clean Air Act), and energy taxes rather than investment tax credits. Market failures in research and development (R&D) of energy technologies due to the fact that information from the research becomes public, suggests either an R&D tax credit or government expenditure on energy research.

Selected Bibliography

Due, John F. "The Tax Aspects of the President's Energy Proposals," Tax Notes, v. 5. June 20, 1977, pp. 11-16.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Lazzari, Salvatore. An Explanation of the Business Energy Investment Tax Credits, Library of Congress, Congressional Research Service Report 85-25 E. Washington, DC: 1985.

McDonald, Stephen L. "The Energy Tax Act of 1978," Natural Resources Journal, v. 19. October 1979, pp. 859-869.

McIntyre, Robert S. "Lessons for Tax Reformers From the History of the Energy Tax Incentives in the Windfall Profits Tax Act of 1980," Boston College Law Review, v. 22. May 1981, pp. 705-745.

Minan, John H., and William H. Lawrence. "Encouraging Solar Energy Development Through Federal and California Tax Incentives," Hastings Law Journal, v. 32. September 1980, pp. 1-58.

Sav, G. Thomas. "Tax Incentives for Innovative Energy Sources: Extensions of E-K Complementarity," Public Finance Quarterly, v. 15. October 1987, pp. 417-427.

Rich, Daniel, and J. David Roessner. "Tax Credits and U.S. Solar Commercialization Policy, Energy Policy, v. 18. March 1990, pp. 186- 198.

U.S. General Accounting Office. Tax Policy: Business Energy Investment Credit, GAO/GGD-86-21. Washington, DC: December, 1985.

U.S. Congress, House Committee on Science and Technology. Tax Incentives for New Energy Technologies. Hearings, 98th Congress, 1st session. July 12, 1983.

--, The Role of Business Incentives in the Development of Renewable Energy Technologies. Hearing, 97th Congress, 2nd session. Washington, DC: U.S. Government Printing Office, July 13, 1982.

--, House Conference Committees. Energy Tax Act of 1978; Conference Report to Accompany H.R. 5263, 95th Congress, 2nd session, House Report No. 95-1773. 1978.

--, Senate Committee on Energy and Natural Resources. Opportunities and Barriers to Commercialization of Renewable Energy and Energy Efficiency Technologies. Hearings, 103rd Congress, 1st session. Washington, DC: U.S. Government Printing Office, April 22, 1993.

--, Senate Committee on Finance. Targeted Extension of Energy Tax Credits. Hearing on S. 1396, 98th Congress, 1st session. Washington, DC: U.S. Government Printing Office, June 17, 1983.

Energy

            CREDITS FOR ELECTRICITY PRODUCTION FROM WIND

 

                             AND BIOMASS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year    Individuals         Corporations        Total

 

____________________________________________________________________

   1995             /1/                 /1/             /1/

 

   1996             /1/                 /1/             /1/

 

   1997             /1/                 /1/             /1/

 

   1998             /1/                0.1             0.1

 

   1999             /1/                0.1             0.1

 

____________________________________________________________________

 

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 45.

Description

Taxpayers are allowed a 1.5-cent credit per kilowatt hour for electricity produced from qualified wind energy or "closed-loop" biomass. The electricity must be produced from a facility owned by a taxpayer and it must be sold to an unrelated third party. The credit is allowed for the first ten years of production from a new facility.

Closed-loop biomass involves the use of plant matter, where plants are grown solely to produce electricity. Use of waste materials such as scrap wood or agricultural/municipal waste) or timber does not qualify for the credit.

The credit is phased out as the average annual contract price of electricity from the renewable source, the reference price, rises from 8 cents to 11 cents per kilowatt. These amounts are adjusted for inflation.

The credit cannot be received by a facility that has received the business energy credit or investment credit and is reduced proportionally if government subsidies (including tax-exempt bonds) are used.

The credit applies to electricity produced by facilities placed in service after 1992 and before July 1, 1999 for biomass, and after 1993 and before June 1, 1999 for wind.

Impact

This tax benefit is a production incentive; it encourages use of wind and biomass to generate electricity. The phase-out is designed to remove the subsidy when the price becomes sufficiently high that a subsidy is no longer needed.

Rationale

This provision was adopted as part of the Energy Policy Act of 1992. Its purpose was to encourage the development and utilization of electric generating technologies that use specified renewable energy resources, as opposed to conventional fossil fuels.

Assessment

Generally, allowing special tax credits and deductions for certain types of investment or consumption results in a misallocation of resources. This provision might be justified, however, on the basis of reducing pollution. In general, it is more efficient to reduce pollution by directly taxing emissions, and allowing individuals to choose the optimal response. In some cases, however, such an approach is not administratively feasible.

The provision might also be justified on the grounds of reducing dependence on imported oil. Such an objective might, however, be obtained more efficiently through a strategic petroleum reserve, or an oil import tax.

The modest revenue costs associated with the provision suggest that the impact will be small as well.

Selected Bibliography

Ecklund, Eugene E. "Alternative Fuels: Progress and Prospects," Chemtech, v. 19. October 1989, pp. 626-631.

Fisher, Anthony C., and Michael H. Rothkopf. "Market Failure and Energy Policy: A Rationale for Selective Conservation," Energy Policy, v. 17. August 1989, pp. 397-406.

Lazzari, Salvatore. Energy Tax Provisions in the Energy Policy Act of 1992, Library of Congress, Congressional Research Service Report 94-525 E, Washington, DC: June 22, 1994.

--. Energy Tax Subsidies: Biomass vs. Oil and Gas, Library of Congress, Congressional Research Service Report 93-19 E, Washington, DC: January 5, 1993.

--. "Federal Tax Policy Toward Biomass Energy: History, Current Law, and Outlook," Biologue. July/August 1989, pp. 8-11.

U.S. Congress, House. Report to Accompany H.R. 776, the Comprehensive Energy Policy Act. Washington, DC: U.S. Government Printing Office, Report 102-474, Part 6, pp. 37-44.

--, Senate. "Technical Explanation of the Senate Finance committee Amendment to Title XIX of H.R. 776," Congressional Record. Washington, DC: U.S. Government Printing Office, June 18, 1992, pp. 8485-8486.

Energy

                DEDUCTIONS AND CREDITS FOR CLEAN-FUEL

 

                   VEHICLES AND REFUELING PROPERTY

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year    Individuals         Corporations        Total

 

____________________________________________________________________

   1995             /1/                 /1/             /1/

 

   1996             /1/                 /1/             /1/

 

   1997             /1/                 /1/             /1/

 

   1998             /1/                 /1/             /1/

 

   1999             /1/                 /1/             /1/

 

_____________________________________________________________________

 

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Sections 30, 179.

Description

Taxpayers are allowed a deduction for investing in a motor vehicle that may be propelled by a clean-burning fuel. The deduction is available for the portion of the cost attributed to the engine, the fuel delivery system, and the exhaust system. The vehicle must be new, but deductions can also be taken for retro-fitting vehicles propelled by gasoline or diesel fuel.

Costs are limited by vehicle type and weight: $50,000 for trucks and buses weighing over 26,000 lbs., $5,000 for trucks and vans weighing between 10,000 and 26,000 lbs., and $2,000 for all other vehicles.

A deduction is also allowed for up to $100,000 of expenditures on facilities used to store or deliver clean fuels and electricity.

Clean-burning fuel is natural gas, liquified natural gas, liquified petroleum gas, hydrogen, or other fuels composed 85 percent of methanol, ethanol, any other alcohol, ether, or any combination.

The deduction is phased out from the years 2002 through 2005 by reducing the cost limits by 25 percent, 50 percent, 75 percent, and 100 percent respectively.

Electric vehicles are allowed a 10-percent income tax credit, not to exceed $4000. This credit is also phased out from 2002 through 2005.

Impact

The deduction and credit reduce the cost of investing in clean- fuel and electric vehicles and should increase the demand for these vehicles. The expensing provisions for business are the equivalent of a zero effective tax rate. The credit combined with current depreciation is roughly equivalent to expensing at reasonable discount rates.

For vehicles for personal use, the deduction is more valuable in most cases because it would be the equivalent of a credit allowed at the individual's tax rate.

Rationale

This provision was adopted as part of the Energy Policy Act of 1992 in order to encourage taxpayers to purchase or convert to motor vehicles that are propelled by clean-burning fuels and to invest in equipment for storing and dispensing clean-burning fuels. It is the only capital-stock incentive of the Federal tax code intended to encourage substitution toward alternative motor fuels. Its purpose was to reduce atmospheric pollution and reduce the dependence of the United States on imported oil.

The tax incentives for alternative-fuel vehicles are intended to make them less unattractive economically to those required to buy them. Unless there are major technical improvements, which would lead to cost reduction, most mandated buyers will still not find the AFVs economic, except for high-mileage vehicles. It is likely that a significant number of propane-fueled vehicles and a small number of natural-gas-fueled vehicles will become more economical to buyers not under mandate, so a nonfleet market may well develop for gaseous- fueled vehicles. Methanol and ethanol flexibly fueled vehicles will not significantly benefit, unless the costs of these fuels can be substantially reduced, a major objective of Title XII of the Act.

Electric vehicles are likely to continue to be significantly more expensive than other alternatives, despite the tax credit, although there are indications of research and development breakthroughs. However, coupled with State incentives and perhaps some credit trading, some buyers, particularly electric utilities, will find the economic gap narrowed significantly.

Assessment

Generally, allowing special tax credits and deductions for certain types of investment or consumption results in a misallocation of resources. This provision might be justified, however, on the basis of reducing pollution. In general, it is more efficient to reduce pollution by directly taxing emissions or by taxing the polluting fuels, and allowing individuals to choose the optimal response. In some cases, however, such an approach is not administratively feasible.

The provision might also be justified on the grounds of reducing dependence on imported oil. Such an objective might, however, be obtained more efficiently through a strategic petroleum reserve.

Selected Bibliography

Bleviss, Deborah Lynn. The New Oil Crisis and Fuel Economy Technologies. New York: Quorum Books, 1988.

Gushee, David E. "Alternative Fuels for Automobiles: Are They Cleaner than Gasoline?" Library of Congress, Congressional Research Service Report 92-235 S, Washington, DC: February 27, 1992.

--. "Impact of Highway Fuel Taxes on Alternative Fuel Vehicle Economics," Library of Congress, Congressional Research Service Report 94-247 S, Washington, DC: March 16, 1994.

Lazzari, Salvatore. Energy Tax Provisions in the Energy Policy Act of 1992, Library of Congress, Congressional Research Service Report 94-525 E, Washington, DC: June 22, 1994.

Pauley, Patricia, et al. "The Energy Policy Act of 1992: Provisions Affecting Individuals, Taxes, February, 1993, pp. 91-96.

U.S. Congress, House. Report to Accompany H.R. 776, the Comprehensive Energy Policy Act. Washington, DC: U.S. Government Printing Office, Report 102-474, Part 6, pp. 37-44.

--, Senate. "Technical Explanation of the Senate Finance committee Amendment to Title XIX of H.R. 776," Congressional Record. Washington, DC: U.S. Government Printing Office, June 18, 1992, pp. 8485-8486.

--, Office of Technology Assessment. Replacing Gasoline: Alternative Fuels for Light-Duty Vehicles, OTA -- 364. Washington, DC: U.S. Government Printing Office, September 1990.

                  Natural Resources and Environment

                    EXPENSING OF EXPLORATION AND

 

                 DEVELOPMENT COSTS: NONFUEL MINERALS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year    Individuals         Corporations        Total

 

____________________________________________________________________

   1995             /1/                 /1/             /1/

 

   1996             /1/                 /1/             /1/

 

   1997             /1/                 /1/             /1/

 

   1998             /1/                 /1/             /1/

 

   1999             /1/                 /1/             /1/

 

_____________________________________________________________________

 

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

Authorization

Section 263(1)A, 291, 616-617, 56, and 1254.

Description

Firms engaged in mining are permitted to expense (to deduct in the year paid or incurred) rather than capitalize (i.e., recover such costs through depletion or depreciation) certain exploration and development (E&D) costs. This is an exception to general tax rules.

In general, mining exploration costs are those costs incurred to ascertain the existence, location, extent or quality of any potentially commercial deposit of ore or other depletable mineral prior to the development stage of the mine or deposit.

Development costs are generally those incurred for the development of a mine or other natural deposits after the existence of ores in commercially marketable quantities has been determined. Development expenditures generally include those for construction of shafts and tunnels, and in some cases drilling and testing to obtain additional information for planning operations. There are no limits on the current deductibility of such costs. Expensing of mine development costs may be taken in addition to percentage depletion. Mining exploration costs subsequently reduce percentage depletion deductions (i.e., are recaptured).

Expensing of E&Ds applies only to domestic properties; E&Ds on foreign properties must be depreciated. The excess of expensing over the capitalized value (amortized over 10 years) is a tax preference item that is subject to the alternative minimum tax.

Impact

E&D costs for nonfuels minerals are not as large a portion of the costs of finding and developing a mineral reserve as is the case for oil and gas, where they typically account for between 75 and 90 percent of the costs of creating a mineral asset. Expensing of such costs is also less of a benefit than percentage depletion allowances.

Nevertheless, they are a capital expense which should be depleted over the income-producing life of the mineral reserve. Combined with other tax subsidies, such as percentage depletion, they reduce effective tax rates in the mineral industry below tax rates in other industries, thereby providing incentives to increase investment, exploration, and output. This increases the supply of the mineral and reduces its price.

This tax expenditure is largely claimed by corporate producers. The at-risk, recapture, and minimum tax restrictions that have since been placed on the use of the provision have primarily limited the ability of high-income taxpayers to shelter their income from taxation through investment in mineral exploration.

Rationale

Expensing of mine development expenditures was enacted in 1951 to reduce ambiguity in the then-existing treatment of, and to encourage, mining. The provision for mine exploration was added in 1966.

Prior to the Tax Reform Act of 1969, a taxpayer could elect either to deduct without dollar limitation exploration expenditures in the United States (which subsequently reduced percentage depletion benefits), or to deduct up to $100,000 a year with a total not to exceed $400,000 of foreign and domestic exploration expenditures without recapture.

The 1969 act subjected all post-1969 exploration expenditures to recapture. The Tax Equity and Fiscal Responsibility Act of 1982 added mineral exploration and development costs as tax preference items subject to the alternative minimum tax, and limited expensing for corporations to 85 percent (the remaining 15 percent of IDCs has to be depreciated). The Tax Reform Act of 1986 required that all exploration and development expenditures on foreign properties be capitalized.

Assessment

E&D costs are generally recognized to be capital costs which, according to standard economic principles, should be recovered through depletion (cost depletion adjusted for inflation).

Lease bonuses and other exploratory costs (survey costs, geological and geophysical costs) are properly treated as capital costs, although they may be recovered through percentage rather than cost depletion. Immediate expensing of E&Ds provides a tax subsidy for capital invested in the mineral industry with a relatively larger subsidy for noncorporate producers.

By expensing rather than capitalizing these costs, taxes on income are effectively set to zero. As a capital subsidy, however, expensing is inefficient because it makes investment decisions based on tax considerations rather than inherent economic considerations.

Arguments have been made over the years to justify expensing on the basis of unusual investment risks, the distortions in the corporate income tax, strategic materials and national security, and to protect domestic producers (especially small independents).

There is very little economic justification, however, for this non-neutral tax treatment of E&Ds. Volatile oil prices make oil and gas investments more risky, but this is not the case for other minerals. In any event, mineral price volatility would not justify expensing or other tax subsidies.

The corporate income tax does have efficiency distortions, but income tax integration is the more appropriate policy. Expensing is a costly and inefficient way to increase mineral output and enhance energy security. Expensing may also have adverse environmental consequences by encouraging the development of raw materials as opposed to recycled substitutes.

Selected Bibliography

Conrad, Robert F. "Mining Taxation: A Numerical Introduction," National Tax Journal, v. 33. December 1980, pp. 443-449.

Fenton, Edmund D. "Tax Reform Act of 1986: Changes in Hard Mineral Taxation," Oil and Gas Tax Quarterly, v. 36. September 1987, pp. 85-98.

Randall, Gory. "Hard Mineral Taxation-Practical Problems," Idaho Law Review, v. 19. Summer 1983, pp. 487-503.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industry, GAO/GGD-87-77 FS. Washington, DC: U.S. Government Printing Office, June 1987.

Lazzari, Salvatore. The Effects of the Administration's Tax Reform Proposal on the Mining Industry, Library of Congress, Congressional Research Service Report 85-872E. Washington, DC: July 29, 1985.

--. The Federal Royalty and Tax Treatment of the Hard Rock Minerals Industry: An Economic Analysis, Library of Congress, Congressional Research Service Report 90-493 E. Washington, DC: October 15, 1990.

Natural Resources and Environment

EXCESS OF PERCENTAGE OVER COST DEPLETION:

 

NONFUEL MINERALS

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  ________________________________________________________

 

     Fiscal year  Individuals   Corporations     Total

 

  ________________________________________________________

 

         1995          /1/           0.2          0.2

 

         1996          /1/           0.2          0.2

 

         1997          0.1           0.2          0.3

 

         1998          0.1           0.2          0.3

 

         1999          0.1           0.2          0.3

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Sections 611, 612, 613, and 291.

Description

Firms that extract minerals, ores, and metals from mines are permitted a deduction to recover their capital investment, which depreciates due to the physical and economic depletion of the reserve as the mineral is recovered (section 611).

There are two methods of calculating this deduction: cost depletion, and percentage depletion. Cost depletion allows for the recovery of the actual capital investment -- the costs of discovering, purchasing, and developing a mineral reserve -- over the period during which the reserve produces income.

Each year, the taxpayer deducts a portion of the adjusted basis (original capital investment less previous deductions) equal to the fraction of the estimated remaining recoverable reserves that have been extracted and sold. Under this method, the total deductions cannot exceed the original capital investment.

Under percentage depletion, the deduction for recovery of capital investment is a fixed percentage of the "gross income" -- i.e., sales revenue -- from the sale of the mineral. Under this method, total deductions typically exceed the capital invested.

Section 613 states that mineral producers must claim the higher of cost or percentage depletion. The percentage depletion allowance is available for many types of minerals, at rates ranging from 10 percent (for clay, sand, gravel, stone, etc.) to 22 percent (for sulphur, uranium, asbestos, lead, etc.).

Metal mines generally qualify for a 14-percent depletion, except for gold, silver, copper, and iron ore, which qualify for a 15- percent depletion. The percentage depletion rate for foreign mines is generally 14 percent.

Percentage depletion is limited to 50 percent of the net income from the property (100 percent in the case of oil and gas wells). For corporate taxpayers, section 291 reduces the percentage depletion allowance for iron ore by 20 percent. Allowances in excess of cost basis are treated as a preference item and taxed under the alternative minimum tax.

Impact

Historically, generous depletion allowances and other tax benefits reduced effective tax rates in the minerals industries significantly below tax rates on other industries, providing incentives to increase investment, exploration, and output, especially for oil and gas. It is possible for cumulative depletion allowances to total many times the amount of the original investment.

Issues of principal concern are the extent to which percentage depletion:

/1/ decreases the price of qualifying minerals, and therefore encourages their consumption;

(2) bids up the price of exploration and mining rights; and

(3) encourages the development of new deposits and increases production.

Most analyses of percentage depletion have focused on the oil and gas industry, which -- before the 1975 repeal of percentage depletion for major oil companies -- accounted for the bulk of percentage depletion.

There has been relatively little analysis of the effect of percentage depletion on other industries. The relative value of the percentage depletion allowance in reducing the effective tax rate of mineral producers is dependent on a number of factors, including the statutory percentage depletion rate, income tax rates, and the effect of the net income limitation.

Rationale

Provisions for a depletion allowance based on the value of the mine were made under a 1912 Treasury Department regulation (T.D. 1742), but this was never effectuated.

A court case resulted in the enactment, as part of the Tariff Act of 1913, of a "reasonable allowance for depletion" not to exceed five percent of the value of output. This statute did not limit total deductions; Treasury regulation No. 33 limited total deductions to the original capital investment.

This system was in effect from 1913 to 1918, although in the Revenue Act of 1916, depletion was restricted to no more than the total value of output, and, in the aggregate, to no more than capital originally invested or fair market value by March 1, 1913 (the latter so that appreciation occurring before enactment of income taxes would not be taxed).

On the grounds that the newer mineral discoveries that contributed to the war effort were treated less favorably, discovery value depletion was enacted in 1918. Discovery depletion, which was in effect through 1926, allowed deductions in excess of capital investment because it was based on the market value of the deposit after discovery. In 1921, because of concern with the size of the allowances, discovery depletion was limited to net income; it was further limited to 50 percent of net income in 1924.

For oil and gas, discovery value depletion was replaced in 1926 by the percentage depletion allowance, at the rate of 27.5 percent. This was due to the administrative complexity and arbitrariness, and due to its tendency to establish high discovery values, which tended to overstated depletion deductions.

For other minerals, discovery value depletion continued until 1932, at which time it was replaced by percentage depletion at the following rates: 23 percent for sulphur, 15 percent for metal mines, and 5 percent for coal.

From 1932 to 1950, percentage depletion was extended to most other minerals. In 1950, President Truman recommended a reduction in the top depletion rates to 15 percent, but Congress disagreed. The Revenue Act of 1951 raised the allowance for coal to 10 percent and granted it to more minerals.

In 1954, still more minerals were granted the allowance, and foreign mines were granted a lower rate. In 1969, the top depletion rates were reduced and the allowance was made subject to the minimum tax. The Tax Equity and Fiscal Responsibility Act of 1982 reduced the allowance for corporations that mined coal and iron ore by 15 percent. The Tax Reform Act of 1986 raised the cutback in corporate allowances for coal and iron ore from 15 to 20 percent.

The House version of H.R.. 776, The Comprehensive National Energy Policy Act of 1992, proposed to repeal percentage depletion for mercury, asbestos, uranium, and lead, but this was eliminated in conference.

Assessment

Standard accounting and economic principles state that the appropriate method of capital recovery in the mineral industry is cost depletion adjusted for inflation. The percentage depletion allowance permits mineral producers to continue to claim a deduction even after all the investment costs of acquiring and developing the property have been recovered. Thus it is a mineral production subsidy rather than an investment subsidy.

As a production subsidy, however, percentage depletion is inefficient, encouraging excessive development of existing properties rather than exploration of new one. Although accelerated depreciation for non-mineral assets may lower effective tax rates by speeding up tax benefits, these assets cannot claim depreciation deductions in excess of investment.

However, arguments have been made to justify percentage depletion on grounds of unusual risks, the distortions in the corporate income tax, national security, and to protect domestic producers. Volatile oil prices make oil and gas investments more risky, but this is not necessarily the case for other minerals. In any event, mineral price volatility alone would not necessarily justify percentage depletion or other tax subsidies.

The corporate income tax does have efficiency distortions, but income tax integration is the appropriate policy. Percentage depletion is also a costly and inefficient way to increase mineral output and enhance energy security, which might better be addressed through a stockpiling program such as the Strategic Petroleum Reserve in the case of oil.

Percentage depletion may also have adverse environmental consequences, encouraging the use of raw materials rather than recycled substitutes.

Selected Bibliography

Anderson, Robert D., Alan S. Miller, and Richard D. Spiegelman. "U.S. Federal Tax Policy: The Evolution of Percentage Depletion for Minerals, "Resources Policy, v. 3. September 1977, pp. 165-176.

Conrad, Robert F. "Mining Taxation: A Numerical Introduction," National Tax Journal, v. 33. December, 1980, pp. 443-449.

Davidson, Paul. "The Depletion Allowance Revisited," Natural Resources Journal, v. 10. January 1970, pp. 1-9.

Fenton, Edmund D. "Tax Reform Act of 1986: Changes in Hard Mineral Taxation," Oil and Gas Tax Quarterly, v. 36. September, 1987, pp. 85-98.

Frazier, Jessica and Edmund D. Fenton. "The Interesting Beginnings of the Percentage Depletion Allowance," Oil and Gas Tax Quarterly, v. 38. June 1990, pp. 697-712.

Lazzari, Salvatore. The Effects of the Administration's Tax Reform Proposal on the Mining Industry. Library of Congress, Congressional Research Service Report 85-872E. Washington, DC: July 29, 1985.

--. The Federal Royalty and Tax Treatment of the Hard Rock Minerals Industry: An Economic Analysis. Library of Congress, Congressional Research Service Report 90-493 E. Washington, DC: October 15, 1990.

Randall, Gory. "Hard Mineral Taxation-Practical Problems," Idaho Law Review, v. 19. Summer 1983, pp. 487-503.

Tripp, John D., Hugh D. Grove, and Michael McGrath. "Maximizing Percentage Depletion in Solid Minerals," Oil and Gas Tax Quarterly, v. 30. June 1982, pp. 631-646.

Updegraft, Kenneth E., and Joel D. Zychnick. Transportation of Crude Mineral Production by Mine Owners and its Effect on Hard Minerals Depletion Allowance," Tax Lawyer, v. 35. Winter 1982, pp. 367-387.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industry. GAO/GGD-87-77 FS. June 1987. Washington, DC: U.S. Government Printing Office, June 1987.

                  Natural Resources and Environment

              INVESTMENT CREDIT AND 7-YEAR AMORTIZATION

 

                   FOR REFORESTATION EXPENDITURES

                      Estimated Revenue Loss *

                      [In billions of dollars]

 

  _________________________________________________________

 

     Fiscal year   Individuals  Corporations     Total

 

  _________________________________________________________

 

         1995          /1/           /1/          /1/

 

         1996          /1/           /1/          /1/

 

         1997          /1/           /1/          /1/

 

         1998          /1/           /1/          /1/

 

         1999          /1/           /1/          /1/

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Sections 48(b), 194.

Description

A taxpayer may elect to amortize, over a 7-year period, up to $10,000 of qualifying reforestation expenditures incurred in connection with the commercial production of timber. Absent this provision, such costs would be deducted only when the timber is sold. Qualifying expenditures are the direct costs incurred to plant or seed for forestation or reforestation purposes, including costs for site preparation, seed or seedlings, and labor and tool costs (including depreciation on equipment used for this purpose).

Costs for which the taxpayer has been reimbursed under a govern- mental cost-sharing program generally are excluded. Costs that are deductible currently also are excluded. Costs in excess of $10,000 in any taxable year may not be carried over to succeeding years.

In addition, a 10-percent investment tax credit is allowed for reforestation costs eligible for the amortization election. The same annual limitation applies, and there is no carryover of excess qualifying costs.

Impact

Before enactment of these provisions, all reforestation costs were treated as capital expenditures, to be recovered when the timber was harvested (as are costs in excess of the limits under present law). Allowing costs to be deducted over a 7-year period provides for a more rapid recovery of expenditures for replanting timber plots, reducing the cost of replanting.

The combination of the investment credit and the rapid write-off is roughly the same (in present value terms) as allowing costs to be deducted when incurred at a 34 percent tax rate. As a result, the effective tax rate on the return to planting new timber is approximately zero for corporations and negative for other investors for eligible investments.

Both provisions are subject to the passive loss limitations, and are available only to taxpayers who participate directly in the activity (i.e., mere investors are not eligible). The passive loss limitations restrict deductions to income from the same activity, e.g., deductions cannot be taken against wage income.

Rationale

The reason for the provisions, as stated by the conference committee, was to promote reforestation on private timberlands. They were originally enacted in the Recreational Boating Safety and Facilities Improvement Act of 1980 (P.L. 96-451) and have survived each tax reform effort since.

Assessment

The tax benefit provides an incentive for small timber producers to increase their investment in timber. Absent any general benefits to society, the effect would be to misallocate resources, which causes a welfare loss. Reforestation may, however, provide benefits to society in general (externalities) that are not captured by investors, because of the aesthetic, recreational, and environmental benefits of timber stands. But it is not clear why the subsidy should be directed at small producers. Moreover, direct subsidies or direct Federal ownership of properties may be a more appropriate alternative.

For larger producers, whose investments are greater than the limit, the tax benefits provide a windfall because they do not affect the cost of marginal investments.

Selected Bibliography

Holley, D. Lester, and Kirk P. Pelland. "New Tax Credit Provides Incentive for Reforestation," Forest Farmer. June 1981, pp. 6-8, 15- 16.

Society of American Foresters, Study Group on Forest Taxation. "Forest Taxation," Journal of Forestry, v. 78. July 1980, pp. 1-7.

U.S. Congress. Conference Report to Accompany H.R. 4310. Recreational Boating Safety Act and Facilities Improvement Act of 1980. 96th Congress, 2nd session. September 16, 1980, pp. 16-19.

U.S. Congress, Joint Economic Committee. "The Federal Tax Subsidy of the Timber Industry," by Emil Sunley, in The Economics of Federal Subsidy Programs. 92nd Congress, 2nd session. July 15, 1972.

U.S. Department of Agriculture, Forest Service. A Guide to Federal Income Tax for Timber Owners, Agriculture Handbook No. 596. Washington, DC: U.S. Government Printing Office, September 1982.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industries, Fact Sheet for the Honorable John Melcher, United States Senate. June 1987.

Forest Service: Timber Harvesting, Planting, Assistance Programs and Tax Provisions, Briefing Report to the Honorable Sander M. Levin, House of Representatives. April 1990.

                  Natural Resources and Environment

              EXPENSING MULTIPERIOD TIMBER-GROWING COSTS

                       Estimated Revenue Loss

                       [In billion of dollars]

 

  ________________________________________________________

 

      Fiscal Year  Individuals  Corporations     Total

 

  ________________________________________________________

 

         1995          /1/           0/4          0.4

 

         1996          /1/           0.4          0.4

 

         1997          /1/           0.5          0.5

 

         1998          0.1           0.5          0.6

 

         1999          0.1           0.5          0.6

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Sections 162, 263(d)(1).

Description

Most of the production costs of maintaining a timber stand after it is established are expensed (deducted when incurred), rather than capitalized (reducing gain when the timber is sold). These costs include indirect carrying costs (e.g., interest and property taxes) as well as costs of disease and pest control and brush clearing. Other costs, such as the costs of planting the stand, are capitalized. In most other industries, such indirect costs are capitalized under the uniform capitalization rules.

Impact

By allowing the deduction of expenses when incurred, the effective tax rate on investments in these indirect costs is zero. This provision lowers the effective tax rate on timber growing in general. The extent of the effect of tax provisions on the timber industry is in some dispute. Most of the benefit goes to corporations, and thus is likely to benefit higher-income individuals (see discussion in introduction).

Rationale

The original ability to expense indirect costs of timber growing was apparently part of a general perception that these costs were maintenance costs, and thus deductible as ordinary costs of a trade or business. There were a series of revenue rulings and court cases over the years distinguishing between what expenses might be deductible and what expenses might be capitalized (e.g., I. T. 1610 in 1923, an income tax unit ruling), Mim. 6030 in 1946 (a mimeographed letter ruling), Revenue Ruling 55-412 in 1955, and Revenue Ruling 66-18 in 1966).

The Tax Reform Act of 1986 included uniform capitalization rules which required indirect expenses of this nature to be capitalized in most cases. Several exception were provided, including timber. There is no specific reason given for exempting timber per se, but the general reason given for exceptions to the uniform capitalization rules is that they are cases were application "might be unduly burdensome."

Assessment

The tax benefit provides a forgiveness of tax on the return to part of the investment in timber growing. Absent any general benefits to society, the effect is to misallocate resources, which causes a welfare loss. Timber growing might, however, provide benefits to society in general (externalities) that are not captured by investors, because of the aesthetic, recreational, and environmental benefits of timber stands. But the tax approach must be weighed against direct subsidies and direct ownership of timber lands by the government to accomplish these objectives.

Selected Bibliography

Society of American Foresters, Study Group on Forest Taxation. "Forest Taxation." Journal of Forestry, v. 78. July 1980, pp. 1-7.

U.S. Congress, Joint Economic Committee. "The Federal Tax Subsidy of the Timber Industry," by Emil Sunley, in The Economics of Federal Subsidy Programs. 92nd Congress, 2nd session. July 15, 1972.

--, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. May 4, 1987, pp. 508-509.

U.S. Department of Agriculture, Forest Service. A Guide to Federal Income Tax for Timber Owners, Agriculture Handbook No. 596. Washington, DC: U.S. Government Printing Office, September 1982.

U.S. Department of Treasury. Tax Reform for Fairness, Simplicity and Economic Growth, vol. 2. Pp. 202-211.

U.S. General Accounting Office. Selected Tax Provisions Affecting the Hard Minerals Mining and Timber Industries, Fact Sheet for the Honorable John Melcher, United States Senate. June 1987.

--, Forest Service: Timber Harvesting, Planting, Assistance Programs and Tax Provisions, Briefing Report to the Honorable Sander M. Levin, House of Representatives. April 1990.

                  Natural Resources and Environment

                        EXCLUSION OF INTEREST

 

            ON STATE AND LOCAL GOVERNMENT SEWAGE, WATER,

 

                 AND HAZARDOUS WASTE FACILITY BONDS

                       Estimated Revenue Loss

                      [In billions of dollars]

 

______________________________________________________________

 

     Fiscal year   Individuals  Corporations     Total

 

______________________________________________________________

 

         1995          0.5           0.2          0.7

 

         1996          0.5           0.2          0.7

 

         1997          0.5           0.2          0.7

 

         1998          0.5           0.2          0.7

 

         1999          0.5           0.2          0.7

Authorization

Sections 103, 141, 142, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance the construction of sewage facilities, facilities for the furnishing of water, and facilities for the disposal of hazardous waste is tax exempt.

These bonds are classified as private-activity bonds rather than as governmental bonds because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

The bonds for these facilities are subject to the State private- activity bond annual volume cap.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to finance the facilities at reduced interest rates.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the sewage, water, and hazardous waste facilities, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Prior to 1968, no restriction was placed on the ability of State and local governments to issue tax-exempt bonds to finance sewage, water, and hazardous waste facilities. Although the Revenue and Expenditure Control Act of 1968 imposed tests that would have restricted issuance of these bonds, it provided a specific exception for sewage and water (allowing continued unrestricted issuance).

Water-furnishing facilities must be made available to the general public (including electric utility and other businesses), and must be either operated by a governmental unit or have their rates approved or established by a governmental unit.

The hazardous waste exception was adopted by the Tax Reform Act of 1986. The portion of a hazardous waste facility that can be financed with tax-exempt bonds cannot exceed the portion of the facility to be used by entities other than the owner or operator of the facility. In other words, a hazardous waste producer cannot use tax-exempt bonds to finance a facility to treat its own wastes.

Assessment

Some of the benefits from investing in these environmentally oriented activities are enjoyed by society as a whole, and some of them accrue to people outside the political boundaries of State and local governments. It is expected that these activities are provided in inadequate amounts by the private and State-local sectors. Providing a Federal subsidy encourages greater sewage, water, and hazardous waste control investment.

Because a portion of the cost is paid by taxpayers rather than by the entities producing the hazardous waste or environmental pollution, the producers of the pollution are encouraged to maintain too high a level of output. The Nation seems uncertain about the desirability of subsidizing such private investments in the environment. The Tax Reform Act of 1986 terminated the general eligibility of private industry's pollution control investment for tax-exempt financing, but several proposals have been introduced that would reinstate eligibility in some form.

Even if a case can be made for subsidy of these activities, it is important to recognize the costs that accrue. As one of many categories of tax-exempt private-activity bonds, bonds issued for these activities have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Peterson, George, and Harvey Galper. "Tax-Exempt Financing of Private Industry's Pollution Control Investment," Public Policy. Winter 1975, pp. 81-103.

Zimmerman, Dennis. Environmental Infrastructure and the State- Local Sector: Should Tax-Exempt Bond Law Be Changed? Library of Congress, Congressional Research Service Report 81-866 E. Washington, DC: December 16, 1991.

--. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activities. Washington, DC: The Urban Institute Press, 1991.

                  Natural Resources and Environment

                        INVESTMENT TAX CREDIT

 

              FOR REHABILITATION OF HISTORIC STRUCTURES

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  _________________________________________________________

 

     Fiscal year   Individuals  Corporations     Total

 

  _________________________________________________________

 

         1995          /1/           0.1          0.1

 

         1996          /1/           0.1          0.1

 

         1997          /1/           0.1          0.1

 

         1998          /1/           0.1          0.1

 

         1999          /1/           0.1          0.1

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 47.

Description

Expenditures on certified structures qualify for a 20 percent tax credit if used to substantially rehabilitate historic structures for use as residential rental or commercial property. The basis (cost for purposes of depreciation) of the building is reduced by the credit.

The amount of the credit that can be offset against unrelated income is limited to the equivalent of $25,000 in deductions under the passive loss restriction rules.

Certified historic structures are either individually registered in the National Register of Historic Places or are structures certified by the Secretary of the Interior as having historic significance and located in a registered historic district. The State Historic Preservation Office reviews applications and forwards recommendations for designation to the Interior Department.

Impact

The credit reduces the taxpayer's cost of preservation projects. Prior to tax reform in 1986, historic preservation projects had become a popular tax shelter with rapid growth. The limits on credits under the passive loss restrictions limit the use of this investment as a tax shelter.

Rationale

Rapid depreciation (over five years) of these investments was adopted in 1976 as an incentive in response to declining usefulness of older buildings and designed to promote stability and economic vitality to deteriorating areas through rehabilitating and preserving historic structures and neighborhoods. Achievement of this goal was thought dependent upon enlistment of private funds in the preservation movement.

Partly in a move toward simplification and partly to add counterbalance to new provisions for accelerated cost recovery, the tax incentives were changed to a tax credit in 1981 and made part of a set of credits for rehabilitating older buildings (varying by type or age).

The credit amount was reduced in 1986 because the rate was deemed too high when compared with the new lower tax rates, and a reduction from a three- to a two-tiered rehabilitation rate credit was adopted. A higher credit rate was allowed for preservation of historic structures than for rehabilitations of older qualified buildings first placed in service prior to 1936.

Assessment

Owners of historic buildings are encouraged to renovate them through the use of the 20 percent tax credit available for substantial rehabilitation expenditures approved by the Department of the Interior. Opponents of the credit note that investments are allocated to historic buildings that would not be profitable projects without the credit, resulting in economic inefficiency. Proponents argue that investors fail to consider external benefits (preservation of social and aesthetic values) which are desirable for society at large.

Selected Bibliography

Everett, John O. "Rehabilitation Tax Credit Not Always Advantageous," Journal of Taxation. August 1989, pp. 96-102.

Preservation Tax Incentives for Historic Buildings. Washington, DC: U.S. National Park Service, 1990.

U.S. General Account Office. Historic Preservation Tax Incentives. August 1, 1986. Washington, DC: GAO, August 1, 1986.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Act of 1978 (H.R. 13511, 95th Congress; Public Law 95- 600). Washington, DC: U.S. Government Printing Office, March 12, 197, pp. 155-158.

--. General Explanation of the Economic Recovery Tax Act of 1981 (H.R. 4242, 97th Congress; Public Law 97-34). Washington, DC: U.S. Government Printing Office, December 31, 1981, pp. 111-116.

--. General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress; Public Law 99-514). Washington, DC: U.S. Government Printing Office, May 4, 1987, pp. 148-152.

Taylor, Jack. Income Tax Treatment of Rental Housing and Real Estate Investment After the Tax Reform Act of 1986. Library of Congress, Congressional Research Service Report 87-603 E. Washington, DC: July 2, 1987.

Natural Resources and Environment

SPECIAL RULES FOR MINING RECLAMATION RESERVES

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  _________________________________________________________

 

     Fiscal year   Individuals  Corporations     Total

 

  _________________________________________________________

 

         1995          /1/           /1/          /1/

 

         1996          /1/           /1/          /1/

 

         1997          /1/           /1/          /1/

 

         1998          /1/           /1/          /1/

 

         1999          /1/           /1/          /1/

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 468.

Description

Firms are generally not allowed to deduct a future expense until "economic performance" occurs -- that is, until the service it pays for is performed and the expense is actually paid. Electing taxpayers may, however, deduct the current-value equivalent of certain estimated future reclamation and closing costs for mining and solid waste disposal sites.

For Federal income tax purposes, the amounts deducted prior to economic performance are deemed to earn interest at a specified interest rate. When the reclamation has been completed, any excess of the amounts deducted plus deemed accrued interest over the actual reclamation or closing costs is taxed as ordinary income.

Impact

Section 468 permits reclamation and closing costs to be deducted at the time of the mining or waste disposal activity that gives rise to the costs. Absent this provision, the costs would not be deductible until the reclamation or closing actually occurs and the costs are paid. Any excess amount deducted in advance (plus deemed accrued interest) is taxed at the time of reclamation or closing.

Rationale

This provision was adopted in 1984. Proponents argued that allowing current deduction of mine reclamation and similar expenses is necessary to encourage reclamation, and to prevent the adverse economic effect on mining companies that might result from applying the general tax rules regarding deduction of future costs.

Assessment

Reclamation and closing costs for mines and waste disposal sites that are not incurred concurrently with production from the facilities are capital expenditures. Unlike ordinary capital expenditures, however, these outlays are made at the end of an investment project rather than at the beginning.

Despite this difference, amortizing (writing off) these capital costs over the project life is appropriate from an economic perspective. This amortization parallels depreciation of up-front capital costs. The tax code does not provide systematic recognition of such end-of-project capital costs. Hence they are treated under special provisions that provide exceptions to the normal rule of denying deduction until economic performance.

It is debatable, however, whether such exceptions should be regarded as tax expenditures. The tax code provides essentially similar treatment for nuclear power plant decommissioning costs, for example, which are also end-of-project capital costs, but in that case the treatment is not counted as a tax expenditure.

Selected Bibliography

Halperin, Daniel I. "Interest in Disguise: Taxing the 'Time Value of Money,"' The Yale Law Journal. January 1986, pp. 506-552.

Kiefer, Donald W. "The Tax Treatment of a 'Reverse Investment,'" Tax Notes. March 4, 1985, pp. 925-932.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th Congress, 2nd session, December 31, 1984, pp. 273-276.

                             Agriculture

                 EXCLUSION OF COST-SHARING PAYMENTS

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  _________________________________________________________

 

     Fiscal year   Individuals  Corporations     Total

 

  _________________________________________________________

 

         1995          /1/           /1/          /1/

 

         1996          /1/           /1/          /1/

 

         1997          /1/           /1/          /1/

 

         1998          /1/           /1/          /1/

 

         1999          /1/           /1/          /1/

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 126.

Description

There are a number of programs under which both the Federal and State Governments make payments to taxpayers which represent a share of the cost of certain improvements made to the land. These programs generally relate to improvements which further conservation, protect the environment, improve forests, or provide habitats for wildlife. Under Section 126, the grants received under certain of these programs are excluded from the recipient's gross income.

To qualify for the exclusion, the payment must be made primarily for the purpose of conserving soil and water resources or protecting the environment, and the payment must not produce a substantial increase in the annual income from the property with respect to which the payment was made.

Impact

The exclusion of these grants and payments from tax provides a general incentive for various conservation and land improvement projects that might not otherwise be undertaken.

Rationale

The income tax exclusion for certain cost-sharing payments was part of the tax changes made under the Revenue Act of 1978. The rationale for this change was that in the absence of an exclusion many of these conservation projects would not be undertaken. In addition, since the grants are spent by the taxpayer on conservation projects, the taxpayer would not necessarily have the additional funds needed to pay the tax on the grants if they were not excluded from taxable income.

Assessment

The partial exclusion of certain cost-sharing payments is based on the premise that the improvements financed by these grants benefit both the general public and the individual landowner. The portion of the value of the improvement financed by grant payments attributable to public benefit should be excluded from the recipient's gross income while that portion of the value primarily benefitting the landowner (private benefit) is properly taxable to the recipient of the payment.

The problem with this tax treatment is that there is no way to identify the true value of the public benefit. In those cases where the exclusion of cost-sharing payment is insufficient to cover the value of the public benefit, the project probably would not be undertaken.

On the other hand, on those projects that are undertaken the exclusion of the cost-sharing payment probably exceeds the value of the public benefit and hence, provides a subsidy primarily benefitting the landowner.

Selected Bibliography

U.S. Congress. Joint Committee on Taxation. General Explanation of the Revenue Act of 1978.

--. Senate Committee on Finance. Technical Corrections Act of 1979, 96th Congress, 1st session. December 13, 1979, pp. 79-81.

                             Agriculture

                      EXCLUSION OF CANCELLATION

 

                  OF INDEBTEDNESS INCOME OF FARMERS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          0.1           --          0.1

 

              1996          0.1           --          0.1

 

              1997          0.1           --          0.1

 

              1998          0.1           --          0.1

 

              1999          0.1           --          0.1

 

_____________________________________________________________________

Authorization

Sections 108 and 1017.

Description

This provision allows farmers who are solvent to treat the income arising from the cancellation of certain indebtedness as if they were insolvent taxpayers. Under this provision, income that would normally be subject to tax, the cancellation of a debt, would be excluded from tax if the discharged debt was "qualified farm debt" discharged or canceled by a "qualified person."

To qualify, farm debt must meet two tests: it must be incurred directly from the operation of a farming business, and at least 50 percent of the taxpayer's previous three years of gross receipts must come from farming.

To qualify, those canceling the qualified farm debt must participate regularly in the business of lending money, cannot be related to the taxpayer who is excluding the debt, cannot be a person from whom the taxpayer acquired property securing the debt, or cannot be a person who received any fees or commissions associated with acquiring the property securing the debt. Qualified persons include federal, state, and local governments.

The amount of canceled debt that can be excluded from tax cannot exceed the sum of adjusted tax attributes and adjusted basis of qualified property. Any canceled debt that exceeds this amount must be included in gross income. Tax attributes include net operating losses, general business credit carryovers, capital losses, minimum tax credits, passive activity loss and credit carryovers, and foreign tax credit carryovers. Qualified property includes business (depreciable) property and investment (including farmland) property.

Taxpayers can elect to reduce the basis of their property before reducing any other tax benefits.

Impact

This exclusion allows solvent farmers to defer the tax on the income resulting from the cancellation of a debt. This tax benefit is not available to other taxpayers unless they are insolvent.

Rationale

The exclusion for the cancellation of qualified farm indebtedness was enacted as part of the Tax Reform Act of 1986. At the time, the intended purpose of the provision was to avoid tax problems that might arise from other legislative initiatives designed to alleviate the credit crisis in the farm sector.

For instance, Congress was concerned that pending legislation providing Federal guarantees for lenders participating in farm-loan write-downs would cause some farmers to recognize large amounts of income when farm loans were canceled. As a result, these farmers might be forced to sell their farmland to pay the taxes on the canceled debt. This tax provision was adopted to mitigate that problem.

Assessment

The exclusion of cancellation of qualified farm income indebtedness does not constitute a forgiveness of tax but rather a deferral of tax. By electing to offset the canceled debt through reductions in the basis of property, a taxpayer can postpone the tax that would have been owed on the canceled debt until the basis reductions are recaptured when the property is sold or through reduced depreciation in the future. Since money has a time value (a dollar today is more valuable than a dollar in the future), however, the deferral of tax provides a benefit in that it effectively lowers the tax rate on the income realized from the discharge of indebtedness.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986.

--, House Committee on the Budget Conference Report. Omnibus Budget Reconciliation Act of 1993. Washington, DC, 1993.

                             Agriculture

            CASH ACCOUNTING AND EXPENSING FOR AGRICULTURE

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          0.2           0.1         0.3

 

              1996          0.2           0.1         0.3

 

              1997          0.2           0.1         0.3

 

              1998          0.2           0.1         0.3

 

              1999          0.2           0.1         0.3

 

____________________________________________________________________

Authorization

Sections 162, 175, 180, 447, 461, 464, and 465.

Description

Most farm businesses (with the exception of certain farm corporations and partnerships or any tax shelter operation) may use the cash method of tax accounting to deduct costs attributable to goods held for sale and in inventory at the end of the tax year. These businesses are also allowed to expense some costs of developing assets that will produce income in future years. Both of these rules thus allow deductions to be claimed before the income associated with the deductions is realized.

Costs that may be deducted before income attributable to them is realized include livestock feed and the expenses of planting crops for succeeding year's harvest. Costs that otherwise would be considered capital expenditures but that may be deducted immediately by farmers include certain soil and water conservation expenses, costs associated with raising dairy and breeding cattle, and fertilizer and soil conditioner costs.

Impact

For income tax purposes, the cash method of accounting is less burdensome than the accrual method of accounting and also provides benefits in that it allows taxes to be deferred into the future. Farmers who use the cash method of accounting and the special expensing provisions receive tax benefits not available to taxpayers required to use the accrual method of accounting.

Rationale

The Revenue Act of 1916 established that a taxpayer may compute income for tax purposes using the same accounting methods used to compute income for business purposes. At the time, because accounting methods were less sophisticated and the typical farming operation was small, the regulations were apparently adopted to simplify record keeping for farmers.

Specific regulations relating to soil and water conservation expenditures were adopted in the Internal Revenue Code of 1954. Provisions governing the treatment of fertilizer costs were added in 1960.

The Tax Reform Act of 1976 required that certain farm corporations and some tax shelter operations use the accrual method of accounting rather than cash accounting. The Tax Reform Act of 1986 further limited the use of cash accounting by farm corporations and tax shelters and repealed the expensing rules for certain land clearing operations. The Act also limited the use of cash accounting for assets that had preproductive periods longer than two years. These restrictions, however, were later repealed by the Technical and Miscellaneous Revenue Act of 1988.

Assessment

The effect of deducting costs before the associated income is realized understates income in the year of deduction and overstates income in the year of realization. The net result is that tax liability is deferred which results in an underassessment of tax. In addition, in certain instances when the income is finally taxed, it may be taxed at preferential capital gains rates.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Act of 1978.

U.S. Senate, Committee on Finance. Technical Corrections Act of 1979. 96th Congress, 1st session, December 13, 1979, pp. 79-81.

                        Commerce and Housing:

 

                       Financial Institutions

             BAD DEBT RESERVES OF FINANCIAL INSTITUTIONS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          --            0.1         0.1

 

              1996          --            0.1         0.1

 

              1997          --            0.1         0.1

 

              1998          --            0.1         0.1

 

              1999          --            0.1         0.1

 

_____________________________________________________________________

Authorization

Sections 585, 593, and 596.

Description

All businesses must use the specific charge-off method in deducting (writing off) bad debts, except for small banks ($500 million or less in assets) and thrift institutions, which may chose a reserve method.

The specific charge-off method requires that bad debts be wholly or partially written off at the time they become wholly or partially worthless. Under a reserve method, a taxpayer deducts additions to a reserve for bad debts. When debts are determined to be worthless, no deduction is allowed, but the amount of the bad debt is charged against the reserve (that is, the reserve is reduced).

Small banks use an experience method which is based on the average amount of bad debts for the past six-year period. A thrift can also chose the percentage-of-taxable-income method, where eight percent of taxable income is deducted, but only if 60 percent of its assets are qualified (essentially residential mortgages).

Impact

The use of the reserve method allows deductions to be taken before losses actually occur, and therefore defers tax, lowering the effective tax rate on the financial institution.

A thrift using the percentage-of-taxable-income method has an incentive to hold at least 60 percent of its assets in residential mortgages. These lower effective tax rates would primarily benefit stockholders. Since most stock of small banks and thrifts is owned by higher-income families, the benefits of this tax preference primarily accrue them.

Rationale

The tax treatment of commercial banks evolved separately from that of thrift institutions. The allowance for special bad debt reserves of commercial banks was first provided by an IRS ruling in 1947, when there was fear of a postwar economic downturn. It was intended to reflect the banking industry's experience during the depression.

In 1969 and 1981, legislation reduced the tax preference for bad debt reserves for commercial banks. In 1986, legislation repealed the reserve method for large banks, but maintained it for small banks because of concern about potential adverse effects on small banks. The reserve method was believed to contribute to a too-low effective tax rate on large banks.

The special treatment of bad debt reserves for thrift institutions was added by statute in 1951. Before that, savings and loan associations and mutual savings banks were viewed as mutual organizations and were exempt from taxation.

Upon removal of this tax-exempt status, special -- and very favorable -- treatment of bad debt reserves was provided, which in effect left these institutions virtually tax exempt for a number of years.

Some of the same factors which led to their tax exemption probably account for the special allowance for bad debts, especially the belief that these institutions fill an important role in providing residential mortgages. In 1986, legislation reduced the magnitude of the percentage-of-taxable-income reserve method because of the reduced distinction between thrifts and other depository institutions.

Assessment

The current tax treatment for bad debt reserves gives preferential treatment to thrifts and small banks, and to thrifts in particular. It can be argued that the tax preference to small banks assists them in competing with larger banks, and thus consumers have a wider selection among banks and pay lower prices for banking services.

Furthermore, the tax preferences for thrifts helps allocate more financial capital into residential mortgages, which assists people in purchasing homes.

Opponents of these tax preferences argue that deregulation and technological change have caused vigorous competition among depository institutions. They argue that for market forces to allocate resources efficiently, all depository institutions and other businesses should receive the same tax treatment; that is, all businesses should be required to use the specific charge-off method for bad debt losses.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. Current Tax Rules Relating to Financially Troubled Savings and Loan Associations, JCS- 3-89. February 16, 1989, pp. 21-23.

--. General Explanation of the Tax Reform Act of 1986, JCS-10- 87. May 4, 1987, pp. 549-557.

                        Commerce and Housing:

 

                       Financial Institutions

                  EXEMPTION OF CREDIT UNION INCOME

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          --            0.7         0.7

 

              1996          --            0.7         0.7

 

              1997          --            0.7         0.7

 

              1998          --            0.8         0.8

 

              1999          --            0.8         0.8

 

_____________________________________________________________________

Authorization

Section 501(c)(14) of the Internal Revenue Code of 1986 and section 122 of the Federal Credit Union Act, as amended (12 U.S.C. sec. 1768).

Description

Credit unions without capital stock and organized and operated for mutual purposes and without profit are not subject to Federal income tax.

Impact

Credit unions are the only depository institutions which are exempt from Federal income taxes. If this exemption is repealed, both Federally chartered and State chartered credit unions would become liable for payment of Federal corporate income taxes on their retained earnings but not on earnings distributed to depositors.

For a given addition to retained earnings, this tax exemption permits credit unions to pay members higher dividends and charge members lower interest rates on loans. Over the past twenty years, this tax exemption may have contributed to the more rapid growth of credit unions compared to other depository institutions.

Opponents of credit union taxation emphasize that credit unions provide many services free or below cost in order to assist low- income members. These services include small loans, financial counseling, and low-balance share drafts. They argue that the taxation of credit unions would create pressure to eliminate these subsidized services. But whether or not consumer access to basic depository services is a significant problem is disputed. Furthermore, access for low-income people could be addressed by regulatory changes applicable to all depository institutions.

Rationale

Credit unions have never been subject to the Federal income tax. Initially, they were included in the provision that exempted domestic building and loan associations -- whose business was at one time confined to lending to members -- and nonprofit cooperative banks operated for mutual purposes. The exemption for mutual banks and savings and loan institutions was removed in 1951, but credit unions retained their exemption. No specific reason was given for continuing the exemption of credit unions.

In 1978, the Carter Administration proposed that the taxation of credit unions be phased in over a five-year period. In 1984, a report of the Department of the Treasury to the President proposed that the tax exemption of credit unions be repealed. In 1985, the Reagan Administration proposed the taxation of credit unions with over $5 million in gross assets. In the budget for fiscal year 1993, the Bush Administration proposed that the tax exemption for credit unions with assets in excess of $50 million be repealed.

Assessment

Opponents of credit union taxation emphasize the uniqueness of credit unions compared to other depository institutions. Credit unions are nonprofit financial cooperatives organized by people with a common bond which is a unifying characteristic among members that distinguishes them from the general public.

Credit unions are directed by volunteers for the purpose of serving their members. Consequently, opponents maintain that credit unions are member-driven while other depository institutions are profit-driven. Furthermore, opponents of taxation argue that credit unions are subject to certain regulatory constraints not required of other depository institutions and that these constraints reduce the competitiveness of credit unions. For example, credit unions may lend only to members.

Proponents of taxation argue that deregulation has caused extensive competition among all depository institutions, including credit unions.

Financial deregulation can be divided into price, product, and geographic deregulation:

Price deregulation concerns the loosening or elimination of restrictions on interest rates that depository institutions may pay on supplies of funds and charge on loans. Price deregulation has caused credit to be rationed more by price than by availability.

Product deregulation is blurring the distinctions among products offered by different types of depository institutions.

Geographic deregulation has been particularly important to commercial banks and bank holding companies which are prevented by Federal and State banking laws from offering full-service interstate banking. Deregulation has assisted banks in offering specific financial services across State lines.

Proponents of taxation argue that depository institutions should have a level playing field in order for market forces to allocate resources efficiently.

Selected Bibliography

Bickley, James M. Should Credit Unions be Taxed? Library of Congress, Congressional Research Service Report No. 90-498 E. Washington, DC: October 16, 1990.

U.S. Congress, Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. Washington, DC: U.S. Government Printing Office, March 1994, p. 328.

U.S. General Accounting Office. Credit Unions: Reforms for Ensuring Future Soundness. Washington, DC: July 1991, pp. 299-309.

                        Commerce and Housing:

 

                         Insurance Companies

                   EXCLUSION OF INVESTMENT INCOME

 

               ON LIFE INSURANCE AND ANNUITY CONTRACTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year   Individuals  Corporations      Total

 

____________________________________________________________________

         1995          10.3          0.8          11.1

 

         1996          11.5          0.9          12.4

 

         1997          12.4          1.0          13.4

 

         1998          13.3          1.1          14.4

 

         1999          14.3          1.2          15.5

 

____________________________________________________________________

Authorization

Section 72, 101, 7702, 7702A.

Description

The premiums life insurance companies collect are invested and the investment return used to help pay benefits. Amounts not paid as benefits may be paid as policy dividends or made available to the policyholders as cash surrender values or loan values.

This investment income (also called "inside build-up") is generally not taxed to the policyholders as it accumulates (and it is not usually taxed at the company level, either). For most policies, amounts paid as death benefits are not taxed at all, and amounts paid as dividends or withdrawn as cash values are taxed only when they exceed total premiums paid for the policy, allowing the cost of the insurance protection to be paid for in part by the tax-free investment income.

Annuity policies are also free from tax on the accumulating investment income, but annuities are taxed on their investment component when paid.

Life insurance policies must meet tests designed to limit the tax-free accumulation of income. If they accumulate investment income very much faster than is needed to fund the promised benefits, the income will be attributed to the owner of the policy and taxed currently. If the owner of any life insurance policy is a corporation, the investment income is included in alternative minimum taxable income.

Impact

The effect of the interest exclusion on life insurance savings allows personal insurance to be partly purchased with tax-free interest income. Although the interest earned is not currently paid to the policyholder, it is used to cover at least part of the cost of the insurance coverage, and it may be received in cash if the policy is terminated. In spite of recent limitations on the amount of income that can accumulate tax-free in a contract, the tax-free interest income benefit can be substantial.

The tax deferral for interest credited to annuity contracts allows taxpayers to save for retirement in a tax-deferred environment without restriction on the amount that can be invested for these purposes. Although the amounts invested in an annuity are not deductible by the taxpayer, as are contributions to qualified pension plans or some IRA'S, the tax deferral on the income credited to such investments represents significant tax benefits for the taxpayer.

These provisions thus offer preferential treatment for the purchase of life insurance coverage and for savings held in life insurance policies and annuity contracts. Because middle-income taxpayers are the major purchasers of this insurance, they are the primary beneficiaries of the provision. Higher-income taxpayers who are not seeking insurance protection can generally obtain better after-tax yields from tax-exempt State and local obligations or tax- deferred capital gains.

Rationale

The exclusion of death benefits paid on life insurance dates back to the 1913 tax law. While no specific reason was given for exempting such benefits, insurance proceeds may have been excluded because they were believed to be comparable to bequests, which also were excluded from the tax base.

The nontaxable status of the life insurance inside build-up and the tax deferral on annuity investment income also dates from 1913. Floor discussions of the bill made it clear that inside build-up was not taxable, and that amounts received during the life of the insured would be taxed only when they exceeded the investment in the contract (premiums paid), although these provisions were not explicitly included in the law.

These rules were to some extent based on the general tax principle of constructive receipt. The interest income was not viewed as actually belonging to the policyholders because they would have to give up the insurance protection or the annuity guarantees to obtain the interest.

The inside build-up in several kinds of insurance products was made taxable to the policy owners in recent years. (Corporate-owned policies were included under the minimum tax in the Tax Reform Act of 1986. Policies with too large an investment component were made taxable on inside build-up or on distributions in the Deficit Reduction Act of 1984, and the Technical and Miscellaneous Revenue Act of 1988.) This suggests that the Congress no longer finds completely persuasive the exclusion rationale based on the constructive receipt doctrine.

Assessment

The tax treatment of policy income combined with the tax treatment of life insurance company reserves (see "Special Treatment of Life Insurance Company Reserves," below) makes investments in life insurance policies virtually tax-free. This distorts investors' decisions by encouraging them to choose life insurance over competing savings vehicles such as bank accounts, mutual funds, or bonds. The result could be too much invested in life insurance and excessive use of life insurance protection.

There is some evidence, however, that people underestimate the financial loss their deaths could cause and so tend to be underinsured. If this is the case, some encouragement of the purchase of life insurance might be warranted. There is no evidence of the degree of encouragement required or of the efficacy of providing that encouragement through tax exemption.

The practical difficulties of taxing inside build-up to the policy owners and the desire not to add to the distress of heirs by taxing death benefits have discouraged many tax reform proposals covering life insurance. Taxing at the company level as a proxy for individual income taxation has been a suggested alternative.

Selected Bibliography

Goode, Richard. "Policyholders' Interest Income from Life Insurance Under the Income Tax," Vanderbilt Law Review. December 1962, pp. 33-55.

--, The Individual Income Tax (revised ed.). Washington, DC: The Brookings Institution, 1976, pp. 125-133.

Kotlikoff, Lawrence J. The Impact of Annuity Insurance on Savings and Inequality, Cambridge, Mass.: National Bureau of Economic Research, 1984.

McClure, Charles E. "The Income Tax Treatment of Interest Earned on Savings in Life Insurance," in U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs, Part 3, "Tax Subsidies." July 15, 1972, pp. 370-405.

Taylor, Jack. How Life Insurance Policies Generate Investment Income. Library of Congress, Congressional Research Service Report 90-290 E. June 15, 1990.

--. Taxing Deferred Annuities. Library of Congress, Congressional Research Service Report 92-170 E. February 13, 1992.

U.S. Congress, Committee on Ways and Means. Technical and Miscellaneous Revenue Act of 1988, Conference Report to Accompany H.R. 4333, House Report 100-1104. October 21, 1988, pp. 96-108.

--, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, JCS-41-84. December 31, 1984, pp. 572-665.

--. Tax Reform Proposals: Taxation of Insurance Products and Companies, JCS-41-85. September 20, 1985, pp. 2-16.

U.S. Department of the Treasury. Report to the Congress on the Taxation of Life Insurance Company Products. March 30, 1990.

U.S. General Accounting Office. Tax Treatment of Life Insurance and Annuity Accrued Interest, GAO/GGD-90-31. January 1990.

Vickrey, William S. Agenda for Progressive Taxation. New York: Ronald Press, 1947 (reprinted Clifton, NJ: Kelley, 1970), pp. 64-75.

--. "Insurance Under the Federal Income Tax, "Yale Law Journal. June 1943, pp. 554-585.

                        Commerce and Housing:

 

                         Insurance Companies

                   EXCLUSION OF INVESTMENT INCOME

 

                 FROM STRUCTURED SETTLEMENT ACCOUNTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year  Individuals   Corporations     Total

 

____________________________________________________________________

         1995          --            /1/          /1/

 

         1996          --            /1/          /1/

 

         1997          --            /1/          /1/

 

         1998          --            /1/          /1/

 

         1999          --            /1/          /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million

                           END OF FOOTNOTE

Authorization

Section 104(A)(2), 130.

Description

Liability for periodic damage payments due to personal injury or sickness may be satisfied by arranging with a third party, called a "structured settlement company," to assume liability for the payments.

The settlement company receives a lump-sum payment from the person liable for the damages, purchases an annuity from an insurance company (or a U.S. bond) to fund the periodic payments, and passes the payments on to the injured party. The entire transaction is tax- free (although the settlement company is taxable on any profit it makes on the deal). Since damage payments received because of personal injury or sickness are excluded from the gross income of the recipient, the interest component of the annuity payments are not taxable to anyone.

Impact

If the injured party received a lump-sum settlement and invested the proceeds, the lump-sum amount would be tax-free but the earnings on it would be taxable (and the settlement would need to be higher to make up the difference). Funding periodic payments through a third party who has accepted the legal liability to make them allows the person responsible for the damages to clear his books of the liability. It costs less, since his lump-sum payment compounds tax- free. Thus the principal beneficiaries of the provision are probably the persons responsible for causing the damages or sickness.

Rationale

Section 104 was amended in P.L. 97-473 to insure that periodic payments would qualify as tax-free damage payments. The tax exemption for the structured settlement funds, which was added at the same time, was not discussed in the committee reports in terms of the investment income, but only with regard to the initial payment.

Assessment

Allowing those responsible for causing injury or sickness to reduce the cost of their actions by tax-exempt funding of liabilities may encourage less responsible behavior. This tax exemption will also encourage investment through the particular vehicles prescribed (insured annuities and Government bonds) rather than through competing vehicles (banks, mutual funds). The tax benefit may be shared with the injured parties (or their attorneys) under some conditions.

Selected Bibliography

Cane, Michael A. "How to Use and Benefit from Structured Settlements in Personal Injury Suits," The Journal of Taxation. November, 1983, pp. 330-333.

U.S. Congress, Committee on Ways and Means. Report to Accompany H.R. 5470, No. 97-832. September 16, 1982, pp. 3-6.

--, Joint Committee on Taxation. Tax Reform Proposals: Taxation of Insurance Products and Companies, JCS-41-85. September 20, 1985, pp. 18-20.

                        Commerce and Housing:

 

                         Insurance Companies

                    SMALL LIFE INSURANCE COMPANY

 

                      TAXABLE INCOME ADJUSTMENT

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal Year  Individuals   Corporations     Total

 

____________________________________________________________________

         1995          --            0.1          0.1

 

         1996          --            0.1          0.1

 

         1997          --            0.1          0.1

 

         1998          --            0.1          0.1

 

         1999          --            0.1          0.1

 

____________________________________________________________________

Authorization

Section 806.

Description

Small life insurance companies are allowed a special deduction not available to other taxpayers. The amount of the deduction is 60 percent of so much of otherwise taxable income from insurance operations for a taxable year that does not exceed $3 million, reduced by 15 percent of the excess of otherwise taxable income over $3 million.

Thus, the deduction phases out as a company's taxable insurance income computed without this deduction increases from $3 million to $15 million. A company with otherwise taxable insurance income over $15 million is not entitled to a small life insurance company deduction.

The small life insurance company deduction is allowed only to companies with gross assets of less than $500 million. Generally, consolidated group tests are used in applying the taxable income and gross asset standards.

Impact

The small life insurance company deduction reduces the tax rate for "small" life insurance companies. (The industry is characterized by very large companies, so assets of up to $500 million and taxable incomes of up to $15 million can still be considered relatively small.) A company eligible for the maximum small company deduction of $1.8 million is, in effect, taxed at a rate of 13.6 percent instead of the regular 34 percent corporate rate.

These companies may be either investor-owned stock companies or policyholder-owned mutual companies, so it is difficult to determine the distribution of benefits. It is possible that competitive pressures would cause the benefits to be passed on to life insurance policyholders in general.

Rationale

This provision was added in the massive revision of life insurance company taxation included in the Deficit Reduction Act of 1984 (P.L. 98-369). The justification given is that, although "the Congress believed that, without this provision, the Act provided for the proper reflection of taxable income, the Congress was also concerned about a sudden sharp increase in the companies' taxes. A companion provision, reducing taxes an arbitrary amount for all life insurance companies, was repealed in the Tax Reform Act of 1986, but the deduction for small companies was retained.

Assessment

Reducing taxes on business income based on the size of the business does not serve the equity purpose of basing taxes on the ability to pay them, since it is the OWNERS of the business (or the customers, employees, or other individuals) who bear the burden of the business's taxes (and their ability to pay is not determined by the size of the business).

It distorts the efficient allocation of resources, since it offers a cost advantage based on size and not economic performance. Nor does this tax reduction serve any simplification purpose, since it requires an additional set of computations and some complex rules to keep it from being abused. It may serve to help newer companies to become established and build up the reserves State law requires of insurance companies.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, JCS- 41-84. December 31, 1984, pp. 582-593.

Tax Reform Proposals: Taxation of Insurance Products and Companies, JCS-41-85. September 20, 1985, pp. 23-24.

                        Commerce and Housing:

 

                         Insurance Companies

                          SPECIAL TREATMENT

 

                 OF LIFE INSURANCE COMPANY RESERVES

                       Estimated Revenue Loss

 

                       [In billion of dollars]

____________________________________________________________________

      Fiscal Year  Individuals  Corporations     Total

 

____________________________________________________________________

         1995          --            2.1          2.1

 

         1996          --            2.3          2.3

 

         1997          --            2.5          2.5

 

         1998          --            2.7          2.7

 

         1999          --            2.9          2.9

 

____________________________________________________________________

Authorization

Section 803(a)(2), 805(a)(2), 807.

Description

Most businesses calculate taxable income by deducting expenses when the business becomes liable for paying them. Life insurance companies, however, are allowed to deduct additions to reserves for future liabilities under insurance policies, offsetting current income with future expenses.

Impact

Reserves are accounts recorded in the liabilities section of balance sheets to indicate a claim against assets for future expenses. When additions to the reserve accounts are allowed as deductions in computing taxable income, it allows an amount of tax- free (or tax-deferred) income to be used to purchase assets. Amounts are added to reserves from both premium income and the investment income earned by the invested assets, so reserve accounting shelters both premium and investment income from tax.

A large part of the reserves of life insurance companies is credited to individual policyholders, to whom the investment income is not taxed either (see "Exclusion of Investment Income on Life Insurance and Annuity Contracts," above).

The nature of the life insurance industry suggests that a reduction in its corporate taxes would go primarily to policyholders. Thus the beneficiaries of this tax expenditure are probably not the owners of capital in general (see Introduction) but rather those who invest in life insurance products in particular.

Rationale

The first modern corporate income tax enacted in 1909 provided that insurance companies could deduct additions to reserves required by law, and some form of reserve deduction has been allowed ever since.

Originally, the accounting rules of most regulated industries were adopted for tax purposes, and reserve accounting was required by all State insurance regulations. The many different methods of taxing insurance companies tried since 1909 all allowed some form of reserve accounting.

Before the Deficit Reduction Act of 1984, which set the current rules for taxing life insurance companies, reserves were those required by State law and generally computed by State regulatory rules. The Congress, concluding that the conservative regulatory rules allowed a significant overstatement of deductions, set rules for tax reserves that specified what types of reserves would be allowed and what discount rates would be used.

Assessment

Reserve accounting allows the deduction from current income of expenses relating to the future. This is the standard method of accounting for insurance regulatory purposes, where the primary goal is to assure that a company will be able to pay its promised benefits and the understatement of current income is regarded as simply being conservative.

Under the income tax, however, the understatement of current income gives a tax advantage. Combined with virtual tax exemption of life insurance product income at the individual level, this tax advantage makes life insurance a far more attractive investment vehicle than it would otherwise be and leads to the overpurchase of insurance and overinvestment in insurance products.

One often-proposed solution would retain reserve accounting but limit the deduction to amounts actually credited to the accounts of specific policyholders, who would then be taxable on the additions to their accounts. This would assure that all premium and investment income not used to pay current expenses was taxed at either the company or individual level, more in line with the tax treatment of banks, mutual funds, and other competitors of the life insurance industry.

Selected Bibliography

Aaron, Henry J. The Peculiar Problem of Taxing Life Insurance Companies. Washington, DC: The Brookings Institution, 1983.

Johnson, J. Walker. "Common Trends in the Taxation of Banks, Thrifts and Insurance Companies," Taxes -- the Tax Magazine. August 1989, pp. 485-501.

Kopcke, Richard W. "The Federal Income Taxation of Life Insurance Companies," New England Economic Review. March/April 1985, pp. 5-19.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, JCS- 41-84. December 31, 1984, pp. 572-665.

--. Tax Reform Proposals: Taxation of Insurance Products and Companies, JCS-41-85. September 20, 1985, pp. 21-23.

--. Taxation of Life Insurance Companies, JCS-17-89. October 16, 1989, pp. 8-11.

U.S. Department of the Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth, Volume 2, General Explanation of the Treasury Department Proposals. November 1984, pp. 268-269.

                        Commerce And Housing:

 

                         Insurance Companies

                DEDUCTION OF UNPAID LOSS RESERVES FOR

 

              PROPERTY AND CASUALTY INSURANCE COMPANIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

      Fiscal year    Individuals    Corporations     Total

 

____________________________________________________________________

          1995           --             1.6           1.6

 

          1996           --             1.8           1.8

 

          1997           --             1.9           1.9

 

          1998           --             2.1           2.1

 

          1999           --             2.3           2.3

 

____________________________________________________________________

Authorization

Section 832(b)(5), 846.

Description

Most businesses calculate taxable income by deducting expenses when the business becomes liable for paying them. Property and casualty insurance companies, however, are allowed to deduct the discounted value of estimated losses they will be required to pay in the future under insurance policies currently in force, including claims in dispute. This allows them to deduct future expenses from current income and thereby defer tax liability.

Impact

The allowance of a deduction for unpaid losses of a property or casualty insurer differs from the treatment of other taxpayers in two important respects. First, insurers may estimate not only the amount of liabilities they have incurred but also the existence of the liability itself. Second, the company may deduct an unpaid loss even though it is contesting the liability. An ordinary accrual-method taxpayer generally may not deduct the amount of a contested liability.

The net effect of these differences is to permit insurers to accelerate the deduction of losses claimed relative to the timing of those deductions under the generally applicable rules.

Competition in the property and casualty insurance industry would cause most of this reduction in corporate taxes to go to the benefit of the purchasers of insurance, including other businesses, homeowners, and private property owners.

Rationale

The first modern corporate income tax enacted in 1909 provided that insurance companies could deduct additions to reserves required by law, and some form of loss-reserve deduction has been allowed ever since. Originally, the accounting rules of most regulated industries were adopted for tax purposes, and reserve accounting was required by all State insurance regulations.

Before the Tax Reform Act of 1986, property and casualty insurance company reserves for unpaid losses were simply the undiscounted amount expected to be paid eventually, as generally required or allowed by State law. The Congress, concluding that the conservative regulatory rules allowed an overstatement of loss reserve deductions, required that loss reserves be discounted for tax purposes.

Assessment

Reserve accounting allows the deduction from current income of expenses relating to the future. This is the standard method of accounting for insurance regulatory purposes, where the primary goal is assuring that a company will be able to pay its policyholders and the possible understatement of current income is not regarded as a problem.

But the understatement of current income gives an income tax advantage, which is the basis for calling this item a tax expenditure.

An argument can be made, however, that deducting additions to a properly discounted reserve for losses that have already occurred and that can be estimated with reasonable certainty does not distort economic income. Since the insurance industry is based on being able to estimate its future payments from current policies, measuring current income could appropriately take into account the known future payments. From this perspective, only those additions to reserves that exceed expected losses (as perhaps those for contested liabilities) would properly be considered a tax expenditure.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, JCS-10-87. May 4, 1987, pp. 600-618.

-- Tax Reform Proposals Taxation of Insurance Products and Companies, JCS-41-85. September 20, 1985, pp. 32-49.

U.S. Department of the Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth, Volume 2, General Explanation of the Treasury Department Proposals. November 1984, pp. 273-277.

U.S. General Accounting Office. Congress Should Consider Changing Federal Income Taxation of the Property/Casualty Insurance Industry, GAO/GGD-85-10. March 25, 1985.

              SPECIAL ALTERNATIVE TAX ON SMALL PROPERTY

 

                  AND CASUALTY INSURANCE COMPANIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year    Individuals    Corporations     Total

 

____________________________________________________________________

          1995           --             /1/          /1/

 

          1996           --             /1/          /1/

 

          1997           --             /1/          /1/

 

          1998           --             /1/          /1/

 

          1999           --             /1/          /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million

                      END OF FOOTNOTE TO TABLE

Authorization

Section 501(c)(15), 831(b).

Description

Insurance companies other than life insurance companies whose written premiums (net or direct, whichever is greater) do not exceed $350,000 are exempt from the corporate income tax. Those whose premiums are greater than $350,000 but less than $1,200,000 may elect to be taxed (at regular corporate rates) on only their investment income.

Impact

These provisions give tax exemption to very small companies, and since a company would not elect to be taxed on investment income unless this were to its advantage, they reduce taxes for relatively small ones. Many of these companies are mutual companies, so the principal beneficiaries of the provision are the policyholders. If they enable the companies to offer insurance more cheaply or to remain in business and compete more effectively with larger companies, property and casualty insurance premiums in general may be lower than they would otherwise be.

Rationale

These provisions were enacted in the Tax Reform Act of 1986 to replace several more complex exemptions and tax reductions applicable only to small mutual insurance companies. The earlier provisions had been justified as encouraging the formation of new companies and assisting small companies in staying in business, but criticized for discriminating against stock companies.

The original exemption of small mutual companies in the Revenue Act of 1942 was explained as simply recognizing the reality that mutual insurance companies did not make enough money to pay taxes anyway. The reduced rates on the larger mutual companies also date from that Act.

Assessment

The exemption for small companies is probably an important simplification measure; since it involves very minor revenue losses, the administrative cost involved in collecting the taxes is likely to exceed the revenue loss. The need to choose between alternative taxes, however, means that the tax reduction for other small companies does not contribute to simplification. The cost of tax reductions for small businesses is a loss of efficiency in the economy, since they cause economic distortions.

Selected Bibliography

Seidman, J.S. Seidman's Legislative History of Federal Income and Excess Profits Tax Laws, 1953-1939. New York: Prentice-Hall, 1954, pp. 1493-1496 (for comm. reports on Revenue Act of 1942).

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, JCS-10-87. May 4, 1987, pp. 619-621.

--. Tax Reform Proposal's: Taxation of Insurance Products and Companies, JCS-41-85. September 20, 1985, pp. 52-53.

                        Commerce and Housing

 

                         Insurance Companies

            TAX EXEMPTION FOR CERTAIN INSURANCE COMPANIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year         Individuals    Corporations    Total

 

____________________________________________________________________

          1995                --             /1/         /1/

 

          1996                --             /1/         /1/

 

          1997                --             /1/         /1/

 

          1998                --             /1/         /1/

 

          1999                --             /1/         /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million

                      END OF FOOTNOTE TO TABLE

Authorization

Section 501(c)(8), 501(c)(9), 501(c)(12)(A), 501(m).

Description

Fraternal associations operating under the lodge system, voluntary employee benefit associations, local benevolent life insurance associations, and a few other membership associations are allowed to provide insurance protection (mostly life insurance or accident and sickness protection) to their members without being subject to the unrelated business income tax.

Impact

Tax-exempt organizations that engage in business operations in competition with the for-profit sector are usually subject to tax (at corporate tax rates) on this "unrelated business income." Several kinds of tax-exempt membership organizations, however, provide insurance protection for their members without incurring any tax on their insurance operations, thus reducing the cost of their members' insurance. Some of these insurance operations are relatively large, especially those of the national fraternal associations.

Rationale

The insurance operations of fraternal organizations have been tax-exempt since the first modern corporate tax law was enacted in 1909 (P.L. 5, 61st Congress, 1st session), apparently because they were not thought of as being the equivalent of commercial insurance.

Local benevolent life insurance associations were made tax exempt in 1924 (P.L. 176, 68th Congress, 1st session) because of a desire to exempt "smaller, cooperative insurance companies." (It was also noted that the larger, fraternal association insurance companies were already tax exempt.)

Voluntary employee benefit associations were added in the Revenue Act of 1928 (P.L. 562, 70th Congress, 1st session) with no explanation except that such associations were common then and it seemed desirable to exempt them.

Assessment

The unrelated business income tax was designed to take away the tax advantage tax-exempt organizations might otherwise have in competing with for-profit businesses. Failure to apply the tax to insurance operations competing with commercial insurance companies creates economic distortions by decreasing the tax-exempts' relative cost of providing insurance. In the case of the very small associations, savings in administrative costs help make up for the small revenue loss from their tax exemption.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, JCS-10-87. May 4, 1987, pp. 583-586.

--. Tax Reform Proposals: Taxation of Insurance Products and Companies, JCS-41-85. September 20, 1985, pp. 64-72.

                        Commerce and Housing:

 

                         Insurance Companies

                        SPECIAL DEDUCTION FOR

 

                BLUE CROSS AND BLUE SHIELD COMPANIES

                       Estimated Revenue Loss

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year         Individuals    Corporations     Total

 

____________________________________________________________________

        1995                  --             0.3          0.3

 

        1996                  --             0.3          0.3

 

        1997                  --             0.1          0.1

 

        1998                  --             0.1          0.1

 

        1999                  --             0.1          0.1

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ [sic] Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 833.

Description

Blue Cross and Blue Shield health insurance providers in existence on August 16, 1986, and other nonprofit health insurers that meet strict community-service standards, are subject to tax as property and casualty insurance companies, but are allowed a special deduction (for regular tax purposes only) of up to 25 percent of the excess of the year's health-related claims and expenses over their accumulated surplus at the beginning of the year. The deduction is limited to net taxable income for the year and is not allowed in computing the alternative minimum tax. These organizations are also allowed a full deduction for unearned premiums, unlike other property and casualty insurance companies.

Impact

The special deduction exempts from the regular 34-percent corporate tax enough taxable income each year to maintain reserves equal to 25 percent of the year's health-related payouts (three month's worth). Since the deduction is not allowed for the alternative minimum tax, however, the income is subject to tax at the minimum tax rate of 20 percent. The Blue Cross/Blue Shield organizations are not investor owned, so the reduced taxes benefit either their subscribers or all health insurance purchasers (in reduced premiums), their managers and employees (in increased wages and/or discretionary funds), or affiliated hospitals and physicians (in increased fees).

Rationale

The Blue Cross/Blue Shield plans were first subjected to tax in the Tax Reform Act of 1986, which also provided for the special deduction described above. The "Blues" had been ruled tax-exempt by Internal Revenue regulations since their inception in the 1920s, apparently because they were regarded as community service organizations. The special tax deduction was given them in 1986 partly in recognition of their continuing (but much more limited) role in providing community-rated health insurance.

Assessment

Most of the health insurance written by Blue Cross and Blue Shield plans is in the form of group policies indistinguishable in price and coverage from those offered by commercial insurers. Some of the plans have accumulated enough surplus to purchase unrelated businesses, many receive a substantial part of their income from administering Medicare or self-insurance plans of other companies, and some have argued that their tax preferences have benefitted their managers and their affiliated hospitals and physicians more than their communities.

They do, however, retain in their charters a commitment to offer individual policies not available elsewhere. Some continue to offer policies with premiums based on community payout experience ("community rated"). Their former tax exemption and their current reduced tax rates presumably serve to subsidize these community activities.

Selected Bibliography

Blue Cross and Blue Shield Association. Questions and Answers About the Blue Cross and Blue Shield Organization. May, 1987.

Law, Sylvia A. Blue Cross: What Went Wrong? New Have: Yale University Press, 1974.

McGovern, James J. "Federal Tax Exemption of Prepaid Health Care Plans," The Tax Adviser. February 1976, pp. 76-81.

Taylor, Jack. Blue Cross/Blue Shield and Tax Reform. Library of Congress, Congressional Research Service Report 86-651 E. Washington, DC: April 9,1986.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, JCS-10-87. May 4, 1987, pp. 583-592.

--. Description and Analysis of Title VII of H.R. 360, S. 1757, and S. 1775 ("Health Security Act"), JCS-20-93. December 20, 1993, pp. 82-96.

Weiner, Janet Ochs. "The Rebirth of the Blues," Medicine and Health (Supplement). February 18, 1991.

                        Commerce and Housing:

 

                               Housing

                 DEDUCTIBILITY OF MORTGAGE INTEREST

 

                    ON OWNER-OCCUPIED RESIDENCES

                       Estimated Revenue Loss

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year         Individuals    Corporations     Total

 

____________________________________________________________________

         1995                53.5           --            53.5

 

         1996                56.8           --            56.8

 

         1997                60.2           --            60.2

 

         1998                63.9           --            63.9

 

         1999                67.8           --            67.8

 

____________________________________________________________________

Authorization

Section 163(h).

Description

A taxpayer may take an itemized deduction for "qualified residence interest," which includes interest paid on a mortgage secured by a principal residence and a second residence. The underlying mortgage loans can represent acquisition indebtedness of up to $1 million, plus home equity indebtedness of up to $100,000.

Impact

The deduction is considered a tax expenditure because homeowners are allowed to deduct their mortgage interest even though the implicit rental income from the home (comparable to the income they could earn if the home were rented to someone else) is not subject to tax.

Renters and the owners of rental property do not receive a comparable benefit. Renters may not deduct any portion of their rent under the Federal income tax. Landlords may deduct mortgage interest paid for rental property, but they are subject to tax on the rental income.

For taxpayers who can itemize, the home mortgage interest deduction encourages home ownership by reducing the cost of owning compared with renting. It also encourages them to spend more on housing (measured before the income tax offset), and to borrow more than they would in the absence of the deduction.

The mortgage interest deduction primarily benefits middle- and upper-income households. Higher-income taxpayers are more likely to itemize deductions. As with any deduction, a dollar of mortgage interest deduction is worth more the higher the taxpayer's marginal tax rate.

Higher-income households also tend to have larger mortgage interest deductions because they can afford to spend more on housing and can qualify to borrow more. The home equity loan provision favors taxpayers who have been able to pay down their acquisition indebtedness and whose homes have appreciated in value.

               DISTRIBUTION BY INCOME CLASS OF THE TAX

 

                  EXPENDITURE FOR MORTGAGE INTEREST

 

              AT 1994 TAX RATES AND 1994 INCOME LEVELS

____________________________________________________________________

      Income Class                       Percentage

 

      (in thousands of $)                Distribution

 

____________________________________________________________________

          Below $10                          0.0

 

          $10 to $20                         0.4

 

          $20 to $30                         1.5

 

          $30 to $40                         3.8

 

          $40 to $50                         6.3

 

          $50 to $75                        22.0

 

          $75 to $100                       21.9

 

          $100 to $200                      27.6

 

          $200 and over                     16.5

 

____________________________________________________________________

Rationale

The income tax code instituted in 1913 contained a deduction for all interest paid, with no distinction between interest payments made for business, personal, living, or family expenses. There is no evidence in the legislative history that the interest deduction was intended to encourage home ownership or to stimulate the housing industry at that time. In 1913 most interest payments represented business expenses. Home mortgages and other consumer borrowing were much less prevalent than in later years.

Prior to the Tax Reform Act of 1986 (TRA86), there were no restrictions on either the dollar amount of mortgage interest deduction or the number of homes on which the deduction could be claimed. The limits placed on the mortgage interest deduction in 1986 and 1987 were part of the effort to limit the deduction for personal interest.

Under the provisions of TRA86, for home mortgage loans settled on or after August 16, 1986, mortgage interest could be deducted only on a loan amount up to the purchase price of the home, plus any improvements, and on debt secured by the home but used for qualified medical and educational expense. This was an effort to restrict tax- deductible borrowing of home equity in excess of the original purchase price of the home. The interest deduction was also restricted to mortgage debt on a first and second home.

The Omnibus Budget Reconciliation Act of 1987 placed new dollar limits on the mortgage debt incurred after October 13, 1987, upon which interest payments could be deducted. An upper limit of $1 million ($500,000 for married filing separately) was placed on the combined "acquisition indebtedness" for a principal or second residence. Acquisition indebtedness includes any debt incurred to buy, build, or substantially improve the residence(s). The ceiling on acquisition indebtedness for any residence is reduced down to zero as the mortgage balance is paid down, and can only be increased if the amount borrowed is used for improvements.

The TRA86 exception for qualified medical and educational expenses was replaced by the explicit provision for home equity indebtedness: in addition to interest on acquisition indebtedness, interest can be deducted on loan amounts up to $100,000 ($50,000 for married filing separately) for other debt secured by a principal or second residence, such as a home equity loan, line of credit, or second mortgage. The sum of the acquisition indebtedness and home equity debt cannot exceed the fair market value of the home(s). There is no restriction on the purposes for which home equity indebtedness can be used.

Mortgage interest is one of several deductions subject to the phaseout on itemized deductions for taxpayers whose AGI exceeds the applicable threshold amount -- $111,800 in 1994, indexed for inflation. (This phaseout was instituted for tax years 1991 through 1995 by the Omnibus Budget Reconciliation Act of 1990 and made permanent by the Omnibus Budget Reconciliation Act of 1993.)

Assessment

Major justifications for the mortgage interest deduction have been the desire to encourage homeownership and to stimulate residential construction. Homeownership is alleged to encourage neighborhood stability, promote civic responsibility, and improve the maintenance of residential buildings. Homeownership is also viewed as a mechanism to encourage families to save and invest in what for many will be their major financial asset.

A major criticism of the mortgage interest deduction has been its distribution of tax benefits in favor of higher-income taxpayers. It is unlikely that a housing subsidy program that gave far larger amounts to high income compared with low income households would be enacted if it were proposed as a direct expenditure program.

The preferential tax treatment of owner-occupied housing relative to other assets is also criticized for encouraging households to invest more in housing and less in other investments that might contribute more to increasing the Nation's productivity and output.

Efforts to limit the deduction of some forms of interest more than others must deal with taxpayers' ability to substitute one form of borrowing for another. For those who can make use of it, the home equity interest deduction can substitute for the deductions phased out by TRA86 for consumer interest and investment interest in excess of investment income. This alternative is not available to renters or to homeowners with little equity buildup.

Analysts have pointed out that the rate of homeownership in the United States is not significantly higher than in countries such as Canada that do not provide a mortgage interest deduction under their income tax. The value of the U.S. deduction may be at least partly capitalized into higher prices at the middle and upper end of the housing market.

Selected Bibliography

Aaron, Henry. "Federal Housing Subsidies," U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs, Part 5, "Housing Subsidies." October 9, 1972, pp. 571-96.

--. Shelter and Subsidies: Who Benefits from Federal Housing Policies? Washington, DC: The Brookings Institution, 1972, pp. 53-73.

Berkovec, James, and Don Fullerton. "A General Equilibrium Model of Housing, Taxes, and Portfolio Choice," Journal of Political Economy, v. 100, no. 2. April 1992, pp. 390-429.

DeLeeuw, Frank, and Larry Ozanne. "The Impact of the Federal Income Tax on Investment in Housing," Survey of Current Business, v. 59. December 1979, pp. 50-61. Another version of this article appears as "Housing" in How Taxes Affect Economic Behavior, eds. Henry J. Aaron and Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 283-319.

Dolbeare, Cushing N. Federal Housing Assistance: Who Needs It, Who Gets It? Washington, DC: National League of Cities, 1985.

Follain, James R., and David C. Ling. "The Federal Tax Subsidy to Housing and the Reduced Value of the Mortgage Interest Deduction," National Tax Journal, v. 44, no. 2, June 1991, pp. 147-68.

Follain, James R., David C. Ling, and Gary A. McGill. "The Preferential Income Tax Treatment of Owner-Occupied Housing: Who Really Benefits?" Housing Policy Debate (Fanny Mae), v. 4, issue 1, 1993, pp. 1-24; "Comment," by William G. Grigsby and Amy L.W. Hosier, pp. 33-42.

Giertz, J. Fred, and Dennis H. Sullivan. "Housing Tenure and Horizontal Equity," National Tax Journal, v. 31, no. 4, December 1978, pp. 329-38.

Goode, Richard. The Individual Income Tax. Washington, DC: The Brookings Institution, 1976, pp. 117-25, 148-53.

Hellmuth, William F. "Homeowner Preferences," Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 163-203.

Laidler, David. "Income Tax Incentives for Owner-Occupied Homes," The Taxation of Income from Capital, eds. Arnold C. Harberger and Martin J. Bailey. Washington, DC: The Brookings Institution, 1969, pp. 50-70.

Litzenberger, Robert H., and Howard B. Sosin. "Taxation and the Incidence of Homeownership Across Income Groups," Journal of Finance, v. 33. June 1978, pp. 947-961.

Merz, Paul E. "Foreign Income Tax Treatment of the Imputed Rental Value of Owner-Occupied Housing: Synopsis and Commentary," National Tax Journal, v. 30. December 1977, pp. 435-39.

Pierce, Bethane Jo. "Homeowner Preferences: The Equity and Revenue Effects of Proposed Changes in the Status Quo," Journal of the American Taxation Association, vol. 10, no. 2, Spring 1989, pp. 54-67.

Poterba, James M. "Taxation and Housing Markets: Preliminary Evidence on the Effects of Recent Tax Reforms," NBER Working Paper No. 3270. February 1990.

Rosen, Harvey S. "Housing Decisions and the U.S. Income Tax: An Economic Analysis," Journal of Public Economics, v. 11, no. 1. February 1979, pp. 1-23.

--. "Housing Subsidies: Effects on Housing Decisions, Efficiency, and Equity," Handbook of Public Economics, v. I, eds. Alan J. Auerbach and Martin Feldstein. The Netherlands, Elsevier Science Publishers B.V. (North-Holland), 1985, pp. 375-420.

Surrey, Stanley R. "Three Special Tax Expenditure Items: Support to State and Local Governments, to Philanthropy, and to Housing," Pathways to Tax Reform. Cambridge, Mass.: Harvard University Press, 1973, pp. 232-36.

U.S. Congress, Congressional Budget Office. The Tax Treatment of Homeownership: Issues and Options. Washington, DC: 1981.

Wells, Robert J. "It's Time to Revisit the Interest Deduction Rules," Tax Notes, vol. 60, no. 6, August 2, 1993, pp. 649-657.

White, Michelle J., and Lawrence J. White. "The Tax Subsidy to Owner-Occupied Housing: Who Benefits?" Journal of Public Economics, v. 7, no. 1. February 1977, pp. 111-26.

                        Commerce and Housing:

 

                               Housing

                    DEDUCTIBILITY OF PROPERTY TAX

 

                    ON OWNER-OCCUPIED RESIDENCES

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  _________________________________________________________

 

     Fiscal year   Individuals  Corporations      Total

 

  _________________________________________________________

 

         1995          13.7          --           13.7

 

         1996          14.5          --           14.5

 

         1997          15.3          --           15.3

 

         1998          16.2          --           16.2

 

         1999          17.1          --           17.1

Authorization

Section 164.

Description

Taxpayers may claim an itemized deduction for property taxes paid on owner-occupied residences.

Impact

The deductibility of property taxes on owner-occupied residences provides a subsidy both to home ownership and to the financing of State and local governments. Like the deduction for home mortgage interest, the Federal deduction for real property (real estate) taxes reduces the cost of home ownership relative to renting.

Renters may not deduct any portion of their rent under the Federal income tax. Landlords may deduct the property tax they pay on a rental property but are taxed on the rental income.

Homeowners may deduct the property taxes but are not subject to income tax on the imputed rental value of the dwelling. For itemizing homeowners, the deduction lowers the net price of State and local public services financed by the property tax and raises their after- Federal-tax income.

Like all personal deductions, the property tax deduction provides uneven tax savings per dollar of deduction. The tax savings are higher for those with higher marginal tax rates, and those homeowners who do not itemize deductions receive no direct tax savings.

Higher-income groups receive larger average benefits per itemizing return and are more likely to itemize property taxes. Consequently, the tax expenditure benefits of the property tax deduction are concentrated in the upper-income groups.

               Distribution by Income Class of the Tax

 

                   Expenditure for Property Taxes

 

              at 1994 Tax Rates and 1994 Income Levels

 

      _______________________________________________

 

          Income Class                   Percentage

 

      (in thousands of $)               Distribution

 

      _______________________________________________

 

         Below $10                           0.0

 

         $10 to $20                          0.4

 

         $20 to $30                          1.7

 

         $30 to $40                          4.0

 

         $40 to $50                          6.3

 

         $50 to $75                         22.2

 

         $75 to $100                        22.1

 

         $100 to $200                       27.0

 

         $200 and over                      16.2

Rationale

Under the original 1913 Federal income tax law all Federal, State, and local taxes were deductible, except those assessed against local benefits (for improvements which tend to increase the value of the property), for individuals as well as businesses.

A major rationale was that tax payments reduce disposable income in a mandatory way and thus should be deducted when determining a taxpayer's ability to pay the Federal income tax.

Over the years, the Congress has gradually eliminated the deductibility of certain taxes under the individual income tax, unless they are business-related. Deductions were eliminated for Federal income taxes in 1917, for estate and gift taxes in 1934, and for excise and import taxes in 1943, for State and local excise taxes on cigarettes and alcohol and fees such as drivers' and motor vehicle licenses in 1964, for excise taxes on gasoline and other motor fuels in 1978, and for sales taxes in 1986.

The major remaining deductions are for State and local income, real property, and personal property taxes. State and local taxes are among several deductions subject to the phaseout on itemized deductions for taxpayers whose AGI exceeds the applicable threshold amount -- $111,800 in 1994, indexed for inflation. (This phaseout was instituted for tax years 1991 through 1995 by the Omnibus Budget Reconciliation Act of 1990 and made permanent by the Omnibus Budget Reconciliation Act of 1993.)

Assessment

Proponents argue that the deduction for State and local taxes is a way of promoting fiscal federalism by helping State and local governments to raise revenues from their own taxpayers. Itemizers receive an offset for their deductible State and local taxes in the form of lower Federal income taxes. Deductibility thus helps to equalize total Federal-State-local tax burdens across the country: itemizers in high-tax States and local jurisdictions pay somewhat lower Federal taxes as a result of their higher deductions, and vice versa.

By allowing property taxes to be deducted in the same way as State and local income and personal property taxes, the Federal Government avoids interfering in State and local decisions about which of these taxes to rely on. The property tax is particularly important as a source of revenue for local governments and school districts.

The property tax deduction is not a cost-efficient way to provide Federal aid to State and local governments in general, or to target aid on particular needs, compared with direct aid. The deduction works indirectly to increase taxpayers' willingness to support higher State and local taxes by reducing the net price of those taxes and increasing their income after Federal taxes.

The same tax expenditure subsidy is available to property taxpayers regardless of whether the money is spent on quasi-private benefits enjoyed by the taxpayers or redistributive public services, or whether they live in exclusive high-income jurisdictions or heterogeneous cities encompassing a low-income population. The property-tax-limitation movements of the 1970s and 1980s, and State and local governments' increased reliance on non-deductible sales and excise taxes and user fees during the 1980s and 1990s, suggest that other forces can outweigh the advantage of the property tax deduction.

Two separate lines of argument by critics suggest that the deduction for real property taxes should be restricted. One is that a large portion of local property taxes may be paying for services and facilities that are essentially private benefits being provided through the public sector. Similar services often are financed by non-deductible fees and user charges paid to local government authorities or to private community associations (e.g., for water and sewer services or trash removal).

Another argument is that if imputed income from owner-occupied housing is not subject to tax, then associated expenses, such as mortgage interest and property taxes, should not be deductible.

Like the mortgage interest deduction, the value of the property tax deduction may be capitalized to some degree into higher prices for the type of housing bought by taxpayers who can itemize. Consequently, restricting the deduction for property taxes could lower the price of housing purchased by middle- and upper-income taxpayers, at least in the short run.

Selected Bibliography

Aaron, Henry. "Housing Subsidies," Part 5, in "Federal Housing Subsidies," U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs. October 9, 1972, pp. 571-96.

--. Who Pays the Property Tax? Washington, DC: The Brookings Institution, 1975.

--. Shelter and Subsidies: Who Benefits from Federal Housing Policies? Washington, DC: The Brookings Institution, 1972, pp. 53-73.

Advisory Commission on Intergovernmental Relations. Strengthening the Federal Revenue System: Implications for State and Local Taxing and Borrowing, Report A-97. Washington, DC: ACIR, October 1984, pp. 37-66. A condensed version is presented in Daphne A. Kenyon, "Federal Income Tax Deductibility of State and Local Taxes," Intergovernmental Perspective, Fall 1984, v. 10, no. 4. Pp. 19-22.

Carroll, Robert J., and John Yinger. "Is the Property Tax a Benefit Tax? The Case of Rental Housing," National Tax Journal, v. 47, no. 2. June 1994, pp. 295-316.

Do, A. Quang, and C.R. Sirmans. "Residential Property Tax Capitalization: Discount Rate Evidence from California," National Tax Journal, v. 47, no. 2. June 1994, pp. 341-348.

Giertz, Fred, Jr., and Dennis H. Sullivan. "Housing Tenure and Horizontal Equity," National Tax Journal, v. 31, no. 4. December 1978, pp. 329-38.

Goode, Richard. The Individual Income Tax, rev. ed. Washington, DC: The Brookings Institution, 1976, pp. 118-25, 168-71.

Hellmuth, William F. "Homeowner Preferences," Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 163-203.

Laidler, David, "Income Tax Incentives for Owner-Occupied Homes," The Taxation of Income from Capital, eds. Arnold C. Harberger and Martin J. Bailey. Washington, DC: The Brookings Institution, 1969, pp. 50-70.

Litzenberger, Robert H., and Howard B. Sosin. "Taxation and the Incidence of Homeownership Across Income Groups," Journal of Finance, v. 33. June 1978, pp. 947-61.

Meyer, Leslie K., and John R. Meyer. "The Impact of National Tax Policies on Homeownership," Working Paper No. 71. Cambridge, Mass.: Joint Center for Urban Studies of MIT and Harvard University, 1981.

Pierce, Bethane Jo. "Homeowner Preferences: The Equity and Revenue Effects of Proposed Changes in the Status Quo," Journal of the American Taxation Association, vol. 10, no. 2, Spring 1989, pp. 54-67.

Rosen, Harvey S. "Housing Decisions and the U.S. Income Tax: An Economic Analysis," Journal of Public Economics, v. 11, no. 1. February 1979, pp. 1-23.

Surrey, Stanley R. Pathways to Tax Reform. Cambridge, Mass.: Harvard University Press, 1973, pp. 232-36.

U.S. Congress, Congressional Budget Office. The Tax Treatment of Homeownership: Issues and Options. Washington, DC: 1981.

--, House Committee on Banking, Finance and Urban Affairs, Subcommittee on the City. Federal Tax Policy and Urban Development, 95th Congress, 1st session. June 16, 1977. See especially G. Tolley and D. Diamond, "Homeownership, Rental Housing, and Tax Incentives," pp. 114-95.

--, Senate Committee on Governmental Affairs, Subcommittee on Intergovernmental Relations. Limiting State-Local Tax Deductibility in Exchange for Increased General Revenue Sharing: An Analysis of the Economic Effects, 98th Congress, 1st session, Committee Print S. Prt. 98-77. August 1983. A condensed version was published in Nonna A. Noto and Dennis Zimmmerman, "Limiting State-Local Tax Deductibility: Effects Among the States," National Tax Journal, v. 37, no. 4. December 1984, pp. 539-49.

U.S. Department of the Treasury, Office of State and Local Finance. Federal-State-Local Fiscal Relations, Report to the President and the Congress. Washington, DC: U.S. Government Printing Office, September 1985, pp. 251-83. Also Technical Papers, September 1986, vol. 1, pp. 349-552.

White, Michelle J., and Lawrence J. White, "The Tax Subsidy to Owner-Occupied Housing: Who Benefits?" Journal of Public Economics, v. 7, no. 1. February 1977, pp. 111-26.

Commerce and Housing:

 

Housing

DEFERRAL OF CAPITAL GAINS ON SALE

 

OF PRINCIPAL RESIDENCE

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  ________________________________________________________

 

     Fiscal year   Individuals  Corporations     Total

 

  ________________________________________________________

 

         1995          14.8          --           14.8

 

         1996          15.3          --           15.3

 

         1997          15.9          --           15.9

 

         1998          16.4          --           16.4

 

         1999          17.0          --           17.0

Authorization

Section 1034.

Description

Capital gains from the sale of a principal residence are not subject to tax if another residence costing at least as much is purchased within two years of the sale of the former one. If the new residence costs less than the adjusted sales price of the old residence, then the gains from the sale of the old residence are taxed to the extent of the difference in price. The tax basis of the new residence is reduced by the amount of the untaxed gain on the sale of the old residence.

Impact

Deferring the capital gains tax on the sale of principal residences benefits primarily middle- and upper-income taxpayers. At the same time, however, this provision avoids putting an additional tax burden on taxpayers, regardless of their income levels, who have to sell their homes because of changes in family status or employment.

Rationale

The deferral of capital gains from home sales was first introduced in the Revenue Act of 1951. Originally the time period required to purchase a new residence was twelve months from the sale of the old residence. This period was increased to 18 months in the Tax Reduction Act of 1975 and further increased to two years in the Economic Recovery Tax Act of 1981.

Committee reports and floor debates at the time of enactment indicate that the Congress believed that taxing capital gains from the sale of principal residences imposed a "hardship," because capital gains may reflect only a general rise in housing prices, in which case the tax on the gain for homeowners who moved would reduce their ability to replace the home they had sold.

The inequity was considered particularly great when such events as an increase in family size or a change in employment required the move. In those cases, the sale of a house was said to have the character of an "involuntary conversion." Sales of principal residences were also singled out for special tax treatment because they were considered to result mostly from personal reasons or uncontrollable circumstances, rather than the desire to make a profit.

Assessment

As is the case with any tax deferral, as a result of deferring the tax on the capital gains arising from the sale of a principal residence the taxpayer receives the equivalent of an interest-free loan. This special tax treatment gives homeownership a competitive advantage over other types of investment, since the capital gains from investments in other assets are taxed when the assets are sold.

Moreover, when combined with other provisions in the tax code such as the exclusion from capital gains tax on the sale of a principal residence by the elderly, the gain on the sale of a principal residence is often never subject to tax. As a result, savings are diverted out of other forms of investment and into housing.

On the other hand, many see this provision as justifiable because the tax law does not allow the deduction of personal capital losses, because much of the profit from the sale of a personal residence represents inflationary gains, and because the purchase of a principal residence is less of a profit-motivated investment than other types of investments.

Selected Bibliography

Hill, D. Frank, III. "The Personal Residence: Disposition Alternatives," West Virginia Law Review, v. 86. Summer 1984.

U.S. Congress, Congressional Budget Office. The Tax Treatment of Homeownership: Issues and Options, 1981.

--. Joint Committee on Taxation. General Explanation of the Economic Recovery Tax Act of 1981. December 31, 1981.

Esenwein, Gregg A. The Neutral Taxation of Capital Gains Income Under the Individual Income Tax. Library of Congress, Congressional Research Service Report 94-395 E. Washington, DC: 1994.

--. Individual Capital Gains Tax Issues. Library of Congress, Congressional Research Service Report 92-456 E. Washington, DC: 1992.

Commerce Clearing House, Inc. Tax Reduction Act of 1975: Law and Explanation. April 11, 1979.

Commerce and Housing:

 

Housing

               EXCLUSION OF CAPITAL GAINS ON SALES OF

 

             PRINCIPAL RESIDENCES FOR PERSONS AGE 55 AND

 

                      OVER ($125,000 EXCLUSION)

                       Estimated Revenue Loss

 

                      (In billions of dollars)

 

  ________________________________________________________

 

     Fiscal Year   Individuals   Corporation     Total

 

  ________________________________________________________

 

         1995          4.9            --           4.9

 

         1996          5.1            --           5.1

 

         1997          5.3            --           5.3

 

         1998          5.5            --           5.5

 

         1999          5.7            --           5.7

Authorization

Section 121.

Description

Taxpayers age 55 and older are allowed a one-time exclusion from taxable income of $125,000 in capital gains on the sale of any property used as a principal residence during 3 of the previous 5 years.

Impact

This provision, together with the deferral of gains on previous home sales, allows older taxpayers to avoid some or all of the tax liability that would otherwise accrue when they sell their principal residence. Housing survey data indicate that approximately 80 percent of those aged 55 years and older are homeowners which means that a large segment of the elderly population receives benefits from this tax expenditure.

Rationale

The one-time exclusion is designed to shield older taxpayers from heavy tax burdens when they decide to become renters or move to a less costly residence. This provision was first enacted in the Revenue Act of 1964 and applied only to taxpayers 65 or older and then only under special circumstances. Full exclusion was available only when the sale price of the home did not exceed $20,000. For more expensive homes, only a portion of the gain could be excluded. The Tax Reform Act of 1976 subsequently increased the basic sale price figure to $35,000.

The Revenue Act of 1978 significantly liberalized the exclusion, increasing the amount of excluded gains to $100,000 and allowing all taxpayers 55 and older to claim it. It also reduced the required period of time that a unit had to serve as a taxpayer's principal residence from 5 of the last 8 years to 3 of the last 5.

The 1978 Act also allowed taxpayers whose previous residence had been "involuntarily converted" (that is, condemned or destroyed) to count toward the 3-year requirement the period spent in a replacement home or apartment. The Economic Recovery Tax Act of 1981 raised the $100,000 limit to its current level of $125,000 ($62,500 in the case of married persons filing separately).

Assessment

Excluding the capital gains on the sale of a principal residence from tax provides a significant tax benefit to homeowners. This special tax treatment gives home ownership a competitive advantage over other types of investment, since the capital gains from investments in other assets are taxed when the assets are sold.

Moreover, when combined with other provisions in the tax code such as the deferral of capital gains taxes on the sale of principal residences, this tax provision means that often the capital gains arising from the sale of owner-occupied housing are never subject to tax. As a result, savings are diverted out of other forms of investment and into housing.

Without this exclusion, however, many elderly taxpayers who sold their principal residences would have to pay capital gains tax on the difference between the sales price of their final home and the purchase price of their first home. Since changes in housing prices over time reflect not only appreciation in the real value of the asset but also inflationary price changes, assessing capital gains taxes on the nominal gain would probably result in an incorrect assessment of tax.

In addition, many taxpayers use the appreciation in the value of their home as a means of saving for their retirement. The exclusion helps shield this investment from taxes when the elderly decide to acquire less costly housing on retirement.

Selected Bibliography

Esenwein, Gregg A. The Neutral Taxation of Capital Gains Income Under the Individual Income Tax. Library of Congress, Congressional Research Service Report 94-395 E. Washington, DC: 1994.

--. Individual Capital Gains Tax Issues. Library of Congress, Congressional Research Service Report 92-456 E. Washington, DC: 1992.

Greenberger, Robert M. "Tax Shelter Possibilities Available When a Principal Residence Is Disposed of by a Client," Taxation for Accountants, v. 24. March 1984, pp. 158-163.

U.S. Congress, Congressional Budget Office. The Tax Treatment of Homeownership: Issues and Options. 1981.

--, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1976. December 29, 1976.

--, General Explanation of the Revenue Act of 1978. March 12, 1979.

--, General Explanation of the Economic Recovery Tax Act of 1981. December 31, 1981.

Commerce and Housing:

 

Housing

EXCLUSION OF INTEREST ON STATE AND LOCAL

 

GOVERNMENT BONDS FOR OWNER-OCCUPIED HOUSING

Estimated Revenue Loss

[In billions of dollars]

  ________________________________________________________

 

     Fiscal year   Individuals  Corporations     Total

 

  ________________________________________________________

 

         1995          1.4           0.5          1.9

 

         1996          1.4           0.5          1.9

 

         1997          1.4           0.5          1.9

 

         1998          1.3           0.4          1.7

 

         1999          1.3           0.4          1.7

Authorization

Sections 103, 141, 143, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds issued to provide mortgages at below-market interest rates on owner-occupied principal residences of first-time homebuyers is tax exempt. The issuer of mortgage bonds typically uses bond proceeds to purchase mortgages made by a private lender. The homeowners make their monthly payments to the private lender, which passes them through as payments to the bondholders.

These mortgage revenue bonds (MRBs) are classified as private- activity bonds rather than governmental bonds because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Numerous limitations have been imposed on State and local MRB programs, among them restrictions on the purchase prices of the houses that can be financed, on the income of the homebuyers, and on the portion of the bond proceeds that must be expended for mortgages in targeted (lower income) areas.

A portion of capital gains on an MRB-financed home sold within ten years must be rebated to the Treasury. Housing agencies may trade in bond authority for authority to issue equivalent amounts of mortgage credit certificates (MCCs). MCCs take the form of nonrefundable tax credits for interest paid on qualifying home mortgages.

MRBs are subject to the private-activity bond annual volume cap equal to the greater of $50 per State resident or $150 million. Housing agencies must compete for cap allocations with bond proposals for all other private-activities subject to the volume cap.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to offer mortgages on owner-occupied housing at reduced mortgage interest rates.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and homeowners, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

The first MRBs were issued without any Federal restrictions during the high-interest-rate period of the late 1970s. State and local officials expected reduced mortgage interest rates to increase the incidence of homeownership. The Mortgage Subsidy Bond Tax Act of 1980 imposed several targeting requirements, most importantly restricting the use of MRBs to lower-income first-time purchasers. The annual volume of bonds issued by governmental units within a State was capped, and the amount of arbitrage profits (the difference between the interest rate on the bonds and the higher mortgage rate charged to the home purchaser) was limited to one percentage point.

Depending upon the state of the housing market, targeting restrictions have been relaxed and tightened over the decade of the 1980s. MRBs were included under the unified volume cap on private- activity bonds by the Tax Reform Act of 1986.

MRBs have long been an "expiring tax provision" with a sunset date. MRBs first were scheduled to sunset on December 31, 1983, by the Mortgage Subsidy Bond Tax Act of 1980. Additional sunset dates have been adopted five times when Congress has decided to extend MRB eligibility for a temporary period. The Omnibus Budget Reconciliation Act of 1993 made MRBs a permanent provision.

Assessment

Income, tenure status, and house-price-targeting provisions imposed on MRBs make them more likely to achieve the goal of increased homeownership than many other housing tax subsidies that make no targeting effort, such as is the case for the mortgage- interest deduction. Nonetheless, it has been suggested that most of the mortgage revenue bond subsidy goes to families that would have been homeowners even if the subsidy were not available.

Even if a case can be made for this subsidy, it is important to recognize the costs that accrue. As one of many categories of tax- exempt private-activity bonds, MRBs have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

MacRae, Duncan, David Rosenbaum, and John Tuccillo. Mortgage Revenue Bonds and Metropolitan Housing Markets. Washington, DC: The Urban Institute, May 1980.

Peterson, G. E., J. A. Tuccillo, and J. C. Weicher. "The Impact of Local Mortgage Revenue Bonds on Securities, Markets, and Housing Policy Objectives," Efficiency in the Municipal Bond Market, ed. George C. Kaufman. Greenwich, Conn.: JAI Press, 1981.

Temple, Judy. "Limitations on State and Local Government Borrowing for Private Purposes," National Tax Journal, vol. 46, March 1993, pp. 41-52.

U.S. Congress, Congressional Budget Office. Tax-Exempt Bonds for Single-Family Housing. April 1979.

U.S. General Accounting Office. Home Ownership: Mortgage Bonds Are Costly and Provide Little Assistance to Those in Need. GAO/RCED- 88-111. 1988.

Wrightson, Margaret T. Who Benefits from Single-Family Housing Bonds? History, Development and Current Experience of State- Administered Mortgage Revenue Bond Programs. Washington, DC: Georgetown University, Public Policy Program, April 1988.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

                        Commerce and Housing:

 

                               Housing

              EXCLUSION OF INTEREST ON STATE AND LOCAL

 

                 GOVERNMENT BONDS FOR RENTAL HOUSING

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  _______________________________________________________

 

     Fiscal year  Individuals   Corporations     Total

 

  _______________________________________________________

 

         1995          0.7           0.2          0.9

 

         1996          0.7           0.2          0.9

 

         1997          0.7           0.2          0.9

 

         1998          0.6           0.2          0.8

 

         1999          0.6           0.2          0.8

Authorization

Sections 103, 141, 142, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance the construction of multifamily residential rental housing units for low- and moderate-income families is tax exempt. These rental housing bonds are classified as private-activity bonds rather than as governmental bonds because a substantial portion of their benefits accrues to individuals or business, rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

These residential rental housing bonds are subject to the State private-activity bond annual volume cap. Several requirements have been imposed on these projects, primarily on the share of the rental units that must be occupied by low-income families and the length of time over which the income restriction must be satisfied.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to offer residential rental housing units at reduced rates. Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and renters, and for estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Before 1968 no restriction was placed on the ability of State and local governments to issue tax-exempt bonds to finance multifamily rental housing. Although the Revenue and Expenditure Control Act of 1968 imposed tests that would have restricted issuance of these bond issues, it provided a specific exception for multifamily residential rental housing (allowing continued unrestricted issuance).

Most States issue these bonds in conjunction with the Leased Housing Program under Section 8 of the United States Housing Act of 1937. The Tax Reform Act of 1986 restricted eligibility for tax- exempt financing to projects satisfying one of two income-targeting requirements: 40 percent or more of the units must be occupied by tenants whose incomes are 60 percent or less of the area median gross income, or 20 percent or more of the units are occupied by tenants whose incomes are 50 percent or less of the area median gross income. The Tax Reform Act of 1986 subjected these bonds to the State volume cap on private-activity bonds.

Assessment

This exception was provided because it was believed that subsidized housing for low- and moderate-income families provided benefits to the Nation, and provided equitable treatment for families unable to take advantage of the substantial tax incentives available to those able to invest in owner-occupied housing.

Even if a case can be made for subsidy due to State and local underinvestment in residential rental housing, it is important to recognize the costs that accrue. As one of many categories of tax- exempt private-activity bonds, bonds issued for rental housing have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

U.S. Congress, Congressional Budget Office. Tax-Exempt Bonds for Multi-Family Residential Rental Property, 99th Congress, 1st session. June 21, 1985.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Tax Reform Act of 1986. May 4, 1987: 1171-1175.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

Commerce and Housing:

 

Housing

DEPRECIATION OF RENTAL HOUSING IN EXCESS

 

OF ALTERNATIVE DEPRECIATION SYSTEM

                       Estimated Revenue Loss

                      [In billions of dollars]

 

  ________________________________________________________

 

     Fiscal year  Individuals   Corporations     Total

 

  ________________________________________________________

 

         1995          0.7           1.0          1.7

 

         1996          0.6           1.0          1.6

 

         1997          0.6           0.9          1.5

 

         1998          0.5           0.8          1.3

 

         1999          0.5           0.7          1.2

Authorization

Sections 167 and 168.

Description

Taxpayers are allowed to deduct the costs of acquiring depreciable assets (assets that wear out or become obsolete over a period of years) as depreciation deductions. The tax code currently allows new rental housing to be written off over 27.5 years, using a "straight line" method where equal amounts are deducted in each period. This rule was adopted in 1986. There is also a prescribed 40- year write-off period for rental housing under the alternative minimum tax (also based on a straight-line method).

The tax expenditure measures the revenue loss from current depreciation deductions in excess of the deductions that would have been allowed under this longer 40-year period. The current revenue effects also reflect different write-off methods and lives prior to the 1986 revisions, since many buildings pre-dating that time are still being depreciated.

Prior to 1981, taxpayers were generally offered the choice of using the straight-line method or accelerated methods of depreciation, such as double-declining balance and sum-of-years digits, in which greater amounts are deducted in the early years. (Used buildings with a life of twenty years or more were restricted to 125-percent declining balance methods). The period of time over which deductions were taken varied with the taxpayer's circumstances.

Beginning in 1981, the tax law prescribed specific write-offs which amounted to accelerated depreciation over periods varying from 15 to 19 years. Since 1986, all depreciation on residential buildings has been on a straight-line basis over 27.5 years.

Example: Suppose a building with a basis of $10,000 was subject to depreciation over 27.5 years. Depreciation allowances would be constant at 1/27.5 x $10,000 = $364. For a 40-year life the write-off would be $250 per year. The tax expenditure in the first year would be measured as the difference between the tax savings of deducting $364 or $250, or $114.

Impact

Because depreciation methods faster than straight-line allow for larger deductions in the early years of the asset's life and smaller depreciation deductions in the later years, and because shorter useful lives allow quicker recovery, accelerated depreciation results in a deferral of tax liability.

It is a tax expenditure to the extent it is faster than economic (i.e., actual) depreciation, and evidence indicates that the economic decline rate for residential buildings is much slower than that reflected in tax depreciation methods.

The direct benefits of accelerated depreciation accrue to owners of rental housing. Benefits to capital income tend to concentrate in the higher-income classes (see discussion in the Introduction).

Rationale

Prior to 1954, depreciation policy had developed through administrative practices and rulings. The straight-line method was favored by IRS and generally used. Tax lives were recommended for assets through "Bulletin F," but taxpayers were also able to use a facts-and-circumstances justification.

A ruling issued in 1946 authorized the use of the 150-percent declining balance method. Authorization for it and other accelerated depreciation methods first appeared in legislation in 1954 when the double declining balance and other methods were enacted. The discussion at that time focused primarily on whether the value of machinery and equipment declined faster in their earlier years. However, when the accelerated methods were adopted, real property was included as well.

By the 1960s, most commentators agreed that accelerated depreciation resulted in excessive allowances for buildings. The first restriction on depreciation was to curtail the benefits that arose from combining accelerated depreciation with lower capital gains taxes when the building was sold. That is, while taking large deductions reduced the basis of the asset for measuring capital gains, these gains were taxed at the lower capital gains rate rather than the ordinary tax rate. In 1964, 1969, and 1976 various provisions to "recapture" accelerated depreciation as ordinary income in varying amounts when a building was sold were enacted.

In 1969, depreciation on used rental housing was restricted to 125 percent declining balance depreciation. Low-income housing was exempt from these restrictions.

In the Economic Recovery Tax Act of 1981, residential buildings were assigned specific write-off periods that were roughly equivalent to 175-percent declining balance methods (200 percent for low-income housing) over a 15-year period under the Accelerated Cost Recovery System (ACRS).

These changes were intended as a general stimulus to investment. Taxpayers could elect to use the straight-line method over 15 years, 35 years, or 45 years. (The Deficit Reduction Act of 1984 increased the 15-year life to 18 years; in 1985, it was increased to 19 years.) The recapture provisions would not apply if straight-line methods were originally chosen. The acceleration of depreciation that results from using the shorter recovery period under ACRS was not subject to recapture as accelerated depreciation.

The current treatment was adopted as part of the Tax Reform Act of 1986, which lowered tax rates and broadened the base of the income tax.

Assessment

Evidence suggests that the rate of economic decline of residential structures is much slower than the rates allowed under current law, and this provision causes a lower effective tax rate on such investments than would otherwise be the case. This treatment in turn tends to increase investment in rental housing relative to other assets, although there is considerable debate about how responsive these investments are to tax subsidies.

At the same time, the more rapid depreciation partly offsets the understatement of depreciation due to the use of historical cost- basis depreciation, assuming inflation is at a rate of five percent or so. Moreover, many other assets are eligible for accelerated depreciation as well.

Much of the previous concern about the role of accelerated depreciation in encouraging tax shelters in rental housing has faded because the current depreciation provisions are less rapid than those previously in place, and because there is a restriction on the deduction of passive losses.

Selected Bibliography

Auerbach, Alan, and Kevin Hassett. "Investment, Tax Policy, and the Tax Reform Act of 1986," Do Taxes Matter: The Impact of the Tax Reform Act of 1986, ed. Joel Slemrod. Cambridge, Mass.: MIT Press, 1990, pp. 13-49.

Board of Governors of the Federal Reserve System. Public Policy and Capital Formation. April 1981.

Brannon, Gerard M. "The Effects of Tax Incentives for Business Investment: A Survey of the Economic Evidence," The Economics of Federal Subsidy Programs, Part 3: Tax Subsidies, U.S. Congress, Joint Economic Committee, July 15, 1972, pp. 245-268.

Break, George F. "The Incidence and Economic Effects of Taxation," The Economics of Public Finance. Washington, DC: The Brookings Institution, 1974.

Bruesseman, William B., Jeffrey D. Fisher and Jerrold J. Stern. "Rental Housing and the Economic Recovery Tax Act of 1981," Public Finance Quarterly, v. 10. April 1982, pp. 222-241.

Burman, Leonard E., Thomas S. Neubig, and D. Gordon Wilson. "The Use and Abuse of Rental Project Models," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 307-349.

DeLeeuw, Frank, and Larry Ozanne. "Housing," How Taxes Affect Economic Behavior, eds. Henry J. Aaron and Joseph A. Pechman. Washington, DC: The Brookings Institution, 1981, pp. 283-326.

Feldstein, Martin. "Adjusting Depreciation in an Inflationary Economy: Indexing Versus Acceleration." National Tax Journal, v. 34. March 1981, pp. 29-43.

Follain, James R., Patric H. Hendershott, and David C. Ling. "Real Estate Markets Since 1980: What Role Have Tax Changes Played?" forthcoming, National Tax Journal . September 1992.

Fromm, Gary, ed. Tax Incentives and Capital Spending. Washington, DC: The Brookings Institution, 1971.

Fullerton, Don, Robert Gillette, and James Mackie. "Investment Incentives Under the Tax Reform Act of 1986," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 131-172.

Fullerton, Don, Yolanda K. Henderson, and James Mackie. "Investment Allocation and Growth Under the Tax Reform Act of 1986," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 173-202.

Gravelle, Jane G. "Differential Taxation of Capital Income: Another Look at the Tax Reform Act of 1986," National Tax Journal, v. 63. December 1989, pp. 441-464.

--. Economic Effects of Taxing Capital Income, Chapters 3 and 5. Cambridge, MA: MIT Press, 1994.

--. "Effects of the 1981 Depreciation Revisions on the Taxation of Income from Business Capital," National Tax Journal, v. 35. March 1982, pp. 1-20.

--. "Taxation and the Allocation of Capital: The Experience of the 1980s," Proceedings of the Annual Conference 1990. National Tax Association -- Tax Institute of America, pp. 27-36.

--. Tax Policy and Rental Housing: An Economic Analysis. Library of Congress, Congressional Research Service Report 87-536 E. Washington, DC: June 27, 1987.

--. Tax Subsidies for Investment: Issues and Proposals. Library of Congress, Congressional Research Service Report 92-205 E. Washington, DC: February 21, 1992.

Harberger, Arnold. "Tax Neutrality in Investment Incentives," The Economics of Taxation, eds. Henry J. Aaron and Michael J. Boskin. Washington, DC: The Brookings Institution, 1980, pp. 299-313.

Hulten, Charles, ed. Depreciation, Inflation, and the Taxation of Income From Capital. Washington, DC: The Urban Institute, 1981.

Poterba, James M. "Taxation and Housing Markets: Preliminary Evidence on the Effects of Recent Tax Reforms," Do Taxes Matter: The Impact of the Tax Reform Act of 1986, ed. Joel Slemrod. Cambridge, Mass: The MIT Press, 1990, pp. 13-49.

Surrey, Stanley S. Pathways to Tax Reform. Chapter VII: "Three Special Tax Expenditure Items: Support to State and Local Governments, to Philanthropy, and to Housing." Cambridge, Mass: Harvard University Press, 1973.

Taubman, Paul and Robert Rasche. "Subsidies, Tax Law, and Real Estate Investment," The Economics of Federal Subsidy Programs, Part 3: "Tax Subsidies." U.S. Congress, Joint Economic Committee, July 15, 1972, pp. 343-369.

U.S. Congress, Congressional Budget Office. Real Estate Tax Shelter Subsidies and Direct Subsidy Alternatives. May 1977.

--. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. May 4, 1987, pp. 89-110.

                        Commerce and Housing:

 

                               Housing

                    LOW-INCOME HOUSING TAX CREDIT

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

          Fiscal year  Individuals   Corporations    Total

 

_____________________________________________________________________

             1995          1.4           0.8          2.2

 

             1996          1.7           0.9          2.6

 

             1997          1.9           1.0          2.9

 

             1998          2.2           1.2          3.4

 

             1999          2.4           1.3          3.7

 

_____________________________________________________________________

Authorization

Section 42.

Description

A tax credit for a portion of acquisition costs (allowed in equal amounts over ten years) is allowed for low-income housing.

The credit rate is set so that the present value of the tax credit is equal to 70 percent for new construction and 30 percent for housing receiving other Federal benefits (such as tax exempt bond financing), or for substantially rehabilitated existing housing.

The credit is allowed only for the fraction of units serving low-income tenants, which are subject to maximum rent. To qualify, 20 percent of the units in a rental project must be occupied by families with less than 50 percent of area median income, or 40 percent of the units must be occupied by families with less than 60 percent of area median income.

An owner loses entitlement to the credit and is required to pay back a portion of credits already taken if the project is sold or ceases to qualify for low-income use within 15 years.

The credit can only be taken if it is allocated by the State housing authority; there is an annual per-resident limit of $1.25 for total credit authority. The housing agency must require an enforceable 30-year low-income use (through restrictive covenants), although if a buyer cannot be found after the initial 15-year period, the property can be converted to market use and sold at a controlled price.

The amount of the credit that can be offset against unrelated income is limited to the equivalent of $25,000 in deductions under the passive loss restriction rules.

Impact

This provision substantially reduces the cost of investing in qualified units. Given the spending caps which limit the allocation of property to this use, excess profits to investors might normally be expected. The oversight requirements should prevent this outcome, and direct much of the benefit to qualified tenants of the housing units. Thus, although the direct benefits are received by high-income investors, the actual benefit is likely to accrue to lower- and moderate-income tenants.

Rationale

The tax credit for low-income housing was adopted in the Tax Reform Act of 1986. It replaced a number of other provisions in the law, including accelerated depreciation, five-year amortization of rehabilitation expenditures, expensing of construction-period interest and taxes, and general availability of tax-exempt bond financing.

The initial credit was nine percent a year for ten years for new housing, and four percent per year for ten years for housing receiving other subsidies, and for the acquisition of rehabilitated existing housing. These amounts totaled 90 percent and 40 percent of the cost respectively, but the credit rate is to be set to be the equivalent of 70 percent and 30 percent in present value.

There was a State ceiling per capita of $1.25. Some minor changes were made by the Revenue Bill of 1987, including carryover of credit authority by States. The credit was scheduled to expire at the end of 1989, but was extended by the Omnibus Budget Reconciliation Acts of 1989 (through 1990 with a $0.9375 ceiling).

This 1989 revision also required States to regulate projects more carefully to insure that investors were not earning excessive rates of return. The law also introduced the requirement that new projects have a long-term plan for providing low-income housing, and Act Legislation in 1990 extended the provision through 1991. The Tax Extension Act of 1991 extended the credit through the first half of 1992. The Omnibus Budget Reconciliation Act of 1993 made the credit permanent.

Assessment

The low-income housing credit is much more targeted to benefiting lower-income individuals than the more general tax provisions it replaced. Moreover, by allowing State authorities to direct use, the credit can be used as part of a general neighborhood revitalization program.

There are, however, a number of criticisms that can be made of the credit (see the Congressional Budget Office study for a more detailed discussion). The credit is unlikely to have a substantial effect on the total supply of low-income housing, based on both micro-economic analysis and some empirical evidence.

There are significant overhead and administrative costs, especially if there are attempts to insure that investors do not earn excess profits. And, in general, some economists would argue that housing vouchers, or direct-income supplements for the low-income, are more direct and fairer methods of providing assistance to lower- income individuals.

Finally, although recapture rules and low-income-use covenants limit the ability of investors to take the credit and then shift use to higher-income purposes, there is an incentive to investors to allow units to deteriorate over time.

Selected Bibliography

U.S. Congress, Congressional Budget Office. The Cost-

 

Effectiveness of the Low-Income Housing Tax Credit Compared With

 

Housing Vouchers, CBO Staff Memorandum by Leonard Burman. April 1992.

House Committee on Ways and Means. Overview of Entitlement Programs. 1994 Green Book. 103d Congress, 2nd session, July 15, 1994, pp. 716-717.

--, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. May 4, 1987, pp. 152-177.

--. Staff Description and Analysis of Tax Provisions Expiring in 1992. January 27, 1992, pp. 69-78.

U.S. Department of Housing and Urban Development, Office of Policy Development and Research. "Evaluation of the Low-Income Housing Tax Credit: Final Report," prepared by ICF, Inc. February, 1991.

                        Commerce and Housing:

 

                     Other Business and Commerce

           MAXIMUM 28% TAX RATE ON LONG-TERM CAPITAL GAINS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

          Fiscal year  Individuals   Corporations    Total

 

_____________________________________________________________________

             1995          9.1           --           9.1

 

             1996         10.5           --          10.5

 

             1997         11.3           --          11.3

 

             1998         12.6           --          12.6

 

             1999         13.9           --          13.9

 

_____________________________________________________________________

Authorization

Sections 11(h), 631, 1201-1256.

Description

Gains on the sale of capital assets held for more than a year are limited to a maximum tax rate of 28 percent under the individual income tax, even though rates on ordinary income go up to 39.6 percent. Also, gain on the sale of property used in a trade or business is treated as a long-term capital gain if all gains for the year on such property exceed all losses for the year on such property. Qualifying property used in a trade or business generally is depreciable property or real estate that is held more than a year, but not inventory.

The tax expenditure is the difference between taxing gains at a 31-, 36-, 39.6- and a 28-percent tax rate. It is associated only with those in these higher brackets.

Several special categories of income that are treated as capital gains have been listed separately in previous tax expenditure compendiums: energy (capital gains treatment of coal royalties), natural resources (capital gains treatment of iron ore royalties and timber), and agriculture (gains on farm property including livestock). These items have become smaller, with only a small subsidy limited to individuals.

Impact

Benefits of the 28-percent maximum tax rate are limited to individuals with tax rates above 28 percent -- that is, those in the 31-percent bracket, the 36 percent bracket, or the 39.6 percent bracket. For 1994, a taxpayer filing a joint return would have to have taxable income of $91,850 before the 31 percent tax rate applied (single taxpayers would have to have $53,500). Total income would be considerably larger, probably in excess of $100,000. Taxable income would have to be $140,000 before the 36 percent rate applied, and $250,000 before the 39.6 percent rate applied.

Even among these higher-income taxpayers, there would be even more skewing of the benefits to the upper part of that higher-income distribution. For example, according to data presented by the Treasury Department (testimony of Ken Gideon, Deputy Assistant Secretary of Treasury for Tax Policy, March 6, 1990, before the House Ways and Means Committee), of capital gains taxes paid by individuals with economic incomes above $100,000, 70 percent of the tax was paid by individuals with incomes above $200,000. (The economic class of $100,000 and above accounted, in fact, for 72 percent of total capital gains tax paid.)

The primary assets that typically yield capital gains are corporate stock, and business and rental real estate. Corporate stock accounts for from 20 percent to 50 percent of total realized gains, depending on the state of the economy and the stock market. There are also gains from assets such as bonds, partnership interests, owner- occupied housing, timber, and collectibles, but all of these are relatively small as a share of total capital gains.

Rationale

Although the original 1913 Act taxed capital gains at ordinary rates, the 1921 law provided for an alternative flat-rate tax for individuals of 12.5 percent for gain on property acquired for profit or investment. This treatment was to minimize the influence of the high progressive rates on market transactions. The Committee Report noted that these gains are earned over a period of years, but are nevertheless taxed as a lump sum.

Over the years many revisions in this treatment have been made. In 1934, a sliding scale treatment was adopted (where lower rates applied the longer the asset was held). This system was revised in 1938.

In 1942, the sliding scale approach was replaced by a 50-percent exclusion for all but short-term gains (held for less than six months), with an elective alternative tax rate of 25 percent. The alternative tax affected only individuals in tax brackets above 50 percent.

The 1942 act also extended special capital gains treatment to property used in the trade or business, and introduced the alternative tax for corporations at a 25-percent rate, the alternative tax rate then in effect for individuals. This tax relief was premised on the belief that many wartime sales were involuntary conversions which could not be replaced during wartime, and that resulting gains should not be taxed at the greatly escalated wartime rates.

Treatment of gain from cutting timber was adopted in 1943, in part to equalize the treatment of those who sold timber as a stand (where income would automatically be considered a capital gain) and those who cut timber. Capital gains treatment for coal royalties was added in 1951 to make the treatment of coal lessors the same as that of timber lessors and to encourage coal production. Similar treatment of iron ore was enacted in 1964 to make the treatment consistent with coal and to encourage production. The 1951 act also specified that livestock was eligible for capital gains, an issue that had been in dispute since 1942.

The alternative tax for individuals was repealed in 1969, and the alternative rate for corporations was reduced to 30 percent. The minimum tax on preference income and the maximum tax offset, enacted in 1969, raised the capital gains rate for some taxpayers.

In 1976 the minimum tax was strengthened, and the holding period lengthened to one year. The effect of these provisions was largely eliminated in 1978, which also introduced a 60-percent exclusion for individuals and lowered the alternative rate for corporations to 28 percent. The alternative corporate tax rate was chosen to apply the same maximum marginal rate to capital gains of corporations as applied to individuals (since the top rate was 70 percent, and the capital gains tax was 40 percent of that rate due to the exclusion).

The Tax Reform Act of 1986, which lowered overall tax rates and provided for only two rate brackets (15 percent and 28 percent), provided that capital gains would be taxed at the same rates as ordinary income. This rate structure included a "bubble" due to phase-out provisions that caused effective marginal tax rates to go from 28 percent to 33 percent and back to 28 percent.

In 1990, this bubble was eliminated, and a 31-percent rate was added to the rate structure. There had, however, been considerable debate over proposals to reduce capital gains taxes. Since the new rate structure would have increased capital gains tax rates for many taxpayers from 28 percent to 31 percent, the separate capital gains rate cap was introduced. The 28 percent rate cap was retained when the 1993 Omnibus Budget Reconciliation Act added a top rate of 36 percent and a ten percent surcharge on very high incomes, producing a maximum rate of 39.6 percent.

Assessment

The original rationale for allowing a capital gains exclusion or alternative tax benefit -- the problem of bunching of income under a progressive tax -- is relatively unimportant under the current flatter rate structure.

A primary rationale for reducing the tax on capital gains is to mitigate the lock-in effect. Since the tax is paid only on a realization basis, an individual is discouraged from selling an asset. This effect causes individuals to hold a less desirable mix of assets, causing an efficiency loss. This loss could be quite large relative to revenue raised if the realizations response is large.

Some have argued, based on certain statistical studies, that the lock-in effect is, in fact, so large that a tax cut could actually raise revenue. Others have argued that the historical record and other statistical studies do not support this view and that capital gains tax cuts will cause considerable revenue loss. This debate about the realizations response has been a highly controversial issue.

Although there are efficiency gains from reducing lock-in, capital gains taxes can also affect efficiency through other means, primarily through the reallocation of resources between types of investments. Lower capital gains taxes may disproportionately benefit real estate investments, and may cause corporations to retain more earnings than would otherwise be the case, causing efficiency losses. At the same time lower capital gains taxes reduce the distortion that favors corporate debt over equity, which produces an efficiency gain.

Another argument in favor of capital gains relief is that much of gain realized is due to inflation. On the other hand, capital gains benefit from deferral of tax in general, and this deferral can become an exclusion if gains are held until death. Moreover, many other types of capital income (e.g., interest income) are not corrected for inflation.

The particular form of this capital gains tax relief also results in more of a concentration towards higher-income individuals than would be the case with an overall exclusion.

Selected Bibliography

Auerbach, Alan J. "Capital Gains Taxation and Tax Reform," National Tax Journal, v. 42. September 1989, pp. 391-401.

Auten, Gerald E., Leonard E. Burman, and William C. Randolph. "Estimation and Interpretation of Capital Gains Realization Behavior: Evidence from Panel Data," National Tax Journal, v. 42. September 1989, pp. 353-374.

Auten, Gerald E., and Joseph Cordes. "Cutting Capital Gains Taxes," Journal of Economic Perspectives, v. 5. Winter 1991, pp. 181- 192.

Bailey, Martin J. "Capital Gains and Income Taxation," Taxation of Income From Capital, ed. Arnold C. Harberger. Washington, DC: The Brookings Institution, 1969, pp. 11-49.

Burman, Leonard E. "Why Capital Gains Tax Cuts (Probably) Don't Pay for Themselves," Tax Notes. April 2, 1990, pp. 109-110.

--, and William C. Randolph. "Measuring Permanent Responses to Capital Gains Tax Changes In Panel Data," American Economic Review, v. 84, September, 1994.

--. "Theoretical Determinants of Aggregate Capital Gains Realizations." Manuscript, 1992.

Cook. Eric W., and John F. O'Hare, "Capital Gains Redux: Why Holding Periods Matter," National Tax Journal, v. 45. March 1992, pp. 53-76.

David, Martin. Alternative Approaches to Capital Gains Taxation. Washington DC: The Brookings Institution, 1968.

Davis, Albert J., "Measuring the Distributional Effects of Tax Changes for the Congress," National Tax Journal, v. 44. September, 1991, pp. 257-268.

Gillingham, Robert, and John S. Greenlees, "The Effect of Marginal Tax Rates on Capital Gains Revenue: Another Look at the Evidence," National Tax Journal, v. 45. June 1992, pp. 167-178.

Gravelle, Jane G. Can a Capital Gains Tax Cut Pay for Itself? Library of Congress, Congressional Research Service Report 90-161 RCO. Washington, DC: March 23, 1990.

--. Capital Gains Tax Issues. Library of Congress, Congressional Research Service Report 88-80. Washington, DC: January 8, 1988.

--. Economic Effects of Taxing Capital Income, Chapter 6. Cambridge, MA: MIT Press, 1994.

--. Limits to Capital Gains Feedback Effects. Library of Congress, Congressional Research Service Report 91-250. Washington, DC: March 15, 1991.

Hoerner, J. Andrew, ed. The Capital Gains Controversy: A Tax Analyst's Reader. Arlington, VA: Tax Analysts, 1992.

Holt, Charles C., and John P. Shelton, "The Lock-In Effect of the Capital Gains Tax," National Tax Journal, v. 15. December 1962, pp. 357-352.

Kiefer, Donald W. "Lock-In Effect Within a Simple Model of Corporate Stock Trading," National Tax Journal, v. 43. March 1990, pp. 75-95.

Minarik, Joseph. "Capital Gains," How Taxes Affect Economic Behavior, eds. Henry J. Aaron and Joseph A. Pechman. Washington, DC: The Brookings Institution, 1983, pp. 241-277.

Poterba, James, "Venture Capital and Capital Gains Taxation," Tax Policy and the Economy, v. 3, ed. Lawrence H. Summers, National Bureau of Economic Research. Cambridge, Mass.: MIT Press, 1989, pp. 47-67.

Slemrod, Joel, and William Shobe. "The Tax Elasticity of Capital Gains Realizations: Evidence from a Panel of Taxpayers," National Bureau of Economic Research Working Paper 3737. January 1990.

U.S. Congress, Congressional Budget Office. How Capital Gains Tax Rates Affect Revenues: The Historical Evidence. Washington, DC: U.S. Government Printing Office, March 1988.

--. Indexing Capital Gains, prepared by Leonard Burman and Larry Ozanne. Washington, DC: U.S. Government Printing Office, August 1990.

U.S. Department of Treasury, Office of Tax Analysis. Report to the Congress on the Capital Gains Tax Reductions of 1978. Washington, DC: U.S. Government Printing Office, September 1985.

Wetzler, James W. "Capital Gains and Losses," Comprehensive Income Taxation, ed. Joseph Pechman. Washington, DC: The Brookings Institution, 1977, pp. 115-162.

Zodrow, George R. "Economic Analysis of Capital Gains Taxation: Realizations, Revenues, Efficiency and Equity," Tax Law Review, v. 48, no. 3, pp. 419-527.

                        Commerce and Housing:

 

                     Other Business and Commerce

         DEPRECIATION ON BUILDINGS OTHER THAN RENTAL HOUSING

 

            IN EXCESS OF ALTERNATIVE DEPRECIATION SYSTEM

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

           Fiscal year  Individuals  Corporations    Total

 

_____________________________________________________________________

              1995          1.4          3.5          4.9

 

              1996          1.3          3.2          4.5

 

              1997          1.1          2.7          3.8

 

              1998          0.9          2.1          3.0

 

              1999          0.6          1.5          2.1

 

_____________________________________________________________________

Authorization

Section 167 and 168.

Description

Taxpayers are allowed to deduct the costs of acquiring depreciable assets (assets that wear out or become obsolete over a period of years) as depreciation deductions. The tax code currently allows new buildings other than rental housing to be written off over 39 years, using a "straight line" method where equal amounts are deducted in each period. There is also a prescribed 40 year write-off period for these buildings under the alternative minimum tax (also based on a straight line method).

The tax expenditure measures the revenue loss from current depreciation deductions in excess of the deductions that would have been allowed under this longer 40-year period. The current revenue effects also reflect different write-off methods and lives prior to the 1993 revisions, which set the 39-year life, since many buildings pre-dating that time are still being depreciated.

Prior to 1981, taxpayers were generally offered the choice of using the straight-line method or accelerated methods of depreciation, such as double-declining balance and sum-of-years digits, in which greater amounts are deducted in the early years. Non-residential buildings were restricted in 1969 to 150-percent declining balance (used buildings were restricted to straight-line). The period of time over which deductions were taken varied with the taxpayer's circumstances.

Beginning in 1981, the tax law prescribed specific write-offs

 

which amounted to accelerated depreciation over periods varying from

 

15 to 19 years. In 1986, all depreciation on nonresidential buildings

 

was on a straight-line basis over 31.5 years, and that period was

 

increased to 39 years in 1993.

Example: Suppose a building with a basis of $10,000 was subject to depreciation over 39 years. Depreciation allowances would be constant at 1/39 x $10,000 = $257. For a 40-year life the write-off would be $250 per year. The tax expenditure in the first year would be measured as the difference between the tax savings of deducting $257 or $250, or $7.

Impact

Because depreciation methods faster than straight-line allow for larger deductions in the early years of the asset's life and smaller depreciation deductions in the later years, and because shorter useful lives allow quicker recovery, accelerated depreciation results in a deferral of tax liability.

It is a tax expenditure to the extent it is faster than economic (i.e., actual) depreciation, and evidence indicates that the economic decline rate for non-residential buildings is much slower than that reflected in tax depreciation methods.

The direct benefits of accelerated depreciation accrue to owners of buildings, and particularly to corporations. The benefit is estimated as the tax saving resulting from the depreciation deductions in excess of straight-line depreciation. Benefits to capital income tend to concentrate in the higher-income classes (see discussion in the Introduction).

Rationale

Prior to 1954, depreciation policy had developed through administrative practices and rulings. The straight-line method was favored by IRS and generally used. Tax lives were recommended for assets through "Bulletin F," but taxpayers were also able to use a facts and circumstances justification.

A ruling issued in 1946 authorized the use of the 150-percent declining balance method. Authorization for it and other accelerated depreciation methods first appeared in legislation in 1954 when the double declining balance and other methods were enacted. The discussion at that time focused primarily on whether the value of machinery and equipment declined faster in their earlier years. However, when the accelerated methods were adopted, real property was included as well.

By the 1960s, most commentators agreed that accelerated depreciation resulted in excessive allowances for buildings. The first restriction on depreciation was to curtail the benefits that arose from combining accelerated depreciation with lower capital gains taxes when the building was sold.

In 1964, 1969, and 1976 various provisions to "recapture" accelerated depreciation as ordinary income in varying amounts when a building was sold were enacted. In 1969, depreciation for nonresidential structures was restricted to 150-percent declining balance methods (straight-line for used buildings).

In the Economic Recovery Tax Act of 1981, buildings were assigned specific write-off periods that were roughly equivalent to 175-percent declining balance methods (200 percent for low-income housing) over a 15-year period under the Accelerated Cost Recovery System (ACRS). These changes were intended as a general stimulus to investment.

Taxpayers could elect to use the straight-line method over 15 years, 35 years, or 45 years. (The Deficit Reduction Act of 1984 increased the 15-year life to 18 years; in 1985, it was increased to 19 years.) The recapture provisions would not apply if straight-line methods were originally chosen. The acceleration of depreciation that results from using the shorter recovery period under ACRS was not subject to recapture as accelerated depreciation.

The current straight-line treatment was adopted as part of the Tax Reform Act of 1986, which lowered tax rates and broadened the base of the income tax. A 31.5-year life was adopted at that time; it was increased to 39 years by the Omnibus Budget Reconciliation Act of 1993.

Assessment

Evidence suggests that the rate of economic decline of rental structures is much slower than the rates allowed under current law, and this provision causes a lower effective tax rate on such investments than would otherwise be the case. This treatment in turn tends to increase investment in nonresidential structures relative to other assets, although there is considerable debate about how responsive these investments are to tax subsidies.

At the same time, the more rapid depreciation partly offsets the understatement of depreciation due to the use of historical cost basis depreciation, assuming inflation is at a rate of five percent or so. Moreover, many other assets are eligible for accelerated depreciation as well.

Much of the previous concern about the role of accelerated depreciation in encouraging tax shelters in commercial buildings has faded because the current depreciation provisions are less rapid than those previously in place and because there is a restriction on the deduction of passive losses.

Selected Bibliography

Auerbach, Alan, and Kevin Hassett. "Investment, Tax Policy, and the Tax Reform Act of 1986," Do Taxes Matter: The Impact of the Tax Reform Act of 1986, ed. Joel Slemrod. Cambridge, Mass: The MIT Press, 1990, pp. 13-49.

Board of Governors of the Federal Reserve System. Public Policy and Capital Formation. April 1981.

Brannon, Gerard M. "The Effects of Tax Incentives for Business Investment: A Survey of the Economic Evidence," U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs, Part 3: "Tax Subsidies." July 15, 1972, pp. 245-268.

Break, George F. "The Incidence and Economic Effects of Taxation," The Economics of Public Finance. Washington, DC: The Brookings Institution, 1974.

Burman, Leonard E., Thomas S. Neubig, and D. Gordon Wilson. "The Use and Abuse of Rental Project Models," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 307-349.

Feldstein, Martin. "Adjusting Depreciation in an Inflationary Economy: Indexing Versus Acceleration," National Tax Journal, v. 34. March 1981, pp. 29-43.

Follain, James R., Patric H. Hendershott, and David C. Ling, "Real Estate Markets Since 1980: What Role Have Tax Changes Played?" forthcoming, National Tax Journal. September 1992.

Fromm, Gary, ed. Tax Incentives and Capital Spending. Washington, DC: The Brookings Institution, 1971.

Fullerton, Don, Robert Gillette, and James Mackie, "Investment Incentives Under the Tax Reform Act of 1986," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 131-172.

Fullerton, Don, Yolanda K. Henderson, and James Mackie, "Investment Allocation and Growth Under the Tax Reform Act of 1986," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 173-202.

Gravelle, Jane G. "Differential Taxation of Capital Income: Another Look at the Tax Reform Act of 1986," National Tax Journal, v. 63. December 1989, pp. 441-464.

--. Economic Effects of Taxing Capital Income, Chapter 6. Cambridge, MA: MIT Press, 1994.

--. "Effects of the 1981 Depreciation Revisions on the Taxation of Income from Business Capital," National Tax Journal, v. 35. March 1982, pp. 1-20.

--. "Taxation and the Allocation of Capital: The Experience of the 1980s," Proceedings of the Annual Conference 1990, National Tax Association -- Tax Institute of American. Pp. 27-36.

--. Tax Subsidies for Investment: Issues and Proposals, Library of Congress, Congressional Research Service Report 92-205 E. Washington, DC: February 21, 1992.

Harberger, Arnold. "Tax Neutrality in Investment Incentives," The Economics of Taxation, eds. Henry J. Aaron and Michael J. Boskin. Washington, DC: The Brookings Institution, 1980.

Hulten, Charles, ed. Depreciation, Inflation, and the Taxation of Income From Capital. Washington, DC: The Urban Institute, 1981.

Taubman, Paul and Robert Rasche. "Subsidies, Tax Law, and Real Estate Investment," U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Program," Part 3: "Tax Subsidies." July 15, 1972, pp. 343-369.

U.S. Congress, Congressional Budget Office. Real Estate Tax Shelter Subsidies and Direct Subsidy Alternatives. May 1977.

--. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. May 4, 1987, pp. 89-110.

                        Commerce and Housing:

 

                     Other Business and Commerce

               DEPRECIATION ON EQUIPMENT IN EXCESS OF

 

                   ALTERNATIVE DEPRECIATION SYSTEM

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

Fiscal year         Individuals       Corporations        Total

 

____________________________________________________________________

   1995                 5.7              19.9             25.6

 

   1996                 5.7              19.9             25.6

 

   1997                 5.6              19.6             25.2

 

   1998                 5.4              19.1             24.5

 

   1999                 5.5              19.2             24.7

 

____________________________________________________________________

Authorization

Section 167 and 168.

Description

Taxpayers are allowed to deduct the cost of acquiring depreciable assets (assets that wear out or become obsolete over a period of years) as depreciation deductions. How quickly the deductions are taken depends on the period of years over which recovery occurs and the method used. Straight-line methods allow equal deductions in each year; accelerated methods, such as declining balance methods, allow larger deductions in the earlier years.

Equipment is currently divided into six categories to be depreciated over 3, 5, 7, 10, 15, and 20 years. Double declining balance depreciation is allowed for all but the last two classes, which are restricted to 150 percent declining balance. A double declining balance method allows twice the straight-line rate to be applied in each year to the remaining undepreciated balance; a 150- percent declining balance rate allows 1.5 times the straight-line rate to be applied in each year to the remaining undepreciated balance. At some point, the taxpayer can switch to straight-line -- write off the remaining undepreciated cost in equal amounts over the remaining life.

The 1986 law also prescribed a depreciation system for the alternative minimum tax, which applies to a broader base. The alternative depreciation system requires recovery over the midpoint of the Asset Depreciation Range, using straight-line depreciation. The Asset Depreciation Range was the set of tax lives specified before 1981 and these lives are longer than the lives allowed under the regular tax system.

This tax expenditure measures the difference between regular tax depreciation and the alternative depreciation system. The tax expenditure also reflects different write-off periods and lives for assets acquired prior to the 1986 provisions. For most of these older assets regular tax depreciation has been completed, so that the effects of these earlier vintages of equipment would be to enter as a revenue gain rather than as a loss.

In the past, taxpayers were generally offered the choice of using the straight-line method or accelerated methods of depreciation such as double-declining balance and sum-of-years digits, in which greater amounts are deducted in the early years. Tax lives varied across different types of equipment under the Asset Depreciation Range System, which prescribed a range of tax lives. Equipment was restricted to 150-percent declining balance by the 1981 Act, which shortened tax lives to five years.

Example: Consider a $10,000 piece of equipment that falls in the five-year class (with double declining balance depreciation) with an eight-year midpoint life. In the first year, depreciation deductions would be 2/5 times $10,000, or $4,000. In the second year, the basis of depreciation is reduced by the previous year's deduction to $6,000, and depreciation would be $2400 (2/5 times $6,000).

Depreciation under the alternative system would be 1/8th in each year, or $1,250. Thus, the tax expenditure in year one would be the difference between $4,000 and $1,250, multiplied by the tax rate. The tax expenditure in year two would be the difference between $2,400 and $1,250 multiplied by the tax rate.

Impact

Because depreciation methods faster than straight-line allow for larger deprecation deductions in the early years of the asset's life and smaller deductions in the later years, and because shorter useful lives allow quicker recovery, accelerated depreciation results in a deferral of tax liability. It is a tax expenditure to the extent it is faster than economic (i.e., actual) depreciation, and evidence indicates that the economic decline rate for equipment is much slower than that reflected in tax depreciation methods.

The direct benefits of accelerated depreciation accrue to owners of assets and particularly to corporations. The benefit is estimated as the tax saving resulting from the depreciation deductions in excess of straight-line depreciation under the alternative minimum tax. Benefits to capital income tend to concentrate in the higher- income classes (see discussion in the Introduction).

Rationale

Prior to 1954, depreciation policy had developed through administrative practices and rulings. The straight-line method was favored by IRS and generally used. Tax lives were recommended for assets through "Bulletin F," but taxpayers were also able to use a facts and circumstances justification.

A ruling issued in 1946 authorized the use of the 150-percent declining balance method. Authorization for it and other accelerated depreciation methods first appeared in legislation in 1954 when the double-declining balance and other methods were enacted. The discussion at that time focused primarily on whether the value of machinery and equipment declined faster in their earlier years.

In 1962, new tax lives for equipment assets were prescribed that were shorter than the lives existing at that time. In 1971, the Asset Depreciation Range System was introduced by regulation and confirmed through legislation. This system allowed taxpayers to use lives up to twenty percent shorter or longer than those prescribed by regulation.

In the Economic Recovery Tax Act of 1981, equipment assets were assigned fixed write-off periods which corresponded to 150-percent declining balance over five years (certain assets were assigned three-year lives). These changes were intended as a general stimulus to investment and to simplify the tax law by providing for a single write-off period. The method was eventually to be phased into a 200- percent declining balance method, but the 150-percent method was made permanent by the Tax Equity and Fiscal Responsibility Act of 1982.

The current treatment was adopted as part of the Tax Reform Act of 1986, which lowered tax rates and broadened the base of the income tax.

Assessment

Evidence suggests that the rate of economic decline of equipment is much slower than the rates allowed under current law, and this provision causes a lower effective tax rate on such investments than would otherwise be the case. The effect of these benefits on investment in equipment is uncertain, although more studies find equipment somewhat responsive to tax changes than they do structures. Many other assets also, however, benefit from accelerated depreciation.

The more rapid depreciation roughly offsets the understatement of depreciation due to the use of historical cost basis depreciation, if inflation is at a rate of about five percent or so. Under these circumstances the effective tax rate on equipment is close to the statutory tax rate and the tax rates of most assets are relatively close. If inflation falls, equipment tends to be favored relative to other assets and the tax system causes a misallocation of capital.

Some arguments are made that investment in equipment should be subsidized because it is more "high tech"; conventional economic theory suggests, however, that tax neutrality is more likely to ensure that investment is allocated to its most productive use.

Selected Bibliography

Auerbach, Man, and Kevin Hassett. "Investment, Tax Policy, and the Tax Reform Act of 1986," Do Taxes Matter: The Impact of the Tax Reform Act of 1986, ed. Joel Slemrod. Cambridge, Mass: MIT Press, 1990, pp. 13-49.

Board of Governors of the Federal Reserve System. Public Policy and Capital Formation. April 1981.

Brannon, Gerard M. "The Effects of Tax Incentives for Business Investment: A Survey of the Economic Evidence," U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs, Part 3: "Tax Subsidies." July 15, 1972, pp. 245-268.

Break, George F. "The Incidence and Economic Effects of Taxation," The Economics of Public Finance. Washington, DC: The Brookings Institution, 1974.

Feldstein, Martin. "Adjusting Depreciation in an Inflationary Economy: Indexing Versus Acceleration," National Tax Journal, v. 34. March 1981, pp. 29-43.

Fromm, Gary, ed. Tax Incentives and Capital Spending. Washington, DC: The Brookings Institution, 1971.

Fullerton, Don, Robert Gillette, and James Mackie. "Investment Incentives Under the Tax Reform Act of 1986," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 131-172.

Fullerton, Don, Yolanda K. Henderson, and James Mackie. "Investment Allocation and Growth Under the Tax Reform Act of 1986," Compendium of Tax Research 1987, Office of Tax Analysis, Department of The Treasury. Washington, DC: U.S. Government Printing Office, 1987, pp. 173-202.

Gravelle, Jane G. "Differential Taxation of Capital Income: Another Look at the Tax Reform Act of 1986," National Tax Journal, v. 63. December 1989, pp. 441-464.

--. Economic Effects of Taxing Capital Income, Chapters 3 and 5. Cambridge, MA: MIT Press, 1994.

--. "Effects of the 1981 Depreciation Revisions on the Taxation of Income from Business Capital," National Tax Journal, v. 35. March 1982, pp. 1-20.

--. "Taxation and the Allocation of Capital: The Experience of the 1980s," Proceedings of the Annual Conference 1990. National Tax Association -- Tax Institute of America, pp. 27-36.

--. Tax Subsidies for Investment: Issues and Proposals." Library of Congress, Congressional Research Service Report 92-205 E. Washington, DC: February 21, 1992.

Harberger, Arnold, "Tax Neutrality in Investment Incentives," The Economics of Taxation, eds. Henry J. Aaron and Michael J. Boskin. Washington, DC: The Brookings Institution, 1980, pp. 299-313.

Hendershott, Patric and Sheng-Cheng Hu, "Investment in Producers' Durable Equipment," How Taxes Affect Economic Behavior, eds. Henry J. Aaron and Joseph A. Pechman. Washington, DC: The Brookings Institution, 1981, pp. 85-129.

Hulten, Charles, ed. Depreciation, Inflation, and the Taxation of Income From Capital. Washington, DC: The Urban Institute, 1981.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. May 4, 1987, pp. 89-110.

                        Commerce and Housing:

 

                     Other Business and Commerce

              EXPENSING OF UP TO $17,500 OF DEPRECIABLE

 

                          BUSINESS PROPERTY

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

Fiscal year         Individuals       Corporations        Total

 

____________________________________________________________________

   1995                 0.6               0.9              1.5

 

   1996                 0.4               0.7              1.1

 

   1997                 0.3               0.5              0.8

 

   1998                 0.1               0.3              0.3

 

   1999                 /1/               0.1              0.2

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 179.

Description

A taxpayer (other than a trust or estate) may elect, in lieu of capital-cost-recovery deductions, to deduct as an expense up to $17,500 of the cost of qualifying property in the taxable year it is placed in service. In general, qualifying property is equipment acquired, by purchase, for use in a trade or business. The amount that can be expensed is phased out if the taxpayer places more than $200,000 of property in service during the year.

Impact

In the absence of this provision, the cost of depreciable business property would have to be recovered over a period of years beginning with the year it is placed in service. The provision therefore permits the depreciation of relatively small amounts of business property to be substantially accelerated. Expensing is equivalent to eliminating taxes; the effective tax rate on the investment falls to zero.

Benefits to capital income tend to concentrate in the higher income classes (see discussion in the Introduction).

Rationale

A special deduction for 20 percent of the first $10,000 of investment ($20,000 in the case of a joint return) was enacted in 1959, to provide relief and incentives for small businesses.

The Economic Recovery Act of 1981 substituted first-year expensing to assist small businesses and to simplify depreciation accounting for them. The 1981 law provided for a $5,000 limit, which was to be gradually raised to $10,000 (the full phase-in was delayed by the Deficit Reduction Act of 1984).

Property eligible for expensing was not eligible for the investment tax credit, making the provision of little economic benefit until the repeal of the credit in 1986. In 1993 the President proposed a temporary investment credit for equipment for large firms and a permanent one for small firms. These credits were not adopted, but the $10,000 expensing limit was increased to $17,500.

Assessment

This provision simplifies accounting for small businesses whose purchases fall under the limit. It also encourages investment in those businesses.

Although some argue that investment should be encouraged in small businesses because they tend to create more jobs and engage in more innovation than larger firms, evidence on this issue is mixed. Conventional economic analysis indicates that maximum output is produced when all investments are taxed at the same rate.

For firms with expenditures normally above the $17,500 limit, expensing is not an incentive to further investment, nor does it simplify depreciation accounting.

Selected Bibliography

Armington, Catherine, and Marjorie Odle. "Small Business -- How Many Jobs?" The Brookings Review, v. 1, no. 2. Winter 1982, pp. 14- 17.

Cahlin, Richard A. "Current Deduction Available for Many Costs That Are Capital in Nature," Taxation for Accountants, v. 29. November 1982, pp. 292-295.

Gravelle, Jane G. Small Business Tax Subsidy Proposals. Library of Congress, Congressional Research Service Report 93-316. Washington, DC: March 15, 1994.

                        Commerce and Housing:

 

                     Other Business and Commerce

                 EXCLUSION OF CAPITAL GAINS AT DEATH

 

              CARRYOVER BASIS OF CAPITAL GAINS ON GIFTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

Fiscal year         Individuals       Corporations        Total

 

____________________________________________________________________

   1995                14.1                -              14.1

 

   1996                15.5                -              15.5

 

   1997                16.9                -              16.9

 

   1998                18.7                -              18.7

 

   1999                20.1                -              20.1

 

____________________________________________________________________

Authorization

Sections 1001, 1002, 1014, 1015, 1023, 1040, 1221, and 1222.

Description

A capital gains tax generally is imposed on the increased value of a capital asset (the difference between sales price and original cost of the asset) when the asset is sold or exchanged. This tax is not, however, imposed on the appreciation in value when ownership of the property is transferred as a result of the death of the owner or as a gift during the lifetime of the owner.

In the case of assets transferred at death, the heir's cost basis in the asset (the amount that he subtracts from sales price to determine gain if the asset is sold in the future) generally is the fair market value as of the date of decedent's death. Thus no income tax is imposed on appreciation occurring before the decedent's death, since the cost basis is increased by the amount of appreciation that has already occurred. In the case of gift transfers, the donee's basis in the property is the same as the donor's (usually the original cost of the asset). Thus, if the donee disposes of the property in a sale or exchange, the capital gains tax will apply to the pre-transfer appreciation. Tax on the gain is deferred, however, and may be forgiven entirely if the donee in turn passes on the property at death.

Assets transferred at death or by inter vivos gifts (gifts between living persons) may be subject to the Federal estate and gift taxes, respectively, based upon their value at the time of transfer.

Impact

The exclusion of capital gains at death is most advantageous to individuals who need not dispose of their assets to achieve financial liquidity. Generally speaking, these individuals tend to be wealthier. The deferral of tax on the appreciation involved combined with the exemption for the appreciation before death is a significant benefit for these investors and their heirs.

Failure to tax capital gains at death encourages lock-in of assets, which in turn means less current turnover of funds available for investment. In deciding whether to change his portfolio, an investor takes into account the higher pre-tax rate of return he might obtain from the new investment, the capital gains tax he might have to pay if he changes his portfolio, and the capital gains tax his heirs might have to pay if he decides not to change his portfolio.

Often an investor in this position decides that, since his heirs will incur no capital gains tax on appreciation that occurs before the investor's death, he should transfer his portfolio unchanged to the next generation. The failure to tax capital gains at death and the deferral of tax tend to benefit high-income individuals (and their heirs) who have assets that yield capital gains.

Some insight into the distributional effects of this tax expenditure may be found by considering the distribution of current payments of capital gains tax. As shown in the Treasury Department's distributional table produced below (based on the testimony of Ken Gideon, Deputy Assistant Secretary for Tax Policy, before the House Ways and Means Committee on March 6, 1990), these taxes are heavily concentrated among high-income individuals.

Of course, the distribution of capital gains taxes could be different from the distribution of taxes not paid because they are passed on at death, but the provision would always accrue largerly to higher-income individuals who tend to hold most of the wealth in the country.

            Estimated Distribution of Capital Gains Taxes

          _________________________________________________

 

              Income Class                  Percentage

 

          _________________________________________________

            less than $10,000                0.6

 

            $10,000-$20,000                  1.4

 

            $20,000-$30,000                  1.6

 

            $30,000-$50,000                  6.1

 

            $50,000-$100,000                16.1

 

            $100,000-$200,000               19.7

 

            Over $200,000                   54.5

 

____________________________________________________________________

The primary assets that typically yield capital gains are corporate stock, real estate, and owner-occupied housing.

Rationale

The original rationale for nonrecognition of capital gains on inter vivos gifts or transfers at death is not indicated in the legislative history of any of the several interrelated applicable provisions. However, one current justification given for the treatment is that death and inter vivos gifts are considered as inappropriate events to result in the recognition of income.

The Tax Reform Act of 1976 provided that the heir's basis in property transferred at death would be determined by reference to the decedent's basis. This carryover basis provision was not permitted to take effect and was repealed in 1980. The primary stated rationale for repeal was the concern that carryover basis created substantial administrative burdens for estates, heirs, and the Treasury Department.

Assessment

Failure to tax gains transferred at death is probably a primary cause of lock-in and its attendant efficiency costs; indeed, without the possibility of passing on gains at death without taxation, the lock-in effect would be greatly reduced.

The lower capital gains taxes that occur because of failure to tax capital gains at death can also affect efficiency through other means, primarily through the reallocation of resources between types of investments. Lower capital gains taxes may disproportionally benefit real estate investments and may cause corporations to retain more earnings than would otherwise be the case, causing efficiency losses. At the same time, lower capital gains taxes reduce the distortion that favors corporate debt over equity, which produces an efficiency gain.

There are several problems with taxing capital gains at death. There are administrative problems, particularly for assets held for a very long time when heirs do not know the basis. In addition, taxation of capital gains at death would cause liquidity problems for some taxpayers, such as owners of small farms and businesses. Therefore most proposals for taxing capital gains at death would combine substantial averaging provisions, deferred tax payment schedules, and a substantial deductible floor in determining the amount of gain to be taxed.

Selected Bibliography

Auerbach, Alan J. "Capital Gains Taxation and Tax Reform," National Tax Journal, v. 42. September, 1989, pp. 391-401.

Bailey, Martin J. "Capital Gains and Income Taxation," Taxation of Income From Capital, ed. Arnold C. Harberger. Washington, DC: The Brookings Institution, 1969, pp. 11-49.

Burman, Leonard E., and William C. Randolph. "Measuring Permanent Responses to Capital Gains Tax Changes In Panel Data," American Economic Review, v. 84, September, 1994.

--. "Theoretical Determinants of Aggregate Capital Gains Realizations," Manuscript, 1992.

David, Martin. Alternative Approaches to Capital Gains Taxation. Washington, DC: The Brookings Institution, 1968.

Gravelle, Jane G. Can a Capital Gains Tax Cut Pay for Itself? Library of Congress, Congressional Research Service Report 90-161 RCO, March 23, 1990.

--. Capital Gains Tax Issues. Library of Congress, Congressional Research Service Report 88-80, January 8, 1988.

--. Economic Effects of Taxing Capital Income, Chapter 6. Cambridge, MA: MIT Press, 1994.

--. Limits to Capital Gains Feedback Effects. Library of Congress, Congressional Research Service Report 91-250, March 15, 1991.

Hoerner, J. Andrew, ed. The Capital Gains Controversy: A Tax Analyst's Reader. Arlington, VA: Tax Analysts, 1992.

Holt, Charles C., and John P. Shelton. "The Lock-In Effect of the Capital Gains Tax," National Tax Journal, v. 15. December 1962, pp. 357-352.

Kiefer, Donald W. "Lock-In Effect Within a Simple Model of Corporate Stock Trading," National Tax Journal, v. 43. March, 1990, pp. 75-95.

Minarik, Joseph. "Capital Gains." How Taxes Affect Economic Behavior, eds. Henry J. Aaron and Joseph A. Pechman. Washington, DC: The Brookings Institution, 1983, pp. 241-277.

Surrey, Stanley S., et al., eds. "Taxing Capital Gains at the Time of a Transfer at Death or by Gift," Federal Tax Reform for 1976. Washington, DC: Fund for Public Policy Research, 1976, pp. 107-114.

U.S. Congress, Senate Committee on Finance hearing. Estate and Gift Taxes: Problems Arising from the Tax Reform Act of 1976. 95th Congress, 1st session, July 25, 1977.

U.S. Department of Treasury, Office of Tax Analysis. Report to the Congress on the Capital Gains Tax Reductions of 1978. Washington, DC: U.S. Government Printing Office, September, 1985.

Wagner, Richard E. Inheritance and the State. Washington, DC: American Enterprise Institute for Public Policy Research, 1977.

Wetzler, James W. "Capital Gains and Losses," Comprehensive Income Taxation, ed. Joseph Pechman. Washington, DC: The Brookings Institution, 1977, pp. 115-162.

Zodrow, George R. "Economic Analysis of Capital Gains Taxation: Realizations, Revenues, Efficiency and Equity," Tax Law Review, v. 48, no. 3, pp. 419-527.

Commerce and Housing:

 

Other Business and Commerce

               AMORTIZATION OF BUSINESS START-UP COSTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

   1995                 0.2                 /1/              0.2

 

   1996                 0.2                 /1/              0.2

 

   1997                 0.2                 /1/              0.2

 

   1998                 0.2                 /1/              0.2

 

   1999                 0.2                 /1/              0.2

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 195.

Description

Costs incurred before the beginning of a business normally are not deductible, because they are not incurred in carrying on a trade or business. These start-up costs normally must be capitalized and added to the taxpayer's basis in the business. Under section 195, a taxpayer may elect to deduct eligible start-up expenditures over a period of not less than 60 months. In the absence of such an election, no deduction is allowed for start-up expenditures,

An expenditure must satisfy two requirements to qualify for this treatment. First, it must be paid or incurred in connection with creating, or investigating the creation or acquisition of, a trade or business entered into by the taxpayer, or in connection with a profit-seeking or income-producing activity prior to the day the taxpayer begins an active trade or business. Second, the expenditure must be one that would have been deductible for the taxable year in which it was paid or incurred, if it had been paid or incurred in connection with the operation of an existing trade or business in the same field as that entered into by the taxpayer.

Impact

The election to amortize business start-up costs encourages the formation of new businesses by permitting the deduction of expenses that would have been deductible by an ongoing business. Without such an election, most of these start-up costs would not be recovered by the taxpayer until the taxpayer sold his interest in the business.

Benefits to capital income tend to concentrate in the higher income classes (see discussion in the Introduction).

Rationale

Before enactment of section 195 in 1980, the question of whether an expense incurred in creating or investigating the creation of a new business was currently deductible or must be capitalized was a source of controversy and litigation between taxpayers and the Internal Revenue Service. Certain business organizational expenditures for the formation of a corporation or partnership could be amortized, on an elective basis, over a period of not less than 60 months (Code sections 248 and 709).

In 1980, Congress added section 195 in order to encourage the creation of new businesses and reduce the controversy and litigation that surrounded the proper income tax classification of start-up expenditures. In 1984, these rules were clarified to reduce any remaining controversy regarding the definition of start-up expenditures.

Assessment

In theory, business organizational costs should be written off over the life of the business. There is, however, a difficulty in determining what that useful life is.

The advantage of this provision in eliminating taxpayer controversy and its small size has made it a provision which has attracted little concern.

Selected Bibliography

U.S. Congress, House Committee on Ways and Means. Miscellaneous Revenue Act of 1980. Report 96-1278, pp. 9-13.

--, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th Congress, 2nd Session, December 31, 1984, pp. 295-297.

Wilcox, Gary B. "Start-Up Cost Treatment Under Section 195: Tax Disparity in Disguise," Oklahoma Law Review, v. 36. Spring 1983, pp. 449-466.

                    Commerce and Housing Credit:

 

                     Other Business and Commerce

                 REDUCED RATES ON FIRST $10,000,000

 

                     OF CORPORATE TAXABLE INCOME

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

   1995                  -                  3.9              3.1

 

   1996                  -                  4.1              3.2

 

   1997                  -                  4.3              3.3

 

   1998                  -                  4.5              3.5

 

   1999                  -                  4.7              3.7

 

____________________________________________________________________

Authorization

Section 11.

Description

Corporate taxable income for corporations with less than $10 million of taxable income is subject to tax under a graduated tax rate structure. The tax rate is 15 percent on the first $50,000 of income, 25 percent on the next $25,000, and 34 percent thereafter. An additional 5-percent corporate tax is imposed on a corporation's taxable income in excess of $100,000 until the maximum additional tax is $11,750.

Thus, the benefit of these graduated rates is eliminated for corporations with taxable income in excess of $335,000, who pay a flat average rate of 34 percent. The tax rate on taxable income in excess of $10 million is 35 percent. When taxable income rises above $15 million, a tax of three percent of the excess or $100,000 (whichever is lesser) is imposed. The benefit of the 34 percent (vs. the 35 percent) rate is thus phased out when income reaches $18,333,333.

The graduated rates are not available for personal-service corporations, and there are restrictions to prevent abuse by related corporations. The tax expenditure is the difference between taxes paid and the tax due if all income were subject to a flat 35 percent tax rate.

Impact

These reduced rates are available to smaller corporations. The phase-out limits the benefits of the graduated rates from 15 to 34 percent to a corporation with taxable income below $335,000. As a result, a corporation with taxable income from $100,000 to $335,000 pays a 39-percent marginal tax rate, which is 5 percent greater than the rate on taxable income just below or above this range. (The average tax, however, is below 34 percent.) A similar notch effect increases the rate to 38 percent in the $15 million to $18.3 million phaseout range.

The graduated rates encourage the use of the corporate structure and allow some small corporate businesses that might otherwise operate as sole proprietorships or partnerships to provide fringe benefits. They also encourage the splitting of operations between sole proprietorships, partnerships, and corporations. Most businesses are not incorporated; only a small fraction of firms are affected by this provision.

This provision is likely to benefit higher-income individuals who are the primary owners of capital (see Introduction for a discussion).

Rationale

In the early years of the corporate income tax, exemptions from tax were allowed in some years. A graduated rate structure was first adopted in 1936. From 1950-1974 there was a "normal" rate on corporate income, and a surtax, with an exemption from surtax for the first $25,000. The purpose was to provide relief for small businesses.

However, many large businesses fragmented their operations into numerous corporations to obtain numerous exemptions from the surtax. Some remedial steps were taken in 1963, and in 1969 legislation was enacted limiting groups of corporations controlled by the same interest to a single surtax exemption.

In 1975, a graduated rate structure with three (and eventually more) rate brackets was adopted. In 1984, a system for phasing out the exemptions was adopted, with exemptions phasing out for taxable incomes between $1 million and $1.405 million; at that time, lower rates applied to incomes up to $100,000.

The present corporate tax rates at the lower level (below $10 million) were enacted in the Tax Reform Act of 1986, which also restricted the phase-out so that the benefits were phased out between $100,000 and $335,000. The general rationale for the lower rates -- to aid small businesses -- was reiterated at this time. The lower ceilings on the rates and the quicker phase-out was based on the notion of targeting the benefit more precisely to smaller businesses. The 35-percent rate was added in 1993 largely to raise revenue to reduce the budget deficit.

Assessment

The graduated rates are commonly justified as aids to small businesses. Unlike graduation in the rates of the individual tax, corporate rate graduation cannot be justified based on ability to pay, since owners of small corporations may, in fact, be very well off. In addition, the graduated rates can constitute a form of tax shelter for individuals, who may be able to retain part of income in corporations at lower rates. Thus the aid to small business must be justified on the grounds of efficiency.

Although some arguments are made that investment should be encouraged in small businesses because they tend to create more jobs and engage in more innovation than larger firms, evidence on this issue is mixed. Conventional economic analysis indicates that maximum output is produced when all investments are taxed at the same rate. Moreover, the vast majority of small businesses are not organized in corporate form. The graduated rate structure also adds complexity to the law and discourages investments of firms subject to the higher marginal tax rates of the phase-out range.

The graduated rate structure allows individuals to avoid taxes by diverting and retaining profits into corporations. In addition, it encourages multiple corporations, to maximize the amount of income taxed at low rates, requiring complicated rules to limit this activity.

The lower rates do, however, make it possible for moderate- income owners of businesses to operate in a corporate form without paying heavy taxes. Generally, individuals are free to organize as corporations for legal purposes, but to be taxed as partners under the Subchapter S provisions. There may be some circumstances, however, where such an election is not feasible (e.g., when more than one class of stock is desired) or when taxable corporate status may be desirable (because of rules allowing for fringe benefits).

Selected Bibliography

Armington, Catherine, and Marjorie Odle. "Small Business -- How Many Jobs?" Brookings Review, v. 1, no. 2. Winter 1982, pp. 14-17.

Pechman, Joseph A. Federal Tax Policy. Washington, DC: The Brookings Institution, 1987, pp.302-305.

Gravelle, Jane G. Small Business Tax Subsidy Proposals. Library of Congress, Congressional Research Service Report 93-316. Washington, DC: March 15, 1994.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, 99th Congress, 2nd session. May 4, 1987: pp. 271-273.

U.S. Department of Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth, v. 2, General Explanation of the Treasury Department Proposals. November, 1974, pp 128-129.

Commerce and Housing:

 

Other Business and Commerce

                         PERMANENT EXEMPTION

 

                     FROM IMPUTED INTEREST RULES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

   1995                 /1/                 0.2              0.2

 

   1996                 /1/                 0.2              0.2

 

   1997                 /1/                 0.2              0.2

 

   1998                 /1/                 0.2              0.2

 

   1999                 /1/                 0.2              0.2

 

____________________________________________________________________

                         FOOTNOTES TO TABLE

     /1/ Less than $50 million

                      END OF FOOTNOTES TO TABLE

Authorization

Section 163(e), 483, 1274, and 1274A.

Description

The failure to report interest as it accrues can allow the deferral of taxes. The tax code generally requires that debt instruments bear a market rate of interest at least equal to the average rate on outstanding Treasury securities of comparable maturity. If an instrument does not, the Internal Revenue Service imputes a market rate to it. The imputed interest must be included as income to the recipient and is deducted by the payer.

There are several exceptions to the general rules for imputing interest on debt instruments. Debt associated with the sale of property when the total sales price is no more than $250,000, the sale of farms or small businesses by individuals when the sales price is no more than $1 million, and the sale of a personal residence, is not subject to the imputation rules at all. Debt instruments for amounts not exceeding an inflation-adjusted maximum (currently about $3 million), given in exchange for real property, may not have imputed to them an interest rate greater than 9 percent.

This tax expenditure is the revenue loss in the current year from the deferral of taxes caused by these exceptions.

Impact

The exceptions to the imputed interest rules are generally directed at "seller take-back" financing, in which the seller of the property receives a debt instrument (note, mortgage) in return for the property. This is a financing technique often used in selling personal residences or small businesses or farms, especially in periods of tight money and high interest rates, both to facilitate the sales and to provide the sellers with continuing income.

This financing mechanism can also be used, however, to shift taxable income between tax years and thus delay the payment of taxes. Under prior law, when interest was fully taxable but the gain on the sale of the property was taxed at greatly reduced capital gains rates, taxes could be completely eliminated, not just deferred, by characterizing more of a transaction as gain and less as interest (that is, the sales price could be increased and the interest rate decreased).

With small or no capital gains differentials, only restricted exceptions to the imputation rules, and other recent tax reforms, the provisions now cause only modest revenue losses and have relatively little economic impact.

Rationale

Restrictions were placed on the debt instruments arising from seller-financed transactions beginning with the Revenue Act of 1964, to assure that taxes were not reduced by manipulating the purchase price and stated interest charges. These restrictions still allowed considerable creativity on the part of taxpayers, however, leading ultimately to the much stricter and more comprehensive rules included in the Deficit Reduction Act of 1984.

The 1984 rules were regarded as so detrimental to real estate sales that they were modified almost immediately (temporarily in 1985 [P.L. 98-612] and permanently in 1986 [P.L. 99-121]). The exceptions to the imputed interest rules described above were introduced in 1984 and 1986 (P.L. 99-121) to allow more flexibility in structuring sales of personal residences, small businesses, and farms by the owners, and to avoid the administrative problems that might arise in applying the rules to other smaller sales.

Assessment

The imputed interest and related rules dealing with property- for-debt exchanges were important in restricting unwarranted tax benefits before the Tax Reform Act of 1986 eliminated the capital gains exclusion and lengthened the depreciable lives of buildings.

Under pre-1986 law, the seller of commercial property would prefer a higher sales price with a smaller interest rate on the associated debt, because the gain on the sale was taxed at lower capital gains tax rates. The buyer would at least not object to, and might prefer, the same allocation because it increased the cost of property and the amount of depreciation deductions (i.e., the purchaser could deduct the principal, through depreciation deductions, as well as the interest). It was possible to structure a sale so that both seller and purchaser had more income at the expense of the government.

Under present tax law, this allocation is much less important. In addition, the 9-percent cap on imputed interest for some real estate sales has no effect when market interest rates are below that figure.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. Description of the Tax Treatment of Imputed Interest on Deferred Payment Sales of Property, JCS-15-85. May 17, 1985.

--. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, JCS-41-84. December 31, 1984, pp.108-127.

Wolf, Lary S., Eliot Pisem, and John M. Graham. "Time Value of Money," Tax Notes. August 18, 1986, pp. 691-713.

Commerce and Housing:

 

Other Business and Commerce

                  EXPENSING OF MAGAZINE CIRCULATION

 

                            EXPENDITURES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

 

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

   1995                 /1/                 /1/              /1/

 

   1996                 /1/                 /1/              /1/

 

   1997                 /1/                 /1/              /1/

 

   1998                 /1/                 /1/              /1/

 

   1999                 /1/                 /1/              /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 173.

Description

Publishers of newspapers, magazines, and other periodicals generally are permitted to elect to deduct expenditures to establish, maintain, or increase circulation in the year that the expenditures are made.

Current deductions are permitted under this rule even though certain of the expenditures would otherwise be treated as capital expenditures. Expenditures eligible for current deduction do not include those for the purchase of land or depreciable property or for the purchase of any part of the business of another publisher.

The tax expenditure is the difference between the current deduction of costs and the recovery that would have been allowed if these expenses were capitalized and deducted over a period of time.

Impact

Publishers are permitted a current deduction for circulation expenditures, including some expenditures otherwise considered capital in nature. This treatment speeds up the deduction of costs. Like other primarily corporate tax expenditures, the benefit tends to accrue to high-income individuals (see Introduction for a discussion).

Rationale

The current deduction rule was codified in 1950 to eliminate the problem of distinguishing between expenditures to maintain circulation (which are currently deductible) and those to establish or develop circulation (which otherwise had to be capitalized).

Assessment

Although this provision provides a benefit for certain investment in building up circulation that yields returns in the future, it simplifies the tax law. Without such a general treatment, it would be necessary to distinguish between expenditures for establishing or expanding circulation and those for maintaining circulation.

Selected Bibliography

Commerce Clearing House. "'50 Act Clarified Tax Treatment of Circulation Expenses of Publishers," Federal Tax Guide Reports, v. 48. September 9, 1966, p. 2.

U.S. Congress, Joint Committee on Internal Revenue Taxation. Summary of H.R. 8920, "The Revenue Act of 1950," as agreed to by the Conferees. September 1950, p. 12.

Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, Committee Print, 99th Congress, 2nd session. May 4, 1987, p. 445.

                        Commerce and Housing:

 

                     Other Business and Commerce

                     SPECIAL RULES FOR MAGAZINE,

 

                 PAPERBACK BOOK, AND RECORD RETURNS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

     Fiscal year   Individuals  Corporations     Total

 

____________________________________________________________________

         1995          /1/           /1/          /1/

 

         1996          /1/           /1/          /1/

 

         1997          /1/           /1/          /1/

 

         1998          /1/           /1/          /1/

 

         1999          /1/           /1/          /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 458.

Description

In general, if a buyer returns goods to the seller, the seller's income is reduced in the year in which the items are returned. If the goods are returned after the tax year in which the goods were sold, the seller's income for the previous year is not affected.

An exception to the general rule has been granted to publishers and distributors of magazines, paperbacks, and records, who may elect to exclude from gross income for a tax year the income from the sale of goods that are returned after the close of the tax year. The exclusion applies to magazines that are returned within two months and fifteen days after the close of the tax year, and to paperbacks and records that are returned within four months and fifteen days after the close of the tax year.

To be eligible for the special election, a publisher or distributor must be under a legal obligation, at the time of initial sale, to provide a refund or credit for unsold copies.

Impact

Publishers and distributors of magazines, paperbacks, and records who make the special election are not taxed on income from goods that are returned after the close of the tax year. The special election mainly benefits large publishers and distributors.

Rationale

The purpose of the special election for publishers and distributors of magazines, paperbacks, and records is to avoid imposing a tax on accrued income when goods that are sold in one tax year are returned after the close of the year.

The special rule for publishers and distributors of magazines, paperbacks, and records was enacted by the Revenue Act of 1978.

Assessment

For goods returned after the close of a tax year, the special exception allows publishers and distributors to reduce income for the previous year. Therefore, the special election is inconsistent with the general principles of accrual accounting.

The special tax treatment granted to publishers and distributors of magazines, paperbacks, and records is not available to producers and distributors of other goods. On the other hand, publishers and distributors of magazines, paperbacks, and records often sell more copies to wholesalers and retailers than they expect will be sold to consumers.

One reason for the overstocking of inventory is that it is difficult to predict consumer demand for particular titles. Overstocking is also used as a marketing strategy that relies on the conspicuous display of selected titles. Knowing that unsold copies can be returned, wholesalers and retailers are more likely to stock a larger number of titles and to carry more copies of individual titles.

For business purposes, publishers generally set up a reserve account in the amount of estimated returns. Additions to the account reduce business income for the year in which the goods are sold. For tax purposes, the special election for returns of magazines, paperbacks, and records is similar, but not identical, to the reserve account used for business purposes.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Act of 1978, 95th Congress, 2nd session. March 12, 1979, pp. 235-41.

--. Tax Reform Proposals: Accounting Issues, Committee Print, 99th Congress, 1st session. September 13, 1985.

U.S. Department of the Treasury, Internal Revenue Service. "Certain Returned Magazines, Paperbacks or Records," Federal Register, v. 57. August 26, 1992, pp. 38595-38600.

                        Commerce and Housing:

 

                     Other Business and Commerce

                   DEFERRAL OF GAIN ON NON-DEALER

 

                          INSTALLMENT SALES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year   Individuals  Corporations     Total

 

____________________________________________________________________

         1995          0.3           0.4          0.7

 

         1996          0.3           0.4          0.7

 

         1997          0.3           0.4          0.7

 

         1998          0.4           0.5          0.9

 

         1999          0.4           0.5          0.9

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Sections 453 and 453A(b).

Description

An installment sale is a sale of property in which at least one payment will be received in a tax year later than the year in which the sale took place. Some taxpayers are allowed to report some such sales for tax purposes under a special method of accounting, called the installment method, in which the gross profit from the sale is prorated over the years during which the payments are received.

This conveys a tax advantage compared to being taxed in full in the year of the sale, because the taxes that are deferred to future years have a time value (the amount of interest they could earn).

Use of the installment method was once widespread, but it has been severely curtailed in recent years. In current law, it can be used only by persons who do not regularly deal in the property being sold (except sellers of timeshares and unimproved building lots, who may continue to use it but must pay interest on the deferred taxes).

For sales by nondealers, interest must be paid to the Government on the deferred taxes for any sale in which the sale price is more than $150,000 by any taxpayer with total installment sales arising during the year and outstanding at the end of the year of more than $5,000,000, except sales of farm property and sales of personal use property by individuals. Interest payments offset the value of the tax deferral, so this tax expenditure represents only the revenue loss from those transactions still giving rise to interest-free deferrals.

Impact

Installment sale treatment constitutes a departure from the normal rule that gain is recognized when the sale of property occurs. The deferral of taxation permitted under the installment sale rules essentially furnishes the taxpayer an interest-free loan equal to the amount of tax on the gain that is deferred.

The benefits of deferral are currently restricted to those transactions by nondealers in which the sales price is no more than $150,000 and to the first $5,000,000 of installment sales arising during the year, to sales of personal-use property by individuals, and to sales of farm property. (There are other restrictions on many types of transactions, such as in corporate reorganizations and sales of depreciable assets.)

Thus the primary benefit probably flows to sellers of farms, small businesses, and small real estate investments.

Rationale

The rationale for permitting installment sale treatment of income from disposition of property is to match the time of payment of tax liability with the cash flow generated by the disposition. It has usually been considered unfair, or at least impractical, to attempt to collect the tax when the cash flow is not available, and some form of installment sale reporting has been permitted since at least the Revenue Act of 1921. It has frequently been a source of complexity and controversy, however, and has sometimes been used in tax shelter and tax avoidance schemes.

Installment sale accounting was greatly liberalized and simplified in the Installment Sales Revision Act of 1980 (P.L. 96- 471). It was greatly restricted by a complex method of removing some of its tax advantages in the Tax Reform Act of 1986, and it was repealed except for the limited uses described above in the Omnibus Budget Reconciliation Act of 1987

Assessment

The installment sales rules have always been pulled between two opposing goals: taxes should not be avoidable by the way a deal is structured, but they should not be imposed when the money to pay them is not available. Allowing people to postpone taxes simply by taking a note instead of cash in a sale leaves obvious room for tax avoidance.

Trying to collect taxes from taxpayers who do not have the cash to pay is administratively difficult and strikes many as unfair. After having tried many different ways of balancing these goals, lawmakers have settled on a compromise that denies the advantage of the method to taxpayers who would seldom have trouble raising the cash to pay (retailers, dealers in property, investors with large amounts of sales) and continues to permit it to small, nondealer transactions (with "small" rather generously defined).

Present law results in modest revenue losses and probably has little effect on economic incentives.

Selected Bibliography

Cross, John J., III. "The Continuing Evolution of the Installment Method of Tax Accounting," Taxes, v. 66. June 1988, pp. 421-425.

U.S. Congress, House. Omnibus Budget Reconciliation Act of 1987, Conference Report to Accompany H.R. 3545. 100th Congress, 1st session, Report 100-495, pp. 926-931.

--. Committee on Ways and Means. Installment Sales Revision Act of 1980, Report to Accompany H.R. 6883. 98th Congress, 2nd session, Report 96-1042.

                        Commerce and Housing:

 

                     Other Business and Commerce

                      COMPLETED CONTRACT RULES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year   Individuals  Corporations     Total

 

____________________________________________________________________

         1995          /1/           0.2          0.2

 

         1996          /1/           0.2          0.2

 

         1997          /1/           0.2          0.2

 

         1998          /1/           0.2          0.2

 

         1999          /1/           0.2          0.2

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ less than $50 million

                           END OF FOOTNOTE

Authorization

Section 460.

Description

Some taxpayers with construction or manufacturing contracts extending for more than one tax year are allowed to report some or all of the profit on the contracts under special accounting rules rather than the normal rules of tax accounting. Many such taxpayers use the "completed contract" method.

A taxpayer using the completed contract method of accounting reports income on a long-term contracts only when the contract has been completed. All costs properly allocable to the contract are also deducted when the contract is completed and the income reported, but many indirect costs may be deducted in the year paid or incurred. This mismatching of income and expenses allows a deferral of tax payments that creates a tax advantage in this type of reporting.

Most taxpayers with long-term contracts are not allowed to use the completed contract method and must capitalize indirect costs and deduct them only when the income from the contract is reported. There are exceptions, however. Home construction contracts may be reported according to the taxpayer's "normal" method of accounting and allow current deductions for costs that others are required to capitalize.

Other real estate construction contracts may also be subject to these more liberal rules if they are of less than two years duration and the contractor's gross receipts for the past three years have averaged $10 million or less. Contracts entered into before 3/1/86, if still ongoing, may be reported on a completed contract basis, but with full capitalization of costs.

Contracts entered into between 2/28/86 and 7/11/89 and residential construction contracts other than home construction may be reported in part on a completed contract basis, but may require full cost capitalization. This tax expenditure is the revenue loss from deferring the tax on those contracts still allowed to be reported under the more liberal completed contract rules.

Impact

Use of the completed contract rules allows the deferral of taxes through mismatching income and deductions because they allow some costs to be deducted from other income in the year incurred, even though the costs actually relate to the income that will not be reported until the contract's completion, and because economic income accrues to the contractor each year he works on the contract but is not taxed until the year the contract is completed. Tax deferral is the equivalent of an interest-free loan from the Government of the amount of the deferred taxes. Because of the restrictions now placed on the use of the completed contract rules, most of the current tax expenditure relates to real estate construction, especially housing.

Rationale

The completed contract method of accounting for long-term construction contracts was permitted by Internal Revenue regulations since 1918 on the grounds that such contracts involved so many uncertainties that profit or loss was undeterminable until the contract was completed.

In regulations first proposed in 1972 and finally adopted in 1976, the Internal Revenue Service extended the method to certain manufacturing contracts (mostly defense contracts), at the same time tightening the rules as to which costs must be capitalized. Perceived abuses, particularly by defense contractors, led the Congress to question the original rationale for the provision and eventually to a series of ever more restrictive rules. The Tax Equity and Fiscal Responsibility Act of 1982 (P.L. 97-248) further tightened the rules for cost capitalization.

The Tax Reform Act of 1986 (P.L. 99-514) for the first time codified the rules for long-term contracts and also placed restrictions on the use of the completed contract method. Under this Act, the completed contract method could be used for reporting only 60 percent of the gross income and capitalized costs of a contract, with the other 40 percent reported on the "percentage of completion" method, except that the completed contract method could continue to be used by contractors with average gross receipts of $10 million or less to account for real estate construction contracts of no more than two years duration. It also required more costs to be capitalized, including interest.

The Omnibus Budget Reconciliation Act of 1987 (P.L. 100-203) reduced the share of a taxpayer's long-term contracts that could be reported on a completed contract basis from 60 percent to 30 percent. The Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647) further reduced the percentage from 30 to 10, (except for residential construction contracts, which could continue to use the 30 percent rule) and also provided the exception for home construction contracts.

The Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239) repealed the provision allowing 10 percent to be reported by other than the percentage of completion method, thus repealing the completed contract method except as noted above.

Assessment

Use of the completed contract method of accounting for long-term contracts was once the standard for the construction industry. Extension of the method to defense contractors, however, created a perception of wide-spread abuse of a tax advantage. The Secretary of the Treasury testified before the Senate Finance Committee in 1982 that "virtually all" defense and aerospace contractors used the method to "substantially reduce" the taxes they would otherwise owe.

The principal justification for the method had always been the uncertainty of the outcome of long-term contracts, an argument that lost a lot of its force when applied to contracts in which the Government bore most of the risk. It was also noted that even large construction companies, who used the method for tax reporting, were seldom so uncertain of the outcome of their contracts that they used it for their own books; their financial statements were almost always presented on a strict accrual accounting basis comparable to other businesses.

Since the use of the completed contract rules is now restricted to a very small segment of the construction industry, it produces only small revenue losses for the Government and probably has little economic impact in most areas. One area where it is still permitted, however, is in the construction of single-family homes, where it adds some tax advantage to an already heavily tax-favored sector.

Selected Bibliography

Knight, Ray A., and Lee G. Knight. "Recent Developments Concerning the Completed Contract Method of Accounting," The Tax Executive, v. 41. Fall 1988, pp. 73-86.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982. JCS-38-82, December 31, 1982, pp. 148-154.

--. General Explanation of the Tax Reform Act of 1986. JCS-10- 87, May 4, 1987, pp. 524-530.

--. Tax Reform Proposals: Accounting Issues. JCS-39-85, September 13, 1985, pp. 45-49.

U.S. General Accounting Office. Congress Should Further Restrict Use of the Completed Contract Method. Report GAO/GGD-86-34, January 1986.

                        Commerce and Housing:

 

                     Other Business and Commerce

                     CASH METHOD OF ACCOUNTING,

 

                       OTHER THAN AGRICULTURE

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year  Individuals   Corporations     Total

 

____________________________________________________________________

         1995          /1/           /1/          /1/

 

         1996          /1/           /1/          /1/

 

         1997          /1/           /1/          /1/

 

         1998          0.1           /1/          0.1

 

         1999          0.1           /1/          0.1

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Sections 446 and 448.

Description

Under the cash method of accounting, income is reported in the year in which it is received and deductions are taken in the year in which expenses are paid. Under the accrual method of accounting, income is generally recognized when it is earned, whether or not it has actually been received. Deductions for expenses are generally allowed in the year in which the costs are actually incurred.

All taxpayers (except some farmers) must use the accrual method of accounting for inventories and for some income and expenses that span tax years (e.g., depreciation and prepaid expenses). Tax shelters, C corporations, partnerships that have C corporations as partners, and certain trusts must use the accrual method of accounting. Individuals and many businesses may use the cash method of accounting, however. The cash method may be used by small businesses, qualified personal service corporations, and certain farm and timber interests (discussed under "Agriculture" above).

A small business is a business with average annual gross receipts of $5 million or less for the three preceding tax years. Qualified personal service corporations are employee-owned service businesses in the fields of health, law, accounting, engineering, architecture, actuarial science, performing arts, or consulting.

Impact

For tax purposes, most individuals and many businesses use the cash method of accounting because it is less burdensome than the accrual method of accounting. The revenue losses mainly benefit the owners of smaller businesses and professional service corporations of all sizes.

Rationale

Individuals and many businesses are allowed to use the cash method of accounting because it generally requires less recordkeeping than other methods of accounting.

According to the Revenue Act of 1916, a taxpayer may compute income for tax purposes using the same accounting method used to compute income for business purposes. The Internal Revenue Code of 1954 allowed taxpayers to use a combination of accounting methods for tax purposes. The Tax Reform Act of 1986 prohibited tax shelters, C corporations, partnerships that have C corporations as partners, and certain trusts from using the cash method of accounting.

Assessment

The choice of accounting methods may affect the amount and timing of a taxpayer's Federal income tax payments. Under the accrual method, income for a given period is more clearly matched with the expenses associated with producing that income. Therefore, the accrual method more clearly reflects a taxpayer's net income for a given period. For business purposes, the accrual method also provides a better indication of a firm's economic performance for a given period.

Under the cash method of accounting, taxpayers have greater control over the timing of receipts and payments. By shifting income or deductions from one tax year to another, taxpayers can defer the payment of income taxes or take advantage of lower tax rates. On the other hand, because of its relative simplicity, the cash method of accounting involves lower costs of compliance. The cash method is also the method most familiar to the individuals and businesses to whom its use is largely confined.

Selected Bibliography

Ferencz, Robert. "A Review of Tax Planning Techniques for Mismatching Income and Expenses," Taxes, v. 61. December 1983, pp. 829-843.

Pizzica, Judith Helm. "Opportunities Exist for a Cash-Basis Taxpayer to Defer the Reporting of Income," Taxation for Accountants, v. 29. July 1982, pp. 4-7.

Tinsey, Frederick C. "Many Accounting Practices Will Have to be Changed as a Result of the Tax Reform Act," Taxation for Accountants, v. 38. January 1987, pp. 48-52.

U.S. Congress, Joint Committee on Taxation. Tax Reform Proposals: Accounting Issues, Committee Print, 99th Congress, 1st session. September 13, 1985.

                        Commerce and Housing:

 

                     Other Business and Commerce

                      EXCLUSION OF INTEREST ON

 

                     STATE AND LOCAL GOVERNMENT

 

                          SMALL-ISSUE BONDS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals       Corporations      Total

 

____________________________________________________________________

        1995             0.4               0.1            0.5

 

        1996             0.3               0.1            0.4

 

        1997             0.3               0.1            0.4

 

        1998             0.3               0.1            0.4

 

        1999             0.2               0.1            0.3

 

____________________________________________________________________

Authorization

Sections 103, 141, 144, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance business loans of $1 million or less for construction of private manufacturing facilities is tax exempt. These small-issue industrial development bonds (IDBs) are classified as private-activity bonds rather than governmental bonds because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

The $1 million loan limit may be raised to $10 million ($20 million in certain economically distressed areas) if the aggregate amount of related capital expenditures (including those financed with tax-exempt bond proceeds) made over a six-year period is not expected to exceed $10 million. The bonds are subject to the State private- activity bond annual volume cap.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to offer loans to manufacturing businesses at reduced interest rates.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and business borrowers, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

The first bonds for economic development were issued without any Federal restrictions. State and local officials expected that reduced interest rates on business loans would increase investment and jobs in their communities. The Revenue and Expenditure Control Act of 1968 imposed several targeting requirements, limiting the bond issue to $1 million and the amount of capital spending on the project to $5 million over a six-year period.

The Revenue Act of 1978 increased the $5 million limit on capital expenditures to $10 million, and to $20 million for projects in certain economically distressed areas.

Several tax acts in the 1970s and early 1980s denied use of the bonds for specific types of business activities. The Deficit Reduction Act of 1984 restricted use of the bonds to manufacturing facilities, and limited any one beneficiary's use to $40 million of outstanding bonds. The annual volume of bonds issued by governmental units within a State first was capped in 1984, and then included by the Tax Reform Act of 1986 under the unified volume cap on private- activity bonds equal to the greater of $50 per capita or $150 million.

Small-issue IDBs long have been an "expiring tax provision" with a sunset date. IDBs first were scheduled to sunset on December 31, 1986 by the Tax Equity and Fiscal Responsibility Act of 1982. Additional sunset dates have been adopted three times when Congress has decided to extend small-issue IDB eligibility for a temporary period. The Omnibus Budget Reconciliation Act of 1993 made IDBS permanent.

Assessment

It is not clear that the Nation benefits from these bonds. Any increase in investment, jobs, and tax base obtained by communities from their use of these bonds probably is offset by the loss of jobs and tax base elsewhere in the economy.

National benefit would have to come from valuing the relocation of jobs and tax base from one location to another, but the use of the bonds is not targeted to a subset of geographic areas that satisfy explicit Federal criteria such as income level or unemployment rate. Any jurisdiction is eligible to utilize the bonds.

As one of many categories of tax-exempt private-activity bonds, small-issue IDBs have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Bibliography

Forbes, Ronald W., and John E. Petersen. "Background Paper," Building a Broader Market: Report of the Twentieth Century Fund Task Force on the Municipal Bond Market. New York: McGraw-Hill, 1976, pp. 27-174.

Stutzer, Michael J. "The Statewide Economic Impact of Small- Issue Industrial Development Bonds," Federal Reserve Bank of Minneapolis Quarterly Review, v. 9. Spring 1985, pp. 2-13.

Tempe, Judy. "Limitations on State and Local Government Borrowing for Private Purposes." National Tax Journal, vol 46, March 1993, pp. 41-53.

U.S. Congress, Congressional Budget Office. The Federal Role in State Industrial Development Programs, 1984.

--. Small Issue Industrial Revenue Bonds, April 1981.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

--. "Federal Tax Policy, IDBs and the Market for State and Local Bonds," National Tax Association -- Tax Institute of America Symposium: Agendas for Dealing with the Deficit, National Tax Journal, v. 37. September 1984, pp. 411-420.

                        Commerce and Housing:

 

                     Other Business and Commerce

               DEFERRAL OF GAIN ON LIKE-KIND EXCHANGES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals       Corporations      Total

 

____________________________________________________________________

        1995             0.2               0.4            0.6

 

        1996             0.3               0.5            0.8

 

        1997             0.3               0.5            0.8

 

        1998             0.3               0.5            0.8

 

        1999             0.4               0.6            1.0

 

____________________________________________________________________

Authorization

Section 1031.

Description

When business or investment property is exchanged for property of a "like kind," no gain or loss is recognized on the exchange and therefore no tax is paid at the time of the exchange on any appreciation. This is in contrast to the general rule that any sale or exchange for money or property is a taxable event.

It is also an exception to the rules allowing tax-free exchanges when the property is "similar or related in service or use," the much stricter standard applied in other areas, such as replacing condemned property (section 1033). The latter is not considered a tax expenditure, but the postponed tax on appreciated property exchanged for "like-kind" property is.

Impact

The like-kind exchange rules have been liberally interpreted by the courts to allow tax-free exchanges of property of the same general type but of very different quality and use. All real estate, in particular, is considered "like-kind," allowing a retiring farmer from the Midwest to swap farm land for a Florida apartment building tax-free.

The provision is very popular with real estate interests, some of whom specialize in arranging property exchanges. It is useful primarily to persons who wish to alter their real estate holdings without paying tax on their appreciated gain. Stocks and financial instruments are not eligible for this provision, so it is not useful for rearranging financial portfolios.

Rationale

A provision allowing tax-free exchanges of like-kind property was included in the first statutory tax rules for capital gains in the Revenue Act of 1921 and has continued in some form until today. Various restrictions over the years took many kinds of property and exchanges out of its scope, but the rules for real estate, in particular, were broadened over the years by court decisions.

In moves to reduce some of the more egregious uses of the rules, the Deficit Reduction Act of 1984 set time limits on completing exchanges and the Omnibus Budget Reconciliation Act of 1989 outlawed tax-free exchanges between related parties. The general rationale for allowing tax-free exchanges is that the investment in the new property is merely a continuation of the investment in the old.

A tax-policy rationale for going beyond this, to allowing tax- free adjustments of investment holdings to more advantageous positions, does not seem to have been offered. It may be that this was an accidental outgrowth of the original rule.

Assessment

From an economic perspective, the failure to tax appreciation in property values as it occurs defers tax liability and thus offers a tax benefit. (Likewise, the failure to deduct DECLINES in value is a tax penalty.) Continuing the "nonrecognition" of gain, and thus the tax deferral, for a longer period by an exchange of properties adds to the tax benefit.

This treatment does, however, both simplify transactions and make it less costly for businesses and investors to replace property. Taxpayers gain further benefit from the loose definition of "like- kind" because they can also switch their property holdings to types they prefer without tax consequences. This might be justified as reducing the inevitable bias a tax on capital gains causes against selling property, but it is difficult to argue for restricting the relief primarily to those taxpayers engaged in sophisticated real estate transactions.

Selected Bibliography

Carnes, Gregory A., and Ted D. Englebrecht. "Like-kind Exchanges -- Recent Developments, Restrictions, and Planning Opportunities," CPA Journal. January, 1991, pp. 26-33.

U.S. Congress, House Committee on Ways and Means. Omnibus Budget Reconciliation Act of 1989. Conference Report to Accompany H.R. 3299, Report 101-386, November 21, 1989, pp. 613-614.

--, Joint Committee on Taxation. Description of Possible Options to Increase Revenues Prepared for the Committee On Ways and Means. JCS-17-87, June 25, 1987, pp. 240-241.

--. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. JCS-41-84, December 31, 1984, pp. 243-247.

Woodrum, William L., Jr. "Structuring an Exchange of Property to Defer Recognition of Gain," Taxation for Accountants. November, 1986, pp. 334-339.

                        Commerce and Housing:

 

                     Other Business and Commerce

            EXCEPTION FROM NET OPERATING LOSS LIMITATIONS

 

             FOR CORPORATIONS IN BANKRUPTCY PROCEEDINGS

                       Estimated Revenue loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals       Corporations      Total

 

____________________________________________________________________

        1995              --               0.4            0.4

 

        1996              --               0.4            0.4

 

        1997              --               0.5            0.5

 

        1998              --               0.5            0.5

 

        1999              __               0.5            0.5

 

____________________________________________________________________

Authorization

Section 382(l)(5).

Description

In general, net operating losses of corporations may be carried back three years or carried forward fifteen years to offset taxable income in those years. If one corporation acquires another, the tax code has rules to determine whether the acquiring corporation inherits the tax attributes of the acquired corporation, including its net operating loss carryforwards, or whether the tax attributes of the acquired corporation disappear.

The acquiring corporation will inherit the tax attributes of the acquired corporation if the transaction qualifies as a tax-free reorganization. To qualify as a reorganization, the acquired corporation must essentially (or largely) continue in operation but in a different form. The owners of the acquired corporation must become owners of the acquiring corporation, and the business of the acquired corporation must be continued. An example is a merger of one corporation into another by exchanging stock of the acquiring corporation for stock of the acquired corporation.

While net operating loss carryforwards from an acquired corporation may be used to offset taxable income of the acquiring corporation after a reorganization, limitations are imposed. In general, the amount of income of the acquiring corporation that may be offset each year is determined by multiplying the value of the stock of the acquired corporation immediately before the ownership change by a specified long-term interest rate.

The purpose of the limitation is to prevent reorganized corporations from being able to absorb net operating loss carryforwards more rapidly than an approximation of the pace at which the acquired corporation would have absorbed them had it continued in existence.

If certain conditions are met, subsection 382(l)(5) provides an exception to the general limitation on net operating loss carryforwards for cases in which the acquired corporation was in bankruptcy proceedings at the time of the acquisition. In this case (unless the corporation elects otherwise), the limitation on net operating loss carryforwards does not apply. In some cases, however, certain adjustments are made to the amount of loss carryforwards of the acquired corporation that may be used by the successor corporation.

Impact

Section 382(l)(5) allows the use of preacquisition net operating loss carryforwards in circumstances in which they could not be used, in most cases, under the general rule.

The general rule determines the amount of the carryforwards which may be used to offset income based on the equity value of the acquired corporation at the time of acquisition. But most corporations in bankruptcy have zero or negative equity value. Hence, absent this exception, their successor corporations would be denied use of any of the carryovers.

Rationale

The rationale for the bankruptcy exception to the limitation on net operating loss carryovers is that the creditors of the acquired corporation who become shareholders in the bankruptcy reorganization may have, in effect, become the owners before the reorganization and borne some of the losses of the bankrupt corporation. In this case, the effective owners of the acquired corporation become owners of the acquiring corporation even though an ownership change appears to have occurred. Limitations are imposed to prevent abusive transactions.

Assessment

While the rationale for the provision is reasonable, the exception is not structured to be fully consistent with the rationale. There is no test to determine what portion, if any, of the preacquisition net operating loss carryforwards was borne by creditors who became shareholders.

Selected Bibliography

Peaslee, James M., and Lisa A. Levy. "Section 382 and Separate Tracking," Tax Notes. September 28, 1992, pp. 1779-1790.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. 100th Congress, 1st session, May 4, 1987, pp. 288-327.

U.S. Senate, Committee on Finance. The Subchapter C Revision Act of 1985. 99th Congress, 1st session, May 1985.

                        Commerce and Housing:

 

                     Other Business and Commerce

               DEFERRAL OF GAIN FROM SALE OR EXCHANGE

 

                     OF BROADCASTING FACILITIES

 

                    TO MINORITY OWNED BUSINESSES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals       Corporations      Total

 

____________________________________________________________________

        1995              --               0.1            0.1

 

        1996              --               0.1            0.1

 

        1997              --               0.1            0.1

 

        1998              --               0.1            0.1

 

        1999              --               0.1            0.1

 

____________________________________________________________________

Authorization

Section 1071, 1245(b).

Description

If the Federal Communications Commission (FCC) certifies that a taxpayer is selling a broadcast property (radio or TV station) because of a change in FCC policies, IR Code section 1071 allows the taxpayer to postpone the tax on any gain from the sale.

In 1978, the FCC adopted a policy of encouraging the sale of broadcast facilities to minority and female owners, and to encourage such sales it began certifying that the sellers were eligible for the tax deferral.

These "tax certificates" offer two ways for the seller to defer the taxes he would otherwise owe on the sale. If the seller reinvests the proceeds of the sale in another broadcast facility, he may "roll over" the gain (just as he would in an "involuntary conversion" under Code section 1033), and not owe any tax until the replacement property is sold.

If he has gain that he does not roll over into a new property, he can still postpone taxation by reducing the basis of his depreciable property and deducting the amount of the reduction from other income (as if he were taking all his future depreciation in the current year).

The estimated revenue loss shown above is the amount of the deferred taxes.

Impact

Deferring taxes otherwise due on the sale of a capital asset is the equivalent of a loan equal to the amount of the deferred taxes. The taxpayer gains (and the Government loses) the use of the funds and so is richer (or poorer) by the amount of the interest he could have earned.

If the capital gains are reinvested, the taxes are deferred until the new asset is sold. If the gain is used to reduce the basis of depreciable assets, the tax is deferred until the year the depreciation would have been taken anyway.

As with most capital income tax benefits, this provision is likely to affect mostly upper-income taxpayers; see the Introduction.

Rationale

This provision was originally enacted as a part of the Revenue Act of 1943 to cover cases in which the FCC ordered the sale of broadcast facilities to reduce media concentration. An additional justification given for the complete deferral of all gain (by allowing the write-down of depreciable assets) was the difficulty of replacing facilities in wartime conditions.

To close a perceived loophole, the Technical Amendments Act of 1957 changed the criteria from a sale because of an FCC policy to one caused by a CHANGE in FCC policy. The provision has survived in its present form since 1957.

Assessment

The FCC issues tax certificates explicitly to encourage the sale of broadcasting businesses to minorities and women. It may accomplish this both by increasing the profitability of the sale for the seller and by reducing the price to the buyer.

Minority ownership of broadcast facilities is said to have increased from 0.5 percent of radio and television stations in 1978 to about 3.5 percent in 1990. Not all of this is due to the tax certificates, however, since only a little over 200 were issued in this period. There are also some indications of tax shelter abuses, in which non-minority investors were able to take advantage of the tax benefits.

Selected Bibliography

Federal Communications Commission. Statement of Policy on Minority Ownership of Broadcasting Facilities, 68 FCC 2d 979.

Krasnow, Erwin G., William E. Kennare, and David L. Crawford. Minority Tax Certificates: Tax Planning and Business Strategies for Buyers, Sellers and Investors. September 1990.

Rudnitsky, Howard. "How the Rich Get Richer," Forbes. May 15, 1989, pp. 38-39.

Seidman, J.S. Seidman's Legislative History of Federal Income and Excess Profits Tax Laws, 1953-1939. New York: Prentice-Hall, 1954, pp. 1602-1603 (for comm. reports on Revenue Act of 1943).

U.S. Congress, House Committee on Ways and Means. Technical Amendments Act of 1957, Report to Accompany H.R. 8381, 85th Congress, 1st session, H. Rept. 775. July 9, 1957, pp. 29-30.

                           Transportation

               DEFERRAL OF TAX ON CAPITAL CONSTRUCTION

 

                     FUNDS OF SHIPPING COMPANIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

            Fiscal year  Individuals  Corporations  Total

 

_____________________________________________________________________

               1995          --           0.1        0.1

 

               1996          --           0.1        0.1

 

               1997          --           0.1        0.1

 

               1998          --           0.1        0.1

 

               1999          --           0.1        0.1

 

_____________________________________________________________________

Authorization

Section 7518.

Description

U.S. operators of vessels in foreign, Great Lakes, or noncontiguous domestic trade, or in U.S. fisheries, may establish a capital construction fund (CCF) into which they may make certain deposits. Such deposits are deductible from taxable income, and income tax on the earnings of the deposits in the CCF is deferred.

When tax-deferred deposits and their earnings are withdrawn from a CCF, no tax is paid if the withdrawal is used for qualifying purposes, such as to construct, acquire, lease, or pay off the indebtedness on a qualifying vessel. A qualifying vessel must be constructed or reconstructed in the United States, and any lease period must be at least five years.

The tax basis of the vessel (usually its cost to the taxpayer), with respect to which the operator's depreciation deductions are computed, is reduced by the amount of such withdrawal. Thus, over the life of the vessel tax depreciation will be reduced, and taxable income will be increased by the amount of such withdrawal, thereby reversing the effect of the deposit. However, since gain on the sale of the vessel and income from the operation of the replacement vessel may be deposited into the CCF, the tax deferral may be extended.

Withdrawals for other purposes are taxed at the top tax rate. This rule prevents firms from withdrawing funds in loss years and escaping tax entirely. Funds cannot be left in the account for more than 25 years.

Impact

The allowance of tax deductions for deposits can, if funds are continually rolled over, amount to a complete forgiveness of tax. Even when funds are eventually withdrawn and taxed, there is a substantial deferral of tax that leads to a very low effective tax burden. The provision makes investment in U.S.-constructed ships and registry under the U.S. flag more attractive than it would otherwise be. Despite these benefits, however, there is very little (in some years, no) U.S. participation in the worldwide market supplying large commercial vessels.

The incentive for construction is perhaps less than it would otherwise be, because firms engaged in international shipping have the benefits of deferral of tax through other provisions of the tax law, regardless of where the ship is constructed. This provision is likely to benefit higher-income individuals who are the primary owners of capital (see Introduction for a discussion).

Rationale

The special tax treatment originated to ensure an adequate supply of shipping in the event of war. Although tax subsidies of various types have been in existence since 1936, the coverage of the subsidies was expanded substantially by the Merchant Marine Act of 1970.

Before the Tax Reform Act of 1976 it was unclear whether any investment tax credit was available for eligible vessels financed in whole or in part out of funds withdrawn from a CCF. The 1976 Act specifically provided (as part of the Internal Revenue Code) that a minimum investment credit equal to 50 percent of an amount withdrawn which was to purchase, construct, or reconstruct qualified vessels was available in 1976 and subsequent years.

The Tax Reform Act of 1986 incorporated the deferral provisions directly into the Internal Revenue Code. It also extended benefits to leasing, provided for the minimum 25-year period in the fund, and required payment of the tax at the top rate.

Assessment

The failure to tax income from the services of shipping normally misallocates resources into less efficient uses, although it appears that the effects on U.S. large commercial shipbuilding are relatively small.

There are two possible arguments that could be advanced for maintaining this tax benefit. The first is the national defense argument -- that it is important to maintain a shipping capability in time of war. This justification is in doubt today, since U.S. firms control many vessels registered under the foreign flag and many U.S. allies control a substantial shipping fleet and have substantial ship-building capability.

There is also an argument that subsidizing domestic ship- building and flagging offsets some other subsidies -- both shipbuilding subsidies that are granted by other countries, and the deferral provisions of the U.S. tax code that encourage foreign flagging of U.S.-owned vessels. Economic theory suggests, however, that efficiency is not necessarily enhanced by introducing further distortions to counteract existing ones.

Selected Bibliography

Jantscher, Gerald R. Chapter VI -- "Tax Subsidies to the Maritime Industries," Bread Upon The Waters: Federal Aids to the Maritime Industries. Washington, DC: The Brookings Institution, 1975.

Madigan, Richard E. Taxation of the Shipping Industry. Centreville, MD: Cornell Maritime Press, 1982.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, Committee Print, 99th Congress, 2nd session. May 4, 1987, pp. 174-176.

U.S. Department of Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth, Volume 2, General Explanation of the Treasury Department Proposals. November, 1974, pp. 128-129.

                           Transportation

                EMPLOYER-PAID TRANSPORTATION BENEFITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

            Fiscal year  Individuals  Corporations  Total

 

_____________________________________________________________________

               1995          1.9          --         1.9

 

               1996          2.1          --         2.1

 

               1997          2.2          --         2.2

 

               1998          2.3          --         2.3

 

               1999          2.4          --         2.4

 

_____________________________________________________________________

Authorization

Section 132(f).

Description

Transit passes provided directly by the employer are excludable from income in amounts up to $60 per month. A similar exclusion applies to van pools, although the limit applies to the total of van pool costs and transit passes.

Parking facilities provided by the employer are excludable from income in amounts up to $155 per month. Cash reimbursements are also eligible for exclusion in the case of parking facilities.

The dollar limits are indexed for inflation.

Impact

Exclusion from taxation of transportation fringe benefits provides a subsidy to employment in those businesses and industries in which such fringe benefits are common and feasible. The subsidy provides benefits both to the employees (more are employed and they receive higher compensation) and to their employers (who have lower wage costs).

The parking exclusion is more likely to benefit higher income individuals than the mass transit and van pool subsidies. For those individuals receiving benefits, the savings rises with marginal tax rate.

Rationale

A statutory exclusion for the value of parking was introduced in 1984, along with exclusions for a number of other fringe benefits. In many cases, these practices had been long established and generally had been treated by employers, employees, and the Internal Revenue Service as not giving rise to taxable income.

Employees clearly receive a benefit from the availability of free or discounted goods or services, but the benefit may not be as great as the full amount of the discount. In enacting these provisions, the Congress also wanted to establish limits on the use of tax-free fringe benefits. Prior to enactment of the provisions, the Treasury Department had been under a congressionally imposed moratorium on issuance of regulations defining the treatment of these fringes. There was a concern that without clear boundaries on use of these fringe benefits, new approaches could emerge that would further erode the tax base and increase inequities among employees in different businesses and industries.

The Comprehensive Energy Policy Act of 1992 placed a dollar ceiling on the exclusion of parking facilities and introduced the exclusions for mass transit facilities and van pools in order to encourage mass commuting, which would in turn reduce traffic congestion and pollution.

Assessment

The exclusion subsidizes employment in those businesses and industries in which transportation fringe benefits are feasible and commonly used. Because the exclusion applies to practices which are common and may be feasible only in some businesses and industries, it creates inequities in tax treatment among different employees and employers.

Subsidies for mass transit and van pools, and for parking when provided primarily for car pools, are methods of encouraging mass commuting and may be beneficial for reducing congestion and pollution. At the same time, all of these subsidies reduce the cost of commuting in general and add to congestion and pollution. Other methods of discouraging automobile commuting, such as higher gasoline taxes, or local parking taxes, might be more efficient in achieving these goals.

One problem with taxing any directly supplied fringe benefit, such as free or reduced parking, is the administrative difficulty in determining fair market value.

Selected Bibliography

Hevener, Mary B. "Energy Act Changes to Transportation Benefits, Travel Expenses, and Backup Withholding." The Tax Executive, November-December 1992, pp. 463-466.

Kies, Kenneth J. "Analysis of the New Rules Governing the Taxation of Fringe Benefits," Tax Notes, v. 38. September 3, 1984, pp. 981-988.

McKinney, James E. "Certainty Provided as to the Treatment of Most Fringe Benefits by Deficit Reduction Act," Journal of Taxation. September 1984, pp. 134-137.

Sunley, Emil M., Jr. "Employee Benefits and Transfer Payments," Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 90-92.

Talley, Alan. Mass Transit Fares: Federal Tax Exclusion Proposals. Library of Congress, Congressional Research Service Report 92-298, March 23, 1994.

U.S. Congress, House. Comprehensive National Energy Policy Act, Report 102-474, 102d Congress, 2d Session, May 5, 1992.

--, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th Congress, 2nd session. December 31, 1984, pp. 838-866.

--, Senate Committee on Finance. Fringe Benefits, Hearings, 98th Congress, 2nd session. July 26, 27, 30, 1984.

                           Transportation

              EXCLUSION OF INTEREST ON STATE AND LOCAL

 

                   GOVERNMENT BONDS FOR HIGH-SPEED

 

                     INTER-URBAN RAIL FACILITIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

          Fiscal year   Individuals   Corporations    Total

 

_____________________________________________________________________

             1995           /1/           /1/          /1/

 

             1996           /1/           /1/          /1/

 

             1997           /1/           /1/          /1/

 

             1998           /1/           /1/          /1/

 

             1999           /1/           /1/          /1/

 

_____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million per year.

                           END OF FOOTNOTE

Authorization

Sections 103, 141, 142, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance the construction of high-speed inter-urban rail facilities is tax exempt. In order to qualify for this exception, high-speed rail facilities must carry passengers (the general public) between metropolitan statistical areas at speeds in excess of 150 miles per hour. Rolling stock is not eligible for tax exemption.

These high-speed rail bonds are classified as private-activity bonds rather than governmental bonds because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to finance rail facilities at reduced interest rates. Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the high-speed rail facilities, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Prior to 1968, no restriction was placed on the ability of State and local governments to issue tax-exempt bonds to finance privately owned mass commuting facilities. Although the Revenue and Expenditure Control Act of 1968 imposed tests that would have restricted issuance of these bond issues, it provided a specific exception for mass commuting facilities (allowing continued unrestricted issuance).

The Tax Reform Act of 1986 classified mass commuting facility bonds as taxable private-activity bonds. Tax exemption was allowed if the facilities were government owned. The 1986 Act established a more favorable exception for high-speed inter-urban rail facilities, allowing private ownership if the owner agreed only to forego depreciation allowances on the rail property. Twenty-five percent of these bonds were subject to the private-activity bond volume cap, but this restriction was eliminated by the Omnibus Budget Reconciliation Act of 1993.

Assessment

The desirability of allowing these bonds to be eligible for tax- exempt status hinges on one's view of whether the users of such facilities should pay the full cost, or whether sufficient social benefits (such as reduction of congestion costs) exist to justify taxpayer subsidy. Public finance theory suggests that to the extent these facilities provide social benefits, the facilities might be underprovided due to the reluctance of State and local taxpayers to finance benefits for nonresidents.

Even if a case can be made for subsidy due to State and local underinvestment, it is important to recognize the costs that accrue. As one of many categories of tax-exempt private-activity bonds, bonds issued for high-speed intercity rail facilities have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Advisory Commission on Intergovernmental Relations. Strengthening the Federal Revenue System. Implications for State and Local Taxing and Borrowing, A Commission Report (H-97). Washington, DC: 1985, pp. 115-132.

Livingston, Michael. "Reform or Revolution? Tax-Exempt Bonds, The Legislative Process, and the Meaning of Tax Reform," U.C. Davis Law Review 22. Summer 1989, pp. 1165-1237.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

                 Community and Regional Development

                INVESTMENT CREDIT FOR REHABILITATION

 

            OF STRUCTURES, OTHER THAN HISTORIC STRUCTURES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

          Fiscal year   Individuals   Corporations    Total

 

_____________________________________________________________________

             1995           /1/           /1/          /1/

 

             1996           /1/           /1/          /1/

 

             1997           /1/           /1/          /1/

 

             1998           /1/           /1/          /1/

 

             1999           /1/           /1/          /1/

 

_____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 47.

Description

Qualified expenditures made to substantially rehabilitate nonresidential building receive a 10-percent tax credit. Only expenditures on buildings placed in service before 1936 are eligible. Expenditures made during any 24-month period must exceed the greater of $5,000 or the adjusted basis (cost less depreciation taken) of the building.

At least 50 percent of external walls must be retained as external walls, at least 75 percent of the exterior walls must be retained as internal or external walls, and at least 75 percent of the internal structural framework of the building must be retained. The building must not have been moved since 1936.

Impact

These provisions encourage business to renovate rather than relocate. They reduce the cost of rehabilitation and thereby can turn unprofitable rehabilitation into profitable rehabilitation, and can make rehabilitation more profitable than new construction.

Rationale

The Revenue Act of 1978 provided a credit for rehabilitation expenditures made for nonresidential buildings at least 20 years old, in response to concerns over the declining usefulness of older buildings (especially those in older neighborhoods and central cities). The purpose was to promote stability and restore economic vitality to deteriorating areas.

Larger rehabilitation tax credits were enacted in the Economic Recovery Tax Act of 1981; the purpose was to counteract any tendency to encourage firms to relocate and build new plants in response to significantly shortened recovery periods. Concerns were expressed that investment in new structures in new locations does not promote economic recovery if it displaces older structures, and that relocation can cause hardship to workers and their families.

The credit was retained in the Tax Reform Act of 1986 because investors were viewed as failing to consider social and aesthetic values of restoring older structures. The credit amount was reduced because the rate would have been too high when compared with the new lower tax rates.

Assessment

The main criticism of the tax credit is that it allocates investments to restoring older buildings that would not otherwise be profitable, causing economic inefficiency. This allocation may be desirable if there are external benefits to society (e.g. aesthetic benefits) that the firm would not take into account.

Selected Bibliography

Davis, Glenn E., and Roxanne J. Coady. "Tax Incentives for Rehabilitating Real Estate Increased by New Law," Taxation for Accountants, v. 27. November 1981, pp. 290-294.

Everett, John O. "Rehabilitation Tax Credit Not Always Advantageous," Journal of Taxation. August 1989, pp. 96-102.

Taylor, Jack. Income Tax Treatment of Rental Housing and Real Estate Investment After the Tax Reform Act of 1986, Library of Congress, Congressional Research Service Report 87-603 E. Washington, DC: July 2, 1987.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Act of 1978, H.R. 13511, 95th Congress, Public Law 95- 600. Washington, DC: U.S. Government Printing Office, March 12, 1979, pp. 155-158.

--. General Explanation of the Economic Recovery Tax Act of 1981, H.R. 4242, 97th Congress, Public Law 97-34. Washington, DC: U.S. Government Printing Office, December 31, 1981, pp. 111-116.

--. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington, DC: U.S. Government Printing Office, May 4, 1987, pp. 148-152.

U.S. General Accounting Office. Historic Preservation Tax Incentives. Washington, DC: August 1, 1986.

                  Community and Regional Development

               EXCLUSION OF INTEREST ON STATE AND LOCAL

 

                           GOVERNMENT BONDS

 

                     FOR PRIVATE IMPORTS, DOCKS,

 

                    AND MASS COMMUTING FACILITIES

                        Estimated Revenue Loss

 

                       [In billions of dollars]

____________________________________________________________________

           Fiscal year  Individuals  Corporations   Total

 

____________________________________________________________________

             1995          0.6          0.2         0.8

 

             1996          0.7          0.2         0.9

 

             1997          0.7          0.2         0.9

 

             1998          0.8          0.3         1.1

 

             1999          0.8          0.3         1.1

 

____________________________________________________________________

Authorization

Sections 103, 141, 142, and 146 of the Internal Revenue Code of 1986.

 

Description

Interest income on State and local bonds used to finance the construction of government-owned airports, docks, wharves, and mass- commuting facilities, such as bus depots and subway stations, is tax exempt. These airport, dock, and wharf bonds are classified as private-activity bonds rather than governmental bonds because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Because private-activity mass commuting facility bonds are subject to the private-activity bond annual volume cap, equal to the greater of $50 per State resident or $150 million, they must compete for cap allocations with bond proposals for all other private activities subject to the volume cap.

Bonds issued for airports, docks, and wharves are not, however, subject to the annual State volume cap on private-activity bonds. The cap is foregone because government ownership requirements restrict the ability of the State or local government to transfer the benefits of the tax exemption to a private operator of the facilities.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low-interest rates enable issuers to provide the services of airport, dock, and wharf facilities at lower cost.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the airport, dock, and wharf facilities, and estimates of the distribution of tax- exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Prior to 1968, no restriction was placed on the ability of State and local governments to issue tax-exempt bonds to finance privately owned airports, docks, and wharves. Although the Revenue and Expenditure Control Act of 1968 imposed tests that would have restricted issuance of these bond issues, it provided a specific exception for airports, docks, wharves, and mass-commuting facilities (allowing continued unrestricted issuance).

The Deficit Reduction Act of 1984 allowed bonds for non- government-owned airports, docks, wharves, and mass-commuting facilities to be tax exempt, but required the bonds to be subject to a volume cap applied to several private activities. The volume cap did not apply if the facilities were "governmentally owned."

The Tax Reform Act of 1986 allowed tax exemption only if the facilities satisfied government ownership requirements, but excluded the bonds for airports, wharves, and docks from the private-activity bond volume cap. This Act also denied tax exemption for bonds used to finance related facilities such as hotels, retail facilities in excess of the size necessary to serve passengers and employees, and office facilities for nongovernment employees.

The Economic Recovery Tax Act of 1981 extended tax exemption to mass-commuting vehicles (bus, subway car, rail car, or similar equipment) that private owners leased to government-owned mass transit systems. This provision allowed both the vehicle owner and the government transit system to benefit from the tax advantages of tax-exempt interest and accelerated depreciation allowances. The vehicle exemption was scheduled to (and did) sunset on December 31, 1984.

Assessment

State and local governments tend to view these facilities as economic development tools. The desirability of allowing these bonds to be eligible for tax-exempt status hinges on one's view of whether the users of such facilities should pay the full cost, or whether sufficient social benefits exist to justify taxpayer subsidy. Public finance theory suggests that to the extent these facilities provide social benefits that extend beyond the boundaries of the State or local government, the facilities might be underprovided due to the reluctance of State and local taxpayers to finance benefits for nonresidents.

Even if a case can be made for subsidy due to State and local underinvestment, it is important to recognize the costs that accrue. As one of many categories of tax-exempt private-activity bonds, bonds issued for airports, docks, and wharves have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Advisory Commission on Intergovernmental Relations. Strengthening the Federal Revenue System: Implications for State and Local Taxing and Borrowing, Commission Report H-97. Washington, DC: 1985, pp. 115-132.

Livingston, Michael. "Reform or Revolution? Tax-Exempt Bonds, The Legislative Process, and the Meaning of Tax Reform," U.C. Davis Law Review, v. 22. Summer 1989, pp. 1165-1237.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

                 Community and Regional Development

              REGIONAL ECONOMIC DEVELOPMENT INCENTIVES:

 

             EMPOWERMENT ZONES, ENTERPRISE COMMUNITIES,

 

                  AND INDIAN INVESTMENT INCENTIVES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

            Fiscal year  Individuals  Corporations  Total

 

____________________________________________________________________

             1995           0.1         0.2         0.3

 

             1996           0.2         0.2         0.4

 

             1997           0.3         0.2         0.5

 

             1998           0.3         0.3         0.6

 

             1999           0.3         0.3         0.6

 

____________________________________________________________________

Authorization

Sections 38(b), 39(d),45A, 168(j), 280C(a), 1391-1397D.

Description

The OBRA 1993 tax legislation specified that nine empowerment zones and 95 enterprise communities will be designated to receive special tax benefits. Six of the empowerment zones and 65 of the enterprise communities will be in urban areas; the remainder will be in rural areas. Indian reservations cannot be designated but will receive separate tax subsidies.

Designated areas must satisfy eligibility criteria including poverty rates and population and geographic size limits; they will be eligible for benefits for ten years.

For empowerment zones, the tax incentives include a 20-percent employer wage credit for the first $15,000 of wages for zone residents who work in the zone, $20,000 in expensing of equipment in investment (in addition to the $17,500 allowed generally) in qualified zone businesses, and expanded tax exempt financing for certain zone facilities, primarily qualified zone businesses.

Enterprise communities receive only the tax exempt financing benefits. Tax exempt bonds for any one community cannot exceed $3 million and bonds for any user cannot exceed $20 million for all zones or communities. Businesses eligible for this financing are subject to limits to target businesses operating primarily within the zones or communities.

Businesses on Indian reservations are eligible for accelerated depreciation and for a credit for 20 percent of the cost of the first $20,000 of wages (and health benefits) paid by the employer to tribal members and their spouses, in excess of payments in 1993. These benefits are available for wages paid, and for property placed in service, for ten years (1994-2003).

Impact

Both businesses and employees within the designated areas may benefit from these provisions. Wage credits given to employers can increase the wages of individuals if not constrained by the minimum wage, and these individuals tend to be lower income individuals. If the minimum wage is binding (so that the wage does not change) the effects may show up in increased employment and/or in increased profits to businesses.

Benefits for capital investments may be largely received by business owners initially, although the eventual effects may spread to other parts of the economy. Eligible businesses are likely to be smaller businesses because they must operate within the designated area.

Rationale

These geographically targeted tax provisions were adopted in 1993, although they had been under discussion for some time and had been included in proposed legislation in 1992. Interest in these types of tax subsidies increased after the 1992 Los Angeles riots.

The objective of the subsidies was to revitalize distressed areas through expanded business and employment opportunities, especially for residents of these areas, in order to alleviate social and economic problems, including those associated with drugs and crime.

Assessment

The geographically targeted tax provisions should encourage increased employment and income of individuals living and working in the zones and increased incentives to businesses working in the zones. The small magnitude of the program may be appropriate to allow time to assess how well such benefits are working; current evidence does not provide clear guidelines.

If the main target of these provisions is an improvement in the economic status of individuals currently living in these geographic areas, it is not clear to what extent these tax subsidies will succeed in that objective. None of the subsidies are given directly to workers; rather they are received by businesses. Capital subsidies may not ultimately benefit workers; indeed, it is possible that they may encourage more capital intensive businesses and make workers worse off. Wage subsidies are more likely to be effective in benefiting poor zone or community residents, although incomes cannot be increased if they are constrained by the minimum wage.

Another reservation about enterprise zones is that they may make surrounding communities, that may also be poor, worse off by attracting businesses away from them. And, in general, questions have been raised about the target efficiency of provisions that target all beneficiaries in a poor area rather than poor beneficiaries in general.

Selected Bibliography

Gravelle, Jane G. Enterprise Zones: The Design of Tax Provisions. Library of Congress, Congressional Research Service Report No. 92-476. June 3, 1992.

Papke, Leslie. "What Do We Know About Enterprise Zones?" In Tax Policy and the Economy 7, ed. James Poterba, National Bureau of Economic Research, Cambridge: MIT Press, 1993.

U.S. Congress, House, Committee on Banking, Finance and Urban Affairs, Subcommittee on economic Growth and Credit Formation. The Administration's Empowerment Zone and Enterprise Community Proposal. Hearing, 103d Congress, 1st Session, May 27 and June 8, 1993.

        Education, Training, Employment, and Social Services:

 

                       Education and Training

               EXCLUSION OF SCHOLARSHIP AND FELLOWSHIP

 

                               INCOME

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

           Fiscal year  Individuals  Corporations   Total

 

____________________________________________________________________

             1995          0.7            -         0.7

 

             1996          0.7            -         0.7

 

             1997          0.8            -         0.8

 

             1998          0.8            -         0.8

 

             1999          0.8            -         0.8

 

____________________________________________________________________

Authorization

Section 117.

Description

Individuals who are candidates for degrees may exclude qualified scholarships and fellowships from gross income. The exclusion applies only to amounts used for tuition and fees required for enrollment or to amounts used for books, supplies, fees, and equipment required for courses. Amounts used for room, board, and incidental expenses are not excludable. In addition, amounts representing payment for services -- teaching, research, or other activities--are not excludable, regardless of when the service is performed or whether it is required of all degree candidates.

Tuition reductions for employees of educational institutions may also be excluded, provided they do not represent payment for services. The exclusion applies as well to tuition reductions for an employee's spouse and dependent children; in addition, reductions can occur at schools other than where the employee works, provided they are granted by the school attended, not paid by the employing school. More restrictive rules apply to graduate education.

Impact

The exclusion reduces the net cost of education for students who receive financial aid in the form of scholarships or fellowships (including grants awarded on the basis of financial need, such as Pell Grants). The potential benefit is greatest for students at private colleges and universities, where higher tuition charges increase the amount of scholarship or fellowship assistance that might be excluded. For students at public institutions with low tuition charges, the exclusion may apply only to a small portion of a scholarship or fellowship award.

The effect of the exclusion may be negligible for students with little additional income: they could otherwise use their standard deduction or personal exemption to offset scholarship or fellowship income (though their personal exemption would be zero if their parents could claim them as dependents). On the other hand, the exclusion may result in a substantial tax benefit for married students who file joint returns with an employed spouse.

The exclusion of tuition reductions similarly reduces the net cost of education for employees of educational institutions. When teachers and other school employees take reduced-tuition courses, the exclusion provides a tax benefit not available to other taxpayers unless their courses are job-related or included under an employer education assistance plan (section 127). When their spouse or children take reduced-tuition courses, the exclusion provides a unique benefit unavailable to other taxpayers.

Rationale

Section 117 was enacted as part of the Internal Revenue Code of 1954 in order to clarify the tax status of grants to students; previously, they could be excluded only if it could be established that they were gifts. The statute has been amended a number of times: prior to the Tax Reform Act of 1986, for example, the exclusion was also available to individuals who were not candidates for a degree (though it was restricted to $300 a month with a lifetime limit of 36 months); in addition, teaching and other service requirements did not bar use of the exclusion, provided all candidates had such obligations. Language regarding tuition reductions was added by the Deficit Reduction Act of 1984 as part of legislation codifying and establishing boundaries for tax-free fringe benefits; similar provisions had existed in regulations since 1956.

Assessment

The exclusion of scholarship and fellowship income traditionally was justified on the grounds that the awards were analogous to gifts. With the development of grant programs based upon financial need, which today probably account for most awards, justification now rests upon the hardship that taxation would impose.

If the exclusion were abolished, awards could arguably be increased to cover students' additional tax liability, but the likely effect would be that fewer students would get assistance. Scholarships and fellowships are not the only educational subsidies that receive favorable tax treatment (for example, government support of public colleges is not considered income to the students), and it might be inequitable to tax them without taxing the others.

The exclusion has been criticized on several grounds. It is unfair to students who pay for college with their own or family earnings; they can neither shield this income from taxation nor deduct their expenses. In addition, the exclusion provides greater benefits to taxpayers with higher marginal tax rates. While students themselves generally have low (or even zero) marginal rates, for economic purposes they often are members of families subject to higher rates. Determining what ought to be the proper taxpaying unit for college students complicates assessment of the exclusion.

Whether the exclusion is justified depends in part on broader considerations about the appropriateness of public subsidies for education. In particular, arguments over the exclusion reflect conflicting views about the extent to which college education is a socially desirable investment as opposed to personal consumption.

Selected Bibliography

Abramowicz, Kenneth F. "Taxation of Scholarship Income," Tax Notes, v. 60. November 8, 1993, pp. 717-725.

Crane, Charlotte. "Scholarships and the Federal Income Tax Base," Harvard Journal on Legislation, v. 28. Winter 1991, pp. 63- 113.

Dodge, Joseph M. "Scholarship under the Income Tax," Tax lawyer, v. 46. Spring, 1993, pp. 697-754.

Evans, Richard, et. al. "Knapp v. Commissioner of Internal Revenue: Tuition Assistance or Scholarship, a Question of Taxation," The Journal of College and University Law, v. 16. Spring 1990, pp. 699-712.

Hoeflich, Adam. "The Taxation of Athletic Scholarships: A Problem of Consistency,." University of Illinois Law Review, v. 1991. 1991, pp. 581-617.

Kelly, Marci. "Financing Higher Education: Federal Income-Tax Consequences," The Journal of College and University Law, v. 17. Winter 1991, pp. 307-328.

Lyke, Bob. Federal Taxation of Student Aid. Library of Congress, Congressional Research Service Report 94-749 EPW. Washington, DC: September 27, 1994.

        Education, Training, Employment, and Social Services:

 

                       Education and Training

             PARENTAL DEPENDENCY EXEMPTION FOR STUDENTS

 

                             AGES 19-23

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

            Fiscal year  Individuals  Corporations  Total

 

____________________________________________________________________

             1995           0.9           -         0.9

 

             1996           0.9           -         0.9

 

             1997           0.9           -         0.9

 

             1998           0.9           -         0.9

 

             1999           0.9           -         0.9

 

____________________________________________________________________

Authorization

Section 151.

Description

Taxpayers may claim dependency exemptions for children 19 through 23 years of age who are full-time students at least 5 months during the year, even if the children have gross income in excess of the personal exemption amount ($2,450 in 1994) and could not normally be claimed. Other standard dependency tests must be met, including provision of one-half of the dependents' support. These dependents cannot claim personal exemptions on their own returns, however, and their standard deduction may be lower. In 1994, with some exceptions, it is limited to the greater of $600 or their earned income, up to a maximum of $3,800 for individuals filing a single return.

Impact

The student dependency exemption generally results in additional tax savings for families with college students. Parents typically have higher income and higher marginal tax rates than their student children (who may not even be taxed); thus, the exemption is worth more if parents claim it. Parents lose some or all of the student dependency exemption if their adjusted gross income is greater than inflation adjusted threshold for phasing out personal exemptions ($167,700 for joint returns in 1994).

Rationale

The Internal Revenue Code enacted in 1954 first allowed parents to claim dependency exemptions for their children regardless of their gross income, provided they were less than 19 years old or were full- time students for at least 5 months. Under prior law, such exemptions could not be claimed for any child whose gross income exceeded $600. Committee reports for the legislation noted that the prior rule was a hardship for parents with children in school and an inducement for the children to stop work before their earnings reached that level.

Under the 1954 Code, dependents whose exemptions could be claimed by their parents could also claim personal exemptions on their own returns. The Tax Reform Act of 1986 disallowed double exemptions, limiting claims just to the parents.

The Technical and Miscellaneous Revenue Act of 1988 restricted the student dependency exemption to children under the age of 24. Students who are older than 23 can be claimed as dependents only if their gross income is less than the personal exemption amount.

Assessment

The student dependency exemption was created before the development of broad-based Federal student aid programs, and some of its effects might be questioned in light of their objectives. The exemption principally benefits families with higher incomes and the tax savings are not related to the cost of education. In contrast, most Federal student aid is awarded according to financial need formulas that reflect both available family resources and educational cost.

Nonetheless, the original rationale for the student dependency exemption remains valid. If the exemption did not exist, as was the case before 1954, students who earned more than the personal exemption amount would cause their parents to lose a dependency exemption worth hundreds of dollars, depending on the latter's tax bracket. Unless they would earn a lot more money, students who knew of this consequence might stop work at the point their earnings reached the personal exemption amount.

Selected Bibliography

Bittker, Boris I. "Federal Income Taxation and the Family," 27 Stanford Law Review 1389, esp. pp. 1444-1456 (1975).

Morris, Marie. Dependency Exemption: Its History under the Federal Income Tax. Library of Congress, Congressional Research Service Report 86-699 A. Washington, DC: November 17, 1986.

Talley, Louis Alan. Student Personal/Dependency Exemption and Standard Deduction. Library of Congress, Congressional Research Service Report 90-172 E. Washington, DC: March 27, 1990.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress; Public Law 99-514). Washington, DC: U.S. Government Printing Office, May 4, 1987, pp. 22-24.

        Education, Training, Employment, and Social Services:

 

                       Education and Training

                 EXCLUSION OF INTEREST ON STATE AND

 

                 LOCAL GOVERNMENT STUDENT LOAN BONDS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals      Corporations      Total

 

____________________________________________________________________

        1995             0.2              0.1            0.3

 

        1996             0.2              0.1            0.3

 

        1997             0.1              /1/            0.1

 

        1998             0.1              /1/            0.1

 

        1999             0.1              /1/            0.1

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million per year.

                      END OF FOOTNOTE TO TABLE

Authorization

Sections 103, 141, 144, and 146 of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance post- secondary loans to students is tax exempt. These student loan bonds are classified as private-activity bonds rather than as governmental bonds because a substantial portion of their benefits accrues to individuals or businesses rather than to the general public. For more discussion of the distinction between governmental bonds and private- activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

These student loan bonds are subject to the private-activity bond annual volume cap, and must compete for cap allocations with bond proposals for all other private activities subject to the volume cap.

Student loan bonds are integrally related to Federal direct subsidy assistance provided by the Stafford Loan, the Parent Loans to Undergraduate Students (PLUS), and the Supplemental Loans for Students (SLS) programs.

The Stafford Loan program

(1) provides a guarantee against loan default;

(2) makes an interest-rate subsidy in the form of a Special Allowance Payment (SAP), which for commercial lenders (banks) fluctuates with the 91-day Treasury bill rate and makes up the difference between the interest rate the student pays and the interest that banks could earn on alternative investments; and

(3) forgoes both accrual and payment of interest and principal while the student is in school and defers repayment for six months after the student leaves school.

The PLUS and SLS programs guarantee loans against default, but the maximum interest rates are higher and interest is paid while students are in school, so the Federal subsidy is less than on Stafford loans, particularly if borrower interest-rate caps are exceeded. The interest rates that borrowers pay under the Stafford, PLUS, and SLS programs are set by law and are the same regardless of whether loan financing comes from taxable or tax-exempt sources

Thus, tax-exempt borrowing does not provide lower interest rates for borrowers, but it does broaden access to loans by enabling State and local nonprofit authorities to make loans wherever privte institutions may be reluctant to do so. Finally, the SAP on loans made or purchased with the proceeds of tax-exempt bonds in 50-percent lower than on loans from commerical banks because the cost of borrowing with tax-exempt bonds is lower.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates may increase the availability of student loans, but they do not lower the interest rate to students, since this is set by Federal law. The availability of student loan bond funds creates a secondary market for student loans made by private lenders in much the same way the Student Loan Marketing Association does.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and student borrowers, and for estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Although the first student loan bonds were issued in the mid- 1960s, few states used them in the next ten years. The use of student loan bonds began growing rapidly in the late 1970s because of the combined effect of three pieces of legislation.

First, the Tax Reform Act of 1976 authorized nonprofit corporations established by State and local governments to issue tax- exempt bonds to acquire guaranteed student loans. It exempted the special allowance payment from tax-code provisions prohibiting arbitrage profits (borrowing at low interest rates and investing the proceeds in assets (e.g., student loans) paying higher interest rates). State authorities could use arbitrage earnings to make or purchase additional student loans or turn them over to the State government or a political subdivision. This provided incentives for State and local governments to establish more student loan authorities.

Second, the Middle Income Student Assistance Act of 1978 made all students, regardless of family income, eligible for interest subsidies on their loans, expanding the demand for loans by students from higher-income families.

Third, legislation in late 1976 raised the ceiling on SAPs and tied them to quarterly changes in the 91-day Treasury bill rate. The Higher Education Technical Amendments of 1979 removed the ceiling, making the program more attractive to commercial banks and other lenders, and increasing the supply of loans.

In 1980, when Congress became aware of the profitability of tax- exempt student loan bond programs, it passed remedial legislation that reduced by one-half the special allowance rate paid on loans originating from the proceeds of tax-exempt bonds.

Subsequently, the Deficit Reduction Act of 1984 mandated a Congressional Budget Office study of the arbitrage treatment of student loan bonds, and required that Treasury enact regulations if Congress failed to respond to the study's recommendations.

Regulations were issued in 1989, effective in 1990, that required Special Allowance Payments to be included in the calculation of arbitrage profits, and that restricted arbitrage profits to 2.0 percentage points in excess of the yield on the student loan bonds. The Tax Reform Act of 1986 allowed student loans to earn 18 months of arbitrage profits on unspent (not loaned) bond proceeds. This special provision expired one-and-a-half years after adoption, and student loans are now subject to the same six-month restriction on arbitrage earnings as other private-activity bonds.

The Tax Reform Act of 1986 also included student loan bonds under the unified volume cap on private-activity bonds.

Assessment

The desirability of allowing these bonds to be eligible for tax- exempt status hinges on one's view of whether students should pay the full cost of their education, or whether sufficient social benefits exist to justify taxpayer subsidy. Students present high credit risk due to their uncertain earning prospects, high mobility, and society's unwillingness to accept human capital as loan collateral (via indentured servitude or slavery). This suggests there may be insufficient funds available for human, as opposed to physical, capital investments.

Even if a case can be made for subsidy due to underinvestment in human capital, it is important to recognize the costs that accrue. As one of many categories of tax-exempt private-activity bonds, bonds issued for student loans have increased the financing costs of bonds issued for public capital stock, and have increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Neubig, Tom. "The Needless Furor Over Tax-Exempt Student Loan Bonds," Tax Notes, April 2, 1984, pp. 93-96.

U.S. Congress, Congressional Budget Office. The Tax-Exempt Financing of Student Loans. 1986.

--. State Profits on Tax-Exempt Student Loan Bonds: Analyses and Options. 1980.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

        Education, Training, Employment, and Social Services:

 

                       Education and Training

                        EXCLUSION OF INTEREST

 

                 ON STATE AND LOCAL GOVERNMENT BONDS

 

            FOR PRIVATE NONPROFIT EDUCATIONAL FACILITIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals      Corporations      Total

 

____________________________________________________________________

        1995             0.6              0.2            0.8

 

        1996             0.6              0.2            0.8

 

        1997             0.6              0.2            0.8

 

        1998             0.7              0.2            0.9

 

        1999             0.7              0.2            0.9

 

____________________________________________________________________

Authorization

Section 103, 141, 145, 146, and 501(c)(3) of the Internal Revenue Code of 1986.

Description

Interest income on State and local bonds used to finance the construction of nonprofit educational facilities (usually university and college facilities such as classrooms and dormitories) is tax exempt. These nonprofit organization bonds are classified as private- activity bonds rather than governmental bonds because a substantial portion of their benefits accrues to individuals or business rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Bonds issued for nonprofit educational facilities are not, however, subject to the State volume cap on private activity bonds. This exclusion probably reflects some belief that the nonprofit bonds have a larger component of benefit to the general public than do many of the other private activities eligible for tax exemption. The bonds are, however, subject to a $150 million cap on the amount of bonds any nonprofit institution can have outstanding.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to finance educational facilities at reduced interest rates. Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the nonprofit educational facilities, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

An early decision of the U.S. Supreme Court predating the enactment of the first Federal income tax, Dartmouth College v. Woodward (17 U.S. 518 [1819]), confirmed the legality of government support for charitable organizations that were providing services to the public. The income tax adopted in 1913, in conformance with this principle, exempted from taxation virtually the same organizations now included under Section 501(c)(3). In addition to their tax- exempt status, these institutions were permitted to receive the benefits of tax-exempt bonds. Almost all States have established public authorities to issue tax-exempt bonds for nonprofit educational facilities.

The Tax Reform Act of 1986 established a $150 million cap on the stock of bonds that may be outstanding for any nonprofit institution. This cap applies to educational institutions. The private-activity bond status of these bonds subjects them to more severe restrictions in some areas, such as arbitrage rebate and advance refunding, than would apply if they were classified as governmental bonds.

Assessment

Efforts have been made to reclassify nonprofit bonds as governmental bonds. Central to this issue is the extent to which nonprofit organizations are fulfilling their public purpose rather than using their tax-exempt status to convert tax subsidies into subsidized goods and services for groups that might receive more critical scrutiny if their subsidy were provided through the spending side of the budget.

As one of many categories of tax-exempt private-activity bonds, nonprofit education bonds have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Odendahl, Teresa. Charity Begins at Home. Generosity and Self- Interest Among the Philanthropic Elite. New York: Basic Books, 1990.

Weisbrod, Burton A. The Nonprofit Economy. Cambridge, Mass.: Harvard University Press, 1988.

Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax Policy," National Tax Journal. September, 1991, pp. 341-349.

--. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activities. Washington, DC: The Urban Institute Press, 1991.

        Education, Training, Employment, and Social Services:

 

                       Education and Training

              DEDUCTIBILITY OF CHARITABLE CONTRIBUTIONS

 

                    FOR EDUCATIONAL INSTITUTIONS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals      Corporations      Total

 

____________________________________________________________________

        1995             2.0              0.5            2.5

 

        1996             2.1              0.5            2.6

 

        1997             2.2              0.5            2.7

 

        1998             2.3              0.5            2.8

 

        1999             2.4              0.5            2.9

 

____________________________________________________________________

Authorization

Section 170 and 642(c).

Description

Subject to certain limitations, charitable contributions may be deducted by individuals, corporations, and estates and trusts. The contributions must be made to specific types of organizations, including scientific, literary, or educational organizations. To be deductible, contributions of $250 or more must be substantiated.

Individuals who itemize may deduct qualified contributions of up to 50 percent of their adjusted gross income (AGI) (30 percent for gifts of capital gain property).

For contributions to nonoperating foundations and organizations, deductibility is limited to the lesser of 30 percent of the taxpayer's contribution base, or the excess of 50 percent of the contribution base for the tax year over the amount of contributions which qualified for the 50 percent deduction ceiling (including carryovers from previous years).

Gifts of capital gain property to these organizations are limited to 20 percent of AGI. A corporation can deduct up to 10 percent of taxable income (with some adjustments).

If a contribution is made in the form of property, the deduction depends on the type of taxpayer (i.e., individual, corporate, etc.), recipient, and purpose.

Impact

The deduction for charitable contributions reduces the net cost of contributing. In effect, the Federal Government provides the donee with a matching grant that increases in value with the donor's marginal tax bracket. Those individuals who use the standard deduction or who pay no taxes receive no benefit from the provision.

A limitation applies to the itemized deductions of high-income taxpayers. Under this provision, in 1994, otherwise allowable deductions are reduced by three percent of the amount by which a taxpayer's adjusted gross income (AGI) exceeds $111,800 or $55,900 for married taxpayers filing separate returns (adjusted for inflation in future years). The table below provides the distribution of all charitable contributions, not just those for educational organizations.

               DISTRIBUTION BY INCOME CLASS OF THE TAX

 

              EXPENDITURE FOR CHARITABLE CONTRIBUTIONS

 

              AT 1992 TAX RATES AND 1992 INCOME LEVELS

     ________________________________________________________

     Income Class                                 Percentage

 

     (in thousands of $)                         Distribution

 

     ________________________________________________________

        Below $10                                   0.0

 

        $10 to $20                                  0.3

 

        $20 to $30                                  1.7

 

        $30 to $40                                  4.0

 

        $40 to $50                                  5.1

 

        $50 to $75                                 15.7

 

        $75 to $100                                13.4

 

        $100 to $200                               17.2

 

        $200 and over                              42.7

 

____________________________________________________________________

Rationale

This deduction was added by passage of the War Revenue Act of October 3, 1917. Senator Hollis, the sponsor, argued that the high wartime tax rates would absorb the surplus funds of wealthy taxpayers, which were generally contributed to charitable organizations.

It was also argued that many colleges would lose students to the military and charitable gifts were needed by educational institutions. Thus the original rationale shows a concern for educational organizations. The deduction was extended to estates and trusts in 1918 and to corporations in 1935.

Assessment

Most economists agree that education produces substantial "spillover" effects benefiting society in general. Examples include a more efficient workforce, lower unemployment rates, lower welfare costs, and less crime. An educated electorate fosters a more responsive and effective government. Since these benefits accrue to society at large, they argue in favor of the government actively promoting education.

Further, proponents argue that the Federal Government would be forced to assume some activities now provided by educational organizations if the deduction were eliminated. However, public spending might not be allowed to make up all the difference. Also, many believe that the best method of allocating general welfare resources is through a dual system of private philanthropic giving and governmental allocation.

Economists have generally held that the deductibility of charitable contributions provides an incentive effect which varies with the marginal tax rate of the giver. There are a number of studies which find significant behavioral responses.

Types of contributions may vary substantially among income classes. For example, contributions to religious organizations are far more concentrated at the lower end of the income scale than contributions to educational institutions.

It has been estimated by the AAFRC Trust for Philanthropy, Inc. that giving to U.S. schools, universities, libraries, research institutions, and other educational facilities amounted to $14.02 billion in 1992, which accounted for 11.3 percent of all philanthropic contributions.

Opponents say that helping educational organizations may not be the best way to spend Government money. The Congress does not routinely review this deduction. Opponents further claim that the present system allows wealthy taxpayers to indulge special interests (such as gifts to their alma mater).

To the extent that charitable giving is independent of tax considerations, Federal revenues are lost without increasing charitable gifts. It is generally argued that the charitable contributions deduction is difficult to administer and complex for taxpayers to comply with.

Selected Bibliography

Broman, Amy J. "Statutory Tax Rate Reform and Charitable Contributions: Evidence from a Recent Period of Reform," Journal of the American Taxation Association. Fall 1989, pp. 7-21.

Clymer, John H. "The Private Foundation: A New Marketing Opportunity?" Trusts & Estates, v. 125. August 1986, pp. 31-37.

Feenberg, Daniel. "Are Tax Price Models Really Identified: The Case of Charitable Giving," National Tax Journal, v. 40, no. 4. December 1987, pp. 629-633.

Gergen, Mark P. "The Case for a Charitable Contributions Deduction," Virginia Law Review, v. 74. November 1988, pp. 1393- 1450.

McCoy, Thomas and Neal Devins. Standing and Adverseness in Challenges of Tax Exemptions for Discriminatory Private Schools, Fordham Law Review, v. 52. March 1984, pp. 441-471.

Robinson, John R. "Estimates of the Price Elasticity of Charitable Giving: A Reappraisal Using 1985 Itemizer and Nonitemizer Charitable Deduction Data," Journal of the American Taxation Association. Fall 1990, pp. 39-59.

Schiff, Jerald, "Does Government Spending Crowd Out Charitable Contributions?" National Tax Journal, v. 38. December 1985, pp. 535- 546.

"Tax Exempt Educational Organization," Journal of Law and Education, v. 15. Summer 1986, pp. 341-346.

"The Demographics of Giving," American Enterprise, v. 2, September-October 1991, pp. 101-104.

Weber, Nathan, ed. Giving USA, The Annual Report on Philanthropy for the Year 1991, American Association of Fund-Raising Counsel Trust for Philanthropy. New York: 1991.

Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax Policy," National Tax Journal, v. 44. September 1991, pp. 341- 349.

Education, Training, Employment, and Social Services:

 

Education and Training

                        EXCLUSION OF INTEREST

 

                     ON EDUCATION SAVINGS BONDS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

  1995                  0.1                  -               0.1

 

  1996                  0.1                  -               0.1

 

  1997                  0.2                  -               0.2

 

  1998                  0.2                  -               0.2

 

  1999                  0.3                  -               0.3

Authorization

Section 135.

Description

Eligible taxpayers can exclude from their gross income all or part of the interest on U.S. Series EE Savings Bonds if the bonds are used to finance higher education.

A taxpayer must meet certain requirements to qualify for the interest exclusion. The savings bonds must be purchased and owned by persons who are age 24 or over, and must be used to finance higher education for the taxpayer or the taxpayer's spouse or dependents. The bonds must be used for tuition and required fees (less any scholarships, fellowships, and employer-provided educational assistance) at qualified institutions, which include most colleges, universities, and certain vocational schools.

The bonds must be used to pay for higher education in the same year that they are redeemed, must be redeemed by the owner, and must have been issued after 1989.

To qualify for the interest exclusion the bonds must have been purchased by the bond owner or spouse, and the exclusion is not allowed if the bonds are used to pay for enrollment at trade or vocational schools run for profit. The bonds cannot be used to pay for room and board or books.

The interest exclusion is phased out for middle- and upper- income taxpayers. The phaseout ranges are based on a taxpayer's modified adjusted gross income, which is the sum of a taxpayer's adjusted gross income (including the interest from Series EE Bonds), the exclusion for foreign earned income, and the exclusions for income from sources within Puerto Rico and certain U.S. possessions.

The phaseout threshold is adjusted annually for inflation, but the size of the range does not change due to inflation. For 1993, the phaseout range for a married couple filing jointly is $68,250 to $98,250. For single taxpayers and heads of household, it is $45,500 to $60,500. No interest exclusion is allowed for taxpayers with incomes above these ranges. Married couples filing separate tax returns are not eligible for the interest exclusion.

If the total amount of principal and interest on bonds redeemed during a year exceeds the amount of qualified education expenses, the amount of the interest exclusion is reduced proportionately.

Impact

Education Saving Bonds provide lower- and middle-income families with a tax-favored way to save for higher education for their children, and working adults may also save for their own and their spouse's education. Tax benefits of Education Savings Bonds are greater for taxpayers who live in areas with higher State and local income taxes.

Rationale

In recent years, college costs have risen faster than the general rate of inflation and faster than the incomes of many Americans. Education Savings Bonds provide a tax break for eligible taxpayers. The interest exclusion for Education Savings Bonds was created by the Technical Corrections and Miscellaneous Revenue Act of 1988 (P.L. 100-607). The provision was amended by the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239) and the Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508).

Assessment

The benefits of Education Savings Bonds depend on several factors, including how soon taxpayers begin to save, the return on alternative savings plans, a taxpayer's marginal income tax rate, and the burden of State and local income taxes.

For many taxpayers, the after-tax rate of return on Education Savings Bonds is approximately the same as the after-tax rate of return on other Government securities with a similar term. Like other U.S. Government securities, the interest income from Series EE Savings Bonds is exempt from State and local income taxes, and Education Savings Bonds are also exempt from Federal income taxes.

The interest rate on Series EE Bonds held for five years or more is set at 85 percent of the market rate on Treasury securities maturing in five years. Therefore, for taxpayers in the 15-percent tax bracket, the interest exclusion for Education Savings Bonds is offset by the below-market rate of interest.

The tax savings from the exclusion are greater for some taxpayers in the 28 percent tax bracket, but the exclusion is phased out for taxpayers with incomes above a certain level. Nevertheless, Series EE Bonds are a safe way to save and many taxpayers may find it easier to purchase and redeem Series EE Bonds than to buy and sell other government securities.

Further, the yield on Series EE Bonds held for five years or more is not allowed to fall below a minimum interest rate (currently four percent). The minimum interest rate is occasionally above the market interest rate, which makes Series EE Bonds an attractive savings option.

Series EE Bonds held for less than five years earn a below- market rate, based on a fixed graduated scale. Therefore, for taxpayers who are saving for educational expenses that will be incurred in less than five years, other savings plans may offer a better after-tax rate of return. On the other hand, Education Savings Bonds may offer an added incentive for many families to begin saving early for their own and their children's education.

The interest exclusion for Education Savings Bonds is based on a taxpayer's income in the year in which the bonds are redeemed. Therefore, taxpayers must predict their eligibility for the interest exclusion. They must also anticipate the future costs of tuition and fees.

Selected Bibliography

Bickley, James M. Variable Rate Savings Bonds: Background, Characteristics, and Evaluation. Library of Congress, Congressional Research Service Report 94-632 E. Washington, DC: August 1, 1994.

Jones-Clayton, Shirley A. "A Survey of Education Incentives in the Internal Revenue Code," Tax lawyer, v. 45, Spring 1992, pp. 801- 813.

Lyke, Bob. Education Savings Bonds: Eligibility for Tax Exclusion. Library of Congress, Congressional Research Service Report 89-570 EPW. Washington, DC: October 16,1989.

Skarbnik, John H. "Financing Future Higher Education Expenses," The Mid-Atlantic Journal of Business, v. 26. Winter 1990, pp. 69-80.

Sullivan, Charlene. "The College Investment Challenge," Journal of Financial Planning, v. 4. January 1991, pp. 10-21.

             Education, Training, Employment, and Social Services:

 

                            Education and Training

                   EXCLUSION FOR EMPLOYER-PROVIDED

 

                   EDUCATIONAL ASSISTANCE BENEFITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

  1995                  0.3                  -               -

 

  1996                   -                   -               -

 

  1997                   -                   -               -

 

  1998                   -                   -               -

 

  1999                   -                   -               -

     * This provision is currently scheduled to expire after December

 

31, 1994.

Authorization

Section 127.

Description

An employee may exclude from gross income amounts paid by the employer for educational assistance (tuition, fees, books, supplies, etc.) pursuant to a qualified educational assistance program. The annual limit is $5,250. The exclusion amount may apply to payments for graduate level courses taken by an individual pursuing a program leading to a law, business, medical, or similar advanced academic or professional degree as well as education required for one's current job. Under Code section 117(d) the exclusion does not apply to graduate teaching or research assistants who receive tuition reduction.

This provision is scheduled to expire after December 31,1994, but may be extended.

Impact

The exclusion of these benefit payments encourages employer educational assistance payments. (If the education were job-related, the taxpayer may be able to deduct educational expenses as an itemized business deduction.) The value of the exclusion is dependent upon the amount of educational expenses furnished and the marginal tax rate.

This exclusion allows certain employees, who otherwise might be unable to do so, to continue their education.

Rationale

Section 127 was added to the law by the passage of the Revenue Act of 1978, effective through 1983. Prior to enactment, the treatment of employer-provided educational assistance was complex, with a case-by-case determination of whether the employee could deduct the assistance as job-related education.

The provision was extended from the end of 1983 through 1985 by the Education Assistance Programs (P.L. 98-611). The Tax Reform act of 1986 raised the maximum excludable assistance from $5,000 to $5,250 and extended it through 1987. The Technical and Miscellaneous Revenue Act of 1988 reauthorized the exclusion retroactively to January 1,1989 and extended it through September 30, 1990. The Revenue Reconciliation Act of 1990 extended it through December 31, 1991 and the Tax Extension Act of 1991 through June 30, 1992. Finally, the exclusion was reauthorized and made retroactive by the Revenue Reconciliation Act of 1993. The provision may be extended further by a future tax act before expiration on December 31,1994.

Assessment

The availability of employer educational assistance encourages employer investment in human capital which may be inadequate in a market economy because of spillover effects. After nearly a decade little information on use of this exclusion exists. Moreover, since all employers do not provide educational assistance, taxpayers with similar incomes are not treated equally. Employer educational assistance programs are typically offered by large employers.

Selected Bibliography

Delaney, Michael J., Richard T. Helleloid, and Scott Kudialis. "The Tax Consequences of Graduate Educational Expenses and Reimbursements," Taxes, v. 68. April 1990, pp. 286-294.

Kelly, Marci. "Financing Higher Education: Federal Income Tax Consequences," Journal of College and University Law, v. 17. Winter 1991, pp. 307-328.

Noto, Nonna A. and Louis Alan Talley. Tax Incentives to Train or Retrain the Work Force. Library of Congress, Congressional Research Service Report 93-739 E. Washington, DC: August 17,1993.

Schendt, Thomas G. "Qualified Educational Assistance Programs: Making the Grade," Employee Benefit Journal, v. 11. December 1986, pp. 2-5.

U.S. Congress, House Committee on Ways and Means. Two-Year Extension of Exclusion With Respect to Educational Assistance Plans; Report Together with Additional Views to Accompany H.R. 2568 Including Cost Estimate of the Congressional Budget Office. Washington, DC: Government Printing Office, 1984.

--, Joint Committee on Taxation. General Explanation of the Revenue Act of 1978 (H.R. 13511, 95th Congress; Public Law 95-600). Washington, DC: Government Printing Office, March 12, 1979, pp. 124- 128.

Lyke, Bob. Employer Education Assistance: Overview of Tax Status. Library of Congress, Congressional Research Service Report 94-761 EPW. Washington, DC: September 30, 1994.

Federal Taxation of Student Aid. Library of Congress, Congressional Research Service Report 94-749 EPW. Washington, DC: September 27,1994.

Education, Training, Employment, and Social Services:

 

Employment

               EXCLUSION OF EMPLOYEE MEALS AND LODGING

 

                        (OTHER THAN MILITARY)

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

  1995                  0.6                  -               0.6

 

  1996                  0.7                  -               0.7

 

  1997                  0.7                  -               0.7

 

  1998                  0.7                  -               0.7

 

  1999                  0.8                  -               0.8

Authorization

Sections 119 and 132(e)(2).

Description

Employees do not include in income the fair market value of meals furnished by employers if the meals are furnished on the employer's business premises and for the convenience of the employer.

The fair market value of meals provided to an employee at a subsidized eating facility operated by the employer is also excluded from income, if the facility is located on or near the employer's business, and if revenue from the facility equals or exceeds operating costs. In the case of highly compensated employees, certain nondiscrimination requirements are met to obtain this second exclusion.

Section 119 also excludes from an employee's gross income the fair market value of lodging provided by the employer, if the lodging is furnished on business premises for the convenience of the employer, and if the employee is required to accept the lodging as a condition of employment.

Impact

Exclusion from taxation of meals and lodging furnished by an employer provides a subsidy to employment in those occupations or sectors in which such arrangements are common. Live-in housekeepers or apartment resident managers, for instance, may frequently receive lodging and/or meals from their employers. The subsidy provides benefits both to the employees (more are employed and they receive higher pay) and to their employers (who receive the employees' services at lower cost).

Rationale

The convenience-of-the-employer exclusion now set forth in section 119 generally had been reflected in income tax regulations since 1918, presumably in recognition of the fact that in some cases, the fair market value of employer-provided meals and lodging may be difficult to measure.

The specific statutory language in section 119 was adopted in the 1954 Code to clarify the tax status of such benefits by more precisely defining the conditions under which meals and lodging would be treated as tax free.

In enacting the limited exclusion for certain employer-provided eating facilities in the 1984 Act, the Congress recognized that the benefits provided to a particular employee who eats regularly at such a facility might not qualify as a de minimis fringe absent another specific statutory exclusion. The record-keeping difficulties involved in identifying which employees ate what meals on particular days, as well as the values and costs for each such meal, led the Congress to conclude that an exclusion should be provided for subsidized eating facilities as defined in section 132(e)(2).

Assessment

The exclusion subsidizes employment in those occupations or sectors in which the provision of meals and/or lodging is common. Both the employees and their employers benefit from the tax exclusion. Under normal market circumstances, more people are employed in these positions and they receive higher pay (after tax). Their employers receive their services at lower cost. Both sides of the transaction benefit because the loss is imposed on the U.S. Treasury in the form of lower tax collections.

Because the exclusion applies to practices common only in a few occupations or sectors, it introduces inequities in tax treatment among different employees and employers.

While some tax benefits are conferred specifically for the purpose of providing a subsidy, this one ostensibly was provided for administrative reasons, and the benefits to employers and employees are side effects. Some observers challenge the rationale for excluding employer-provided meals and lodging on the basis of difficulty in determining their fair market value. They note that a value is placed on these services under some Federal and many State welfare programs.

Selected Bibliography

Katz, Avery, and Gregory Mankiw. "How Should Fringe Benefits Be Taxed?" National Tax Journal. v. 38. March 1985, pp. 37-46.

Kies, Kenneth J. "Analysis of the New Rules Governing the Taxation of Fringe Benefits," Tax Notes. September 3, 1984, pp. 981- 988.

Layne, Jonathan Keith. "Cash Meal Allowances Are Includible in Gross Income and Are Not Excludible Under I.R.C. Section 119 as That Section Permits an Exclusion Only for Meals Furnished in Kind," Emory Law Review. Summer 1978, pp. 791-814.

Sunley, Emil M., Jr. "Employee Benefits and Transfer Payments," Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 90-92.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th Congress, 2nd session. December 31,1984, pp. 858-859.

Education, Training, Employment, and Social Services:

 

Employment

                       SPECIAL TAX PROVISIONS

 

             FOR EMPLOYEE STOCK OWNERSHIP PLANS (ESOPs)

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

 

Fiscal year         Individuals         Corporations        Total

 

____________________________________________________________________

  1995                  /1/                 0.9              0.9

 

  1996                  /1/                 1.0              1.0

 

  1997                  /1/                 1.1              1.1

 

  1998                  /1/                 1.2              1.2

 

  1999                  /1/                 1.2              1.2

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Sections 133, 401(a)(28), 404(a)(9), 404(k), 415(c)(6), 1042,

 

4975(e)(7), 4978, 4979A

Description

An employee stock ownership plan (ESOP) is a defined- contribution plan that is required to invest primarily in the stock of the sponsoring employer. ESOPs are unique among employee benefit plans in their ability to borrow money to buy stock. An ESOP that has borrowed money to buy stock is a leveraged ESOP. An ESOP that acquires stock through direct employer contributions of cash or stock is a nonleveraged ESOP.

ESOPs are provided with various tax advantages. Employer contributions to an ESOP may be deducted by the employer as a business expense. Contributions to a leveraged ESOP are subject to less restrictive limits than contributions to other qualified employee benefit plans.

An employer may deduct dividends paid on stock held by an ESOP if the dividends are paid to plan participants or if the dividends are used to repay a loan that was used to buy the stock. The deduction for dividends used to repay a loan is limited to dividends paid on stock acquired with that loan. Employees are not taxed on employer contributions to an ESOP or the earnings on invested funds until they are distributed.

Qualified lenders may exclude from gross income 50 percent of the interest earned on an ESOP loan if the ESOP owns over 50 percent of the company's stock. A stockholder in a closely held company may defer recognition of the gain from the sale of stock to an ESOP if, after the sale, the ESOP owns at least 30 percent of the company's stock and the seller reinvests the proceeds from the sale of the stock in a U.S. company.

To qualify for these tax advantages, an ESOP must meet the minimum requirements established in the Internal Revenue Code. Many of these requirements are general requirements that apply to all qualified employee benefit plans. Other requirements apply specifically to ESOPs.

In particular, ESOP participants must be allowed voting rights on stock allocated to their accounts. In the case of publicly traded stock, full voting rights must be passed through to participants. For stock in closely held companies, voting rights must be passed through on all major corporate issues.

For lenders to qualify for the 50-percent interest exclusion on ESOP loans, full voting rights must be passed through to participants on stock acquired with the loan.

Closely held companies must give employees the right to sell distributions of stock to the employer (a put option), at a share price determined by an independent appraiser. An ESOP must allow participants who are approaching retirement to diversify the investment of funds in their accounts.

Impact

The various ESOP tax incentives encourage employee ownership of stock through a qualified employee benefit plan and provide employers with a tax-favored means of financing. The deferral of recognition of the gain from the sale of stock to an ESOP encourages the owners of closely held companies to sell stock to the company's employees. The deduction for dividends paid to ESOP participants encourages the current distribution of dividends.

Various incentives encourage the creation of leveraged ESOPs. Compared to conventional debt financing, both the interest and principal on an ESOP loan are tax-deductible. Because of the 50- percent interest exclusion, lenders can charge below-market interest rates on ESOP loans. The deduction for dividends used to make payments on an ESOP loan and the unrestricted deduction for contributions to pay interest encourage employers to repay an ESOP loan more quickly.

According to an analysis of information returns filed with the Internal Revenue Service, most ESOPs are in private companies, and most ESOPs have fewer than 100 participants. But most ESOP participants are employed by public companies and belong to plans with 100 or more participants. Likewise, most ESOP assets are held by plans in public companies and by plans with 100 or more participants.

Rationale

The tax incentives for ESOPs are intended to broaden stock ownership, provide employees with a source of retirement income, and grant employers a tax-favored means of financing.

The Employee Retirement Income Security Act of 1974 (P.L. 93- 406) allowed employers to form leveraged ESOPs. The Tax Reduction Act of 1975 established a tax-credit ESOP (called a TRASOP) that allowed employers an additional investment tax credit of one percentage point if they contributed an amount equal to the credit to an ESOP.

The Tax Reform Act of 1976 allowed employers an increased investment tax credit of one-half a percentage point if they contributed an equal amount to an ESOP and the additional contribution was matched by employee contributions.

The Revenue Act of 1978 required ESOPs in publicly traded corporations to provide participants with full voting rights, and required closely held companies to provide employees with voting rights on major corporate issues. The Act required closely held companies to give workers a put option on distributions of stock.

The Economic Recovery Tax Act of 1981 (P.L. 97-34) replaced the investment-based tax credit ESOP with a tax credit based on payroll (called a PAYSOP). The 1981 Act also allowed employers to deduct contributions of up to 25 percent of compensation to pay the principal on an ESOP loan. Contributions used to pay interest on an ESOP loan were excluded from the 25-percent limit.

The Deficit Reduction Act of 1984 (P.L. 98-369) allowed corporations a deduction for dividends on stock held by an ESOP if the dividends were paid to participants. The Act also allowed lenders to exclude from their income 50 percent of the interest they received on loans to an ESOP.

The Act allowed a stockholder in a closely held company to defer recognition of the gain from the sale of stock to an ESOP if the ESOP held at least 30 percent of the company's stock and the owner reinvested the proceeds from the sale in a U.S. company. The Act permitted an ESOP to assume a decedent's estate tax in return for employer stock of equal value.

The Tax Reform Act of 1986 repealed the tax credit ESOP. The Act also extended the deduction for dividends to include dividends used to repay an ESOP loan. The Act permitted an estate to exclude from taxation up to 50 percent of the proceeds from the sale of stock to an ESOP. The Act allowed persons approaching retirement to diversify the investment of assets in their accounts.

The Omnibus Budget Reconciliation Act of 1989 limited the 50- percent interest exclusion to loans made to ESOPs that hold more than 50 percent of a company's stock. The deduction for dividends used to repay an ESOP loan was restricted to dividends paid on shares acquired with that loan. The Act repealed both estate tax provisions: the exclusion allowed an estate for the sale of stock to an ESOP and the provision allowing an ESOP to assume a decedent's estate tax.

Assessment

One of the major objectives of ESOPs is to expand employee stock ownership. The distribution of stock ownership in ESOP firms is broader than the distribution of stock ownership in the general population.

Some evidence suggests that among firms with ESOPs there is a greater increase in productivity if employees are involved in corporate decision-making. But employee ownership of stock is not a prerequisite for employee participation in decision-making.

ESOPs do not provide participants with the traditional rights of stock ownership. Full vesting depends on a participant's length of service and distributions are generally deferred until a participant separates from service. To provide participants with the full rights of ownership would be consistent with the goal of broader stock ownership, but employees would be able to use employer contributions for reasons other than retirement.

The requirement that ESOPs invest primarily in the stock of the sponsoring employer is consistent with the goal of corporate financing, but it may not be consistent with the goal of providing employees with retirement income. If a firm experiences financial difficulties, the value of its stock and its dividend payments will fall. Because an ESOP is a defined-contribution plan, participants bear the burden of this risk. The partial diversification requirement for employees approaching retirement was enacted in response to this issue.

A leveraged ESOP allows an employer to raise capital to invest in new plant and equipment. But evidence suggests that the majority of leveraged ESOPs involve a change in ownership of a company's stock, and not a net increase in investment.

Although the deduction for dividends used to repay an ESOP loan may encourage an employer to repay a loan more quickly, it may also encourage an employer to substitute dividends for other loan payments.

Because a leveraged ESOP allows an employer to place a large block of stock in friendly hands, leveraged ESOPs have been used to prevent hostile takeovers. In these cases, the main objective is not to broaden employee stock ownership.

ESOPs have been used in combination with other employee benefit plans. A number of employers have adopted plans that combine an ESOP with a 401(k) salary reduction plan. Some employers have combined an ESOP with a 401(h) plan to fund retiree medical benefits

Selected Bibliography

Blasi, Joseph R. Employee Ownership: Revolution or Ripoff? Cambridge, Mass.: Ballinger, 1988.

Blinder, Alan S., ed. Paying for Productivity: A Look at the Evidence. Washington, DC: The Brookings Institution, 1990.

Conte, Michael A., and Helen H. Lawrence. "Trends in ESOPs," Trends in Pensions 1992, eds. John A. Turner and Daniel J. Beller. Washington, DC: U.S. Government Printing Office, 1992, pp. 135-148.

Mayer, Gerald. Employee Stock Ownership Plans: Background and Policy Issues. Library of Congress, Congressional Research Service Report 94-421 E. Washington, DC: May 2, 1994.

--. KSOPs: The Combination of an Employee Stock Ownership Plan with a 401(k) Plan. Library of Congress, Congressional Research Service Report 92-475 E. Washington, DC: June 2, 1992.

Shorter, Gary W. ESOPs and Corporate Productivity. Library of Congress, Congressional Research Service Report 91-557 E. Washington, DC: July 12, 1991.

U.S. General Accounting Office. Employee Stock Ownership Plans: Benefits and Costs of ESOP Tax Incentives for Broadening Stock Ownership, PEMD-87-8. Washington, DC: General Accounting Office, December 29, 1986.

--. Employee Stock Ownership Plans: Little Evidence of Effects on Corporate Performance, PEMD-88-1. Washington, DC: General Accounting Office, October 29, 1987.

        Education, Training, Employment and Social Services:

 

                             Employment

                EXCLUSION FOR BENEFITS PROVIDED UNDER

 

                           CAFETERIA PLANS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

     Fiscal year  Individuals  Corporations      Total

 

____________________________________________________________________

         1995          3.8           --           3.8

 

         1996          4.4           --           4.4

 

         1997          5.0           --           5.0

 

         1998          5.7           --           5.7

 

         1999          6.5           --           6.5

 

____________________________________________________________________

Authorization

Section 125.

Description

Cafeteria plans allow employees to select a mixture of fringe benefits, including some benefits that are not subject to tax. The "menu" for such plans must include both taxable and nontaxable benefits. The tax expenditure measures the loss in revenues from the failure to include the nontaxable cafeteria plan benefits in taxable income.

Taxable benefits that may be offered under a qualified cafeteria plan consist of certain life insurance that is not excludable from gross income, certain vacation pay, or cash.

Nontaxable benefits include any fringe benefit (other than scholarships or fellowships, van-pooling, educational assistance, or miscellaneous fringe benefits) that is excludable from gross income under a specific section of the Code. These nontaxable benefits include nontaxable employer-provided health and accident benefits, life insurance, and qualified deferred compensation (savings) plans.

A highly compensated participant in a cafeteria plan is taxed on all benefits if the cafeteria plan discriminates in favor of highly compensated individuals as to eligibility, benefits or contributions. A highly compensated individual includes an officer, a 5-percent shareholder, someone with high earnings, or a spouse or dependent of any of these individuals.

In addition, if more than 25 percent of the total tax-favored benefits provided under a cafeteria plan for a plan year are provided to key employees, these key employees will be taxed on all benefits. A key employee is an individual who is an officer, a 5-percent owner, a 1-percent owner earning more than $150,000, or one of the top 10 employee-owners.

Impact

This provision permits an employer to allow each employee individual flexibility to choose benefits from a menu. The employee does not include the costs of such plans in income, and his tax bill is reduced compared to another employee with a similar total compensation package received solely in cash wages.

Cafeteria plans have been growing rapidly in popularity, and the tax expenditure cost has been growing as well. For example, the percentage of employees at large and medium sized firms eligible for these plans grew from 5 percent in 1986 to 36 percent in 1991.

Although no direct data are available on the distribution of this tax benefit, it is likely to benefit higher-income individuals more than lower-income ones, not only because of the larger tax advantage of receiving tax-free benefits but also because more highly compensated workers tend to be covered by any type of fringe benefit plan,

For example, in 1988 only 13 percent of individuals earning less than $10,000 and 39 percent of individuals earning between $10,000 and $15,000 were covered by retirement plans; the ratio rises until 73 percent of individuals earning over $30,000 are covered.

Participation is likely to be even more concentrated among higher-income individuals due to the elective nature of the benefit. To illustrate from another elective benefit, Individual Retirement Accounts (IRAs), in 1985 only 2 percent of individuals with adjusted gross income below $10,000 and 14 percent with adjusted gross income from $10,000 to $30,000 participated in IRAs. Yet, 57 percent of those with incomes between $50,000 and $75,000 and about 75 percent of those with incomes above $75,000 contributed.

Rationale

Under a provision of the Employee Retirement Income Security Act of 1974 (ERISA), an employer contribution made before January 1, 1977 to a cafeteria plan in existence on June 27, 1974 was required to be included in an employee's gross income only to the extent that the employee actually elected taxable benefits. For plans not in existence on June 27, 1974, the employer contribution was required to be included in income to the extent the employee could have elected taxable benefits.

Under the Tax Reform Act of 1976, these rules applied to employer contributions made before January 1, 1978. The Foreign Earned Income Act of 1978 (Public Law 95-615) extended these rules until the effective date of the Revenue Act of 1978 (i.e., it extended the treatment through 1978 for calendar-year taxpayers).

In the Revenue Act of 1978, the current provision was added to the Code to ensure that rules were provided on a permanent basis, but no specific rationale was provided.

In the Deficit Reduction Act of 1984, the Congress found it appropriate to limit permissible benefits and provide additional reporting requirements. Reports accompanying that legislation note that these additional limitations were needed to prevent further erosion of the income and employment tax bases.

The Tax Reform Act of 1986 imposed stricter anti-discrimination rules (regarding the favoritism towards highly compensated employees) which affected cafeteria plans. There were other minor revisions as well. The anti-discrimination rules were repealed as part of the public debt limit increase in 1989 (P.L. 101-140).

Assessment

Cafeteria plans are more attractive to employees than less flexible benefit packages, since they can choose those best suited to their individual circumstances. Thus cafeteria plans avoid one of the drawbacks of many other fringe benefit plans, which may not provide the most desirable mix of benefits.

There are some problems with these plans, however. Like all fringe benefit plans, this tax treatment leads to different tax burdens for individuals with the same economic income. They also lead employees to over-consume services covered by the plans, such as health care.

And, because they are elective, they may involve greater administrative costs and be subject to adverse selection (only those individuals who are likely to need the benefits of insurance programs will sign up), which increases costs.

Selected Bibliography

Employee Benefit Research Institute. Chapter 33, "Flexible Benefit Plans," Fundamentals of Employee Benefit Programs. 1990.

Irish, Leon E. "Cafeteria Plans in Transition," Tax Notes, v. 25. December 17, 1984, pp. 1127-1141.

Knox, Peter L. "Cafeteria Plans: New Law Removes Proposed IRS Restrictions and Adds Certainty to Operations," Taxation for Accountants, v. 33. September 1984, pp. 168-172.

Stull, Gregory J. "Elective Compensation: Cafeteria Plans," Taxes, v. 63. March 1985, pp. 210-220.

U.S. Congress, House Committee on Ways and Means. Overview of Entitlement Programs. 1994 Green Book. 103rd Congress, 2nd session. July 15, 1994, pp. 693-695.

--, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Congress, 2nd session, December 31, 1984, pp. 867-872.

        Education, Training, Employment and Social Services:

 

                             Employment

                   EXCLUSION OF RENTAL ALLOWANCES

 

                        FOR MINISTERS' HOMES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

     Fiscal year  Individuals  Corporations      Total

 

____________________________________________________________________

         1995          0.3           --           0.3

 

         1996          0.3           --           0.3

 

         1997          0.3           --           0.3

 

         1998          0.3           --           0.3

 

         1999          0.3           --           0.3

 

____________________________________________________________________

Authorization

Section 107.

Description

Under an exclusion available for a "minister of the gospel," gross income does not include

(1) the fair rental value of a church-owned or church-rented home furnished as part of his or her compensation, or

(2) a cash housing/furnishing allowance paid as part of the minister's compensation.

The housing/furnishing allowance may provide funds for rental or purchase of a home, including down payment, mortgage payments, interest, taxes, repairs, furniture payments, garage costs, and utilities.

Ministers receiving cash housing allowances also may claim deductions on their individual income tax returns for mortgage interest and real estate taxes on their residences even though such expenditures were allocable, in whole or in part, to tax-free receipt of the cash housing allowance.

Impact

As a result of the special exclusion provided for parsonage allowances, ministers receiving such housing allowances pay less tax than other taxpayers with the same or smaller economic incomes. The tax benefit of the exclusion also provides a disproportionately greater benefit to relatively better-paid ministers, by virtue of the higher marginal tax rates applicable to their incomes.

Some ministers may claim deductions for housing costs allocable to tax-free allowances.

Rationale

The provision of tax-free housing allowances for ministers was first made a part of the Internal Revenue Code by passage of the Revenue Act of 1921, without any stated reason. The original rationale may reflect the difficulty of placing a value on the provision of a church-provided rectory. Since some churches provided rectories to their ministers as part of their compensation, while other churches provided a housing allowance, the Congress may have wished to provide equal tax treatment to both groups.

The Internal Revenue Service reversed a 1962 ruling (Ruling 62- 212) in 1983 (Revenue Ruling 83-3) which provided that, to the extent of the tax-free housing allowance, deductions for interest and property taxes may not be itemized. This change was based on the belief that it was unfair to allow tax-free income to be used to generate individual itemized deductions to shelter taxable income.

In the Tax Reform Act of 1986 the Congress reversed the I.R.S. ruling because the tax treatment had been long-standing, and for fear that the I.R.S. might treat tax-free housing allowances provided to U.S. military personnel similarly.

Assessment

The tax-free parsonage allowances encourage some congregations to structure maximum amounts of tax-free housing allowances into their minister's pay and may thereby distort the compensation package.

The provision is inconsistent with both horizontal and vertical equity principles. Since all taxpayers may not exclude amounts they pay for housing from taxable income, the provision violates horizontal equity principles. Ministers with higher incomes will receive a greater subsidy than lower-income ministers because of their higher marginal tax rates, and those ministers that have church-provided homes will not receive the same benefits as those who purchase their homes and also have the tax deductions for interest and property taxes available to them.

Selected Bibliography

Foster, Matthew W. "The Parsonage Allowance Exclusion: Past, Present, and Future," Vanderbilt Law Review, v. 44. January 1991, pp. 149-178.

O'Neill, Thomas E. "A Constitutional Challenge to Section 107 of the Internal Revenue Code," Notre Dame Lawyer, v. 57. June 1982, pp. 853-867.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, H.R. 4170, 98th Congress, Public Law 98-369. Washington, DC: U.S. Government Printing Office, December 31, 1984, pp. 1168-1169.

--. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington, DC: U.S. Government Printing Office, May 4, 1987, pp. 53-54.

Warren, Steven E. "Tax Planning for Clergy," Taxes, v. 72, January 1994, pp. 39-46.

        Education, Training, Employment and Social Services:

 

                             Employment

             EXCLUSION OF MISCELLANEOUS FRINGE BENEFITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

     Fiscal year  Individuals  Corporations      Total

 

____________________________________________________________________

         1995          4.9           --           4.9

 

         1996          5.2           --           5.2

 

         1997          5.5           --           5.5

 

         1998          5.8           --           5.8

 

         1999          6.2           --           6.2

 

____________________________________________________________________

Authorization

Sections 132 and 117(D).

Description

Individuals do not include in income certain miscellaneous fringe benefits provided by employers, including services provided at no additional cost, employee discounts, working condition fringes, de minimis fringes, and certain tuition reductions. Special rules apply with respect to certain parking facilities provided to employees and certain on-premises athletic facilities.

These benefits also may be provided to spouses and dependent children of employees, retired and disabled former employees, and widows and widowers of deceased employees. Certain nondiscrimination requirements apply to benefits provided to highly compensated employees.

Impact

Exclusion from taxation of miscellaneous fringe benefits provides a subsidy to employment in those businesses and industries in which such fringe benefits are common and feasible. Employees of retail stores, for example, may receive discounts on purchases of store merchandise. Such benefits may not be feasible in other industries -- for example, for manufacturers of heavy equipment.

The subsidy provides benefits both to the employees (more are employed and they receive higher compensation) and to their employers (who have lower wage costs).

Rationale

This provision was enacted in 1984; the rules affecting transportation benefits were modified in 1992. The Congress recognized that in many industries employees receive either free or discount goods and services that the employer sells to the general public. In many cases, these practices had been long established and generally had been treated by employers, employees, and the Internal Revenue Service as not giving rise to taxable income.

Employees clearly receive a benefit from the availability of free or discounted goods or services, but the benefit may not be as great as the full amount of the discount. Employers may have valid business reasons, other than simply providing compensation, for encouraging employees to use the products they sell to the public. For example, a retail clothing business may want its salespersons to wear its clothing rather than clothing sold by its competitors. As with other fringe benefits, placing a value on the benefit in these cases is difficult.

In enacting these provisions, the Congress also wanted to establish limits on the use of tax-free fringe benefits. Prior to enactment of the provisions, the Treasury Department had been under a congressionally imposed moratorium on issuance of regulations defining the treatment of these fringes. There was a concern that without clear boundaries on use of these fringe benefits, new approaches could emerge that would further erode the tax base and increase inequities among employees in different businesses and industries.

Assessment

The exclusion subsidizes employment in those businesses and industries in which fringe benefits are feasible and commonly used. Both the employees and their employers benefit from the tax exclusion. Under normal market circumstances, more people are employed in these businesses and industries, and they receive higher compensation (after tax). Their employers receive their services at lower cost. Both sides of the transaction benefit because the loss is imposed on the U.S. Treasury in the form of lower tax collections.

Because the exclusion applies to practices which are common and may be feasible only in some businesses and industries, it creates inequities in tax treatment among different employees and employers. For example, consumer-goods retail stores may be able to offer their employees discounts on a wide variety of goods ranging from clothing to hardware, while a manufacturer of aircraft engines cannot give its workers compensation in the form of tax-free discounts on its products.

Selected Bibliography

Kies, Kenneth J. "Analysis of the New Rules Governing the Taxation of Fringe Benefits," Tax Notes, v. 38. September 3, 1984, pp. 981-988.

McKinney, James E. "Certainty Provided as to the Treatment of Most Fringe Benefits by Deficit Reduction Act," Journal of Taxation. September 1984, pp. 134-137.

Sunley, Emil M., Jr. "Employee Benefits and Transfer Payments," Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 90-92.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Committee Print, 98th Congress, 2nd session. December 31, 1984, pp. 838-866.

--, Senate Committee on Finance. Fringe Benefits, Hearings, 98th Congress, 2nd session. July 26, 27, 30, 1984.

        Education, Training, Employment and Social Services:

 

                             Employment

                    EXCLUSION OF EMPLOYEE AWARDS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

____________________________________________________________________

     Fiscal year  Individuals  Corporations      Total

 

____________________________________________________________________

         1995          0.1           --           0.1

 

         1996          0.1           --           0.1

 

         1997          0.1           --           0.1

 

         1998          0.1           --           0.1

 

         1999          0.1           --           0.1

 

____________________________________________________________________

Authorization

Sections 74(c), 274(j).

Description

Generally, prizes and awards are taxable. Subsection 74(c), however, provides an exclusion for certain awards given to employees for length of service or for safety. To qualify, awards must meet requirements imposed to assure that they are bona fide achievement awards and that they do not constitute disguised compensation.

The amount of the exclusion is limited to $400 generally, or up to $1,600 under certain qualified employee achievement award plans which do not discriminate in favor of highly compensated employees. The amount of employee awards which is excluded from gross income is also excluded under the social security tax.

Impact

Sections 74(c) and 274(j) exclude from gross income certain employee awards for length of service and safety achievement that would otherwise be taxable.

Rationale

The exclusion for employee awards was adopted in the Tax Reform Act of 1986. Prior to that Act, with certain exceptions that were complex and difficult to interpret, awards received by employees generally were taxable. The exclusion recognizes a traditional business practice which may have social benefits. Limitations imposed on the exclusion prevent it from becoming a vehicle for significant tax avoidance.

Assessment

If employee awards were taxable, in some cases employees might prefer not to receive an award because of the tax consequences, and some award programs might be terminated. In other cases, the tax on the award would detract from its value to the employee. Since there is probably some social value in encouraging longevity in employment and safety practices on the job, a limited public subsidy for such awards may be justified.

On the other hand, the exclusion subsidizes employment in those businesses that provide length of service and safety awards for their employees, providing a benefit not enjoyed by business which do not provide such awards. The limitations imposed on the exclusion keep the special benefit relatively small.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, 100th Congress, 1st session. May 4, 1987, pp. 30-38.

        Education, Training, Employment, and Social Services:

 

                             Employment

                    EXCLUSION OF INCOME EARNED BY

 

            VOLUNTARY EMPLOYEES' BENEFICIARY ASSOCIATIONS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year      Individuals      Corporations       Total

 

____________________________________________________________________

       1995              0.5               --             0.5

 

       1996              0.5               --             0.5

 

       1997              0.5               --             0.5

 

       1998              0.6               --             0.6

 

       1999              0.6               --             0.6

 

____________________________________________________________________

Authorization

Sections 419, 419A, and 501(c)(9).

Description

A Voluntary Employees' Beneficiary Association (VEBA), or 501(c)(9) trust, provides life, sickness, accident, and other welfare benefits to its employee members, their dependents, and their beneficiaries. Membership in the organization must be voluntary.

In addition to its tax-exempt status, other tax advantages include the deductibility of employer contributions to fund future benefit payments (within limits). The tax advantages are predicated upon compliance with certain requirements on who may participate, what benefits may be provided, and how the program is administered.

In addition to meeting nondiscrimination requirements of the tax code, most VEBAs are subject to the reporting, disclosure, and fiduciary requirements applicable to "welfare benefit plans" under the Employee Retirement Income Security Act (ERISA).

The VEBA may be subject to unrelated business income tax on some or all of its income if it holds reserves in excess of the limits permitted in Code Sections 419 and 419A, or if it holds a reserve for post-retirement medical benefits.

Impact

In the absence of a VEBA, an employer often provides welfare benefits by directly purchasing life, health, or disability insurance benefits for its employees. Funding these benefits through a VEBA on an insured or self-insured basis provides certain tax advantages to the employer. Subject to the limits in Code Sections 419 and 419A, the employer can deduct its contributions in advance of the time when benefits are actually paid to employee participants. Another economic advantage to an employer is that the VEBA affords a tax-free accumulation (within limits) that reduces the cost of providing the welfare benefits to employees.

Rationale

Tax-favored treatment of VEBAs had its origin in the Revenue Act of 1928. This law permitted an organization to provide payment of life, sickness, accident, or other welfare benefits to its members, provided that the members contributed at least 85 percent of its income and no part of the trusts' earnings inured to the benefit of any private shareholder or individual.

Previously, employee benefit associations providing these types of benefits had attempted unsuccessfully to obtain tax exemption under other Code provisions. Congress, acknowledging that such organizations were common, responded by creating the exemption.

The exemption for VEBAs was expanded in 1942 to allow employers to contribute to the association without violating the 85-percent-of- income requirement. The 85-percent requirement was eliminated completely by the Tax Reform Act of 1969. Since 1986, deductions for contributions have been subject to rules on funded welfare benefit plans under Code Sections 419 and 419A.

Congress considers these costs justifiable if such benefits fulfill important social-policy objectives, such as increasing health insurance coverage among taxpayers who are not highly compensated and who otherwise would not purchase or could not afford such coverage.

However, Congress was concerned that the nondiscrimination rules did not require sufficient coverage of non-highly-compensated employees. As part of the Tax Reform Act of 1986 (TRA86), new rules for welfare benefit plans, particularly health benefit plans and group term life insurance, were added by Section 89 of the Internal Revenue Code. The new rules were complex and met with a substantial amount of resistance. Congress subsequently repealed Section 89 in 1989.

Assessment

VEBAs may be viewed as the welfare benefits complement of pension and profit-sharing plans. VEBAs have become an attractive alternative for sheltering income and providing certain non-pension benefits to employees, because they are not subject to the same restrictions and limitations as pension and profit-sharing plans.

Generally, if a VEBA discriminates in favor of highly compensated employees, it will lose its tax qualification. However, the nondiscrimination rules do not apply in the case of collectively bargained plans where there was good-faith bargaining.

Selected Bibliography

VEBAs and Fringe Benefits. Tax Law and Estate Planning Series, Practising Law Institute. New York, NY: 1984.

Combe, Cynthia M. and Gerard J. Talbot. Employee Benefits Answer Book. New York, NY: Panel Publishers, 1991.

        Education, Training, Employment, and Social Services:

 

                             Employment

                      TARGETED JOBS TAX CREDIT

                     Estimated Revenue Loss /*/

 

                      [In billions of dollars]

____________________________________________________________________

      Fiscal year     Individuals        Corporations       Total

 

____________________________________________________________________

        1995               /1/              0.2              0.2

 

        1996               /1/              0.1              0.1

 

        1997               /1/              /1/              /1/

 

        1998               /1/              /1/              /1/

 

        1999               /1/              /1/              /1/

 

____________________________________________________________________

                         FOOTNOTES TO TABLE

     /*/ The tax credit expired at the end of 1994.

     /1/ Less than $50 million.

                          END OF FOOTNOTES

Authorization

Sections 51 and 52.

Description

The Targeted Jobs Tax Credit (TJTC) is available on a nonrefundable basis to employers who hire employees from the following groups:

(1) economically disadvantaged youth 18-22 years old;

(2) economically disadvantaged cooperative education students 16-19 years old;

(3) economically disadvantaged summer youth 16-17 years old;

(4) economically disadvantaged ex-offenders;

(5) economically disadvantaged Vietnam-era veterans;

(6) vocational rehabilitation referrals;

(7) general assistance recipients;

(8) Supplemental Security Income recipients; and

(9) Aid to Families with Dependent Children recipients.

During the first year in which a TJTC-eligible person is employed, the employer can claim a tax credit of 40 percent of the first $6,000 earned. The credit for summer youth employees is 40 percent of the first $3,000 earned. Thus the maximum amount of the credit would be $2,400 per worker, except in the case of summer-youth hires, when it would be $1,200.

The actual value to an employer of the credit could be less than these amounts, depending on the employer's tax bracket. An employer's usual deduction for wages must be reduced by the amount of the credit as well.

A minimum employment period of 90 days or 120 hours is required for an employer to claim the credit for all TJTC-hires except summer youth; for them, the period is at least 14 days or 20 hours.

Impact

A certification is issued by a local Employment Service (ES) office to employers if they hire target-group members. In FY82, there was a drop in certifications because two loopholes were closed that had inflated prior years' levels. The number of certifications increased through FY85 due to improving economic conditions and to heightened employer awareness of the program.

In FY86, certifications fell because the program expired for 10 months before being reauthorized retroactively. Between 1987 and 1992, certifications fell again, from 598,180 to 344,980. The decrease is related to mandated changes in the program and to the 1990-91 recession. Over the life of the program certifications most often have been issued for hiring economically disadvantaged youths.

Additional information about the program is limited. In 1992, more than 7 of every 10 TJTC-hires earned between the minimum wage and $5.99 an hour. Almost 8 out of every 10 workers for whom a credit was claimed were employed in service and clerical occupations. The States that issued the largest number of certifications in 1992 were California, Texas, Pennsylvania, Florida, Ohio, and New York.

Rationale

The credit is intended to help hard-to-employ individuals get jobs in the private sector. The TJTC is designed to lower the relative cost of hiring target group members by subsidizing their wages, and hence to increase employers' willingness to hire them despite their presumed low productivity.

The TJTC was created by the Revenue Act of 1978 with an initial expiration date of December 31, 1981. Initially, the TJTC was offered for two years: the first-year credit was equal to 50 percent of the first $6,000 earned by a TJTC-hire, and the second-year credit to 25 percent of the first $6,000 earned.

The TJTC was extended for one year by the Economic Recovery Tax Act of 1981. The Act closed two loopholes in the program: it eliminated the issuance of retroactive certifications, which had enabled employers to receive credits for workers already on their payrolls; and it limited the eligibility of cooperative education students to those in economically disadvantaged families.

The Tax Equity and Fiscal Responsibility Act of 1982 extended the program for two years through 1984. The Act created a special credit for summer youth hires and made other changes.

The TJTC was reauthorized for one year, through December 31, 1985, by the Deficit Reduction Act of 1984. The program expired in January 1986, but was reauthorized retroactively and extended through December 31, 1988, by the Tax Reform Act of 1986. The Act eliminated the second-year credit and reduced the proportion of wages subsidized. A minimum employment period was mandated as well.

The Omnibus Budget Reconciliation Act of 1987 provided that the credit no longer is available for wages paid to TJTC-hires who perform essentially the same functions as those of workers who are participating in, or are affected by, a strike or lockout. The 100th Congress also extended the TJTC for one year and amended it in the Technical Corrections and Miscellaneous Revenue Act of 1988. The amount of the summer youth credit was reduced, and 23/24-year-olds were excluded from the economically disadvantaged youth group.

The 101st Congress extended TJTC through September 30, 1990 in the Omnibus Budget Reconciliation Act of 1989. The Act required that employers who request certification must specify one or two target groups to which they think the new hire might belong, and that employers must certify that they have made a good-faith effort to determine the eligibility of new hires. After briefly expiring, the TJTC was extended through December 31, 1991 by the Omnibus Budget Reconciliation Act of 1990.

The TJTC was reauthorized retroactive to its expiration date and extended to the end of 1994 by the Omnibus Budget Reconciliation Act of 1993.

Assessment

One measure of the TJTC's effectiveness is the extent to which it has created jobs for target group members. The net number of jobs created by the credit will be less than the number of certifications, due to the presence of windfall gains and substitution. Windfall gains occur when firms hire people whom they would have hired without benefit of the program. Substitution occurs when employers either fire workers ineligible for the credit and replace them with eligible workers, or hire only eligible workers as vacancies develop.

The TJTC appears to increase the likelihood that economically disadvantaged and non-poor youth will find jobs. But, because TJTC does not seem to increase total employment, the increased youth hires could produce substitution of younger workers for adult workers. Some might argue that such substitution is acceptable if the displaced adult workers can readily find other jobs.

The extent of windfall gains has been substantial under the TJTC. The net number of jobs that the TJTC has created could range from 5 percent to 30 percent of certifications. Expressed differently, most people for whom the credit has been claimed would have gotten jobs without the presence of a tax incentive.

Another measure of program performance is how extensively the credit is used. Relatively few target group members and employers have made use of the credit. Many reasons have been offered for the low usage of the TJTC: (1) only those firms with tax liabilities can benefit from the credit; (2) of these firms, most who want to use the TJTC would need to employ low-skilled labor; and (3) even among firms that typically hire low-skilled workers, few claim the credit because of the high costs associated with it.

The costs are related to the complicated eligibility criteria created by the targeting mechanism, and to employers' perception that target group members are less productive than other job applicants. There appears to be a negative relationship between employers' stigmatizing beliefs about TJTC-eligibles and their use of the program.

Yet a third indicator of the program's success is whether the credit's availability induces employers to alter their hiring practices. According to a study of large TJTC users, 45 percent undertook explicit measures to increase job opportunities for TJTC- eligibles, but 55 percent used their normal hiring practices. The results of some employer surveys indicate that the TJTC might cause employers to seek job referrals from nontraditional sources (e.g., local ES offices).

More recent studies by the Department of Labor's inspector general have been critical of the credit. They indicated that most individuals would have been hired without the TJTC, that employers frequently screened for eligibility for the credit after the hires had already occurred, and that the jobs involved were largely low- skilled jobs with little additional training.

However, referrals from ES offices have been decreasing, while TJTC-eligibles identified by management assistance companies (MACs) have been increasing substantially. As MACs usually screen workers who already have been hired but have not yet started to work, some argue that the MAC-generated certifications represent windfall gains to employers and no net job creation. Others counter that MACs increase the utilization of the program among employers and reduce the administrative burden of the program on employers.

Selected Bibliography

Arwady, Joseph W. Wage Subsidies and Jobs for the Disadvantaged: Applying the Targeted Jobs Tax Credit in an Operating Environment. Pennsylvania: University of Pennsylvania, the Wharton School, 1988.

Berry, Dale W. and Mona A. Feldman. Policy Evaluation and Review of the Targeted Jobs Tax Credit. Washington, DC: TvT Associates, September 1991.

Bishop, John and Suk Kang. "Applying for Entitlements: Employers and the Targeted Jobs Tax Credit," Journal of Policy Analysis and Management, v. 10, no. 1. Winter 1991, pp. 24-44.

Bishop, John H. and Mark Montgomery. "Does the Targeted Jobs Tax Credit Create Jobs at Subsidized Firms?," Industrial Relations, v. 32, no. 3. Fall 1993, pp. 289-306.

Burtless, Gary. "Are Targeted Wage Subsidies Harmful? Evidence from a Wage Voucher Experiment," Industrial and Labor Relations Review, v. 39, no. 1. October 1985, pp. 105-114.

LeGrande, Linda. The Targeted Jobs Tax Credit, 1978-1987, Library of Congress, Congressional Research Service Report 87-616E. Washington, DC: July 14, 1987.

Levine, Linda. Targeted Jobs Tax Credit: Action in the 102nd Congress, Library of Congress, Congressional Research Service Issue Brief 92007.

Levitan, Sar A., and Frank Gallo. "The Targeted Jobs Tax Credit: An Uncertain and Unfinished Experiment," Labor Law Journal. October 1987, pp. 641-649.

Lorenz, Edward C. The Targeted Jobs Tax Credit: An Assessment. Washington, DC: National Commission for Employment Policy, August 1985.

--. The Targeted Jobs Tax Credit in Maryland and Missouri: 1982- 1987. Washington, DC: National Commission for Employment Policy, November 1988.

Macro Systems, Inc. Final Process Analysis Report on the Implementation and Use of the Targeted Jobs Tax Credit Program; Final Report on the Administrative Cost-Effectiveness of the Targeted Jobs Tax Credit Program as a Placement Tool for the Employment Service; Final Report on the Aggregate Employment Effects of the Targeted Jobs Tax Credit Program; Final Report on the Effects of the Targeted Jobs Tax Credit Program on Employers; Final Report on the Short-Term Net Impact of the Targeted Jobs Tax Credit Program on Disadvantaged Populations; and Impact Study of the Implementation and Use of the Targeted Jobs Tax Credit Program: Overview and Summary. Washington, DC: U.S. Employment and Training Administration, 1985-1986.

U.S. Congress, Congressional Budget Office. Staff Memorandum on the Targeted Jobs Tax Credit, by Sandra Christensen. May 1984.

U.S. Department of Labor, Office of Inspector General. Targeted Jobs Tax Credit Program, State of Alabama, October 1, 1990-September 30, 1991. Report No. 04-93-027-03-320. Washington, D.C., August 20, 1993.

U.S. Departments of Labor and Treasury. The Use of Tax Subsidies for Employment. May 1986.

U.S. General Accounting Office. Targeted Jobs Tax Credit: Employer Actions to Recruit, Hire, and Retain Eligible Workers Vary, GAO/HRD-91-33, February 1991.

        Education, Training, Employment, and Social Services:

 

                             Employment

              DEDUCTIBILITY OF CHARITABLE CONTRIBUIONS,

 

                 OTHER THAN FOR EDUCATION AND HEALTH

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

       Fiscal year      Individuals     Corporations      Total

 

____________________________________________________________________

         1995              13.9             0.4            14.3

 

         1996              14.7             0.4            15.1

 

         1997              15.4             0.4            15.8

 

         1998              16.1             0.4            16.5

 

         1999              16.9             0.4            17.3

 

____________________________________________________________________

Authorization

Section 170 and 642(c).

Description

Subject to certain limitations, charitable contributions may be deducted by individuals, corporations, and estates and trusts. The contributions must be made to specific types of organizations: charitable, religious, educational, and scientific organizations, hospitals, public charities, and Federal, State, and local governments. To be deductible, contributions of $250 or more must be substantiated.

Individuals who itemize may deduct qualified contributions of up to 50 percent of their adjusted gross income (AGI) (30 percent for gifts of capital gain property). For contributions to non-operating foundations and organizations, deductibility is limited to the lesser of 30 percent of the taxpayer's contribution base, or the excess of 50 percent of the contribution base for the tax year over the amount of contributions which qualified for the 50 percent deduction ceiling (including carryovers from previous years).

Gifts of capital gain property to these organizations are limited to 20 percent of AGI. A corporation can deduct up to 10 percent of taxable income (with some adjustments).

If a contribution is made in the form of property, the deduction depends on the type of taxpayer (i.e., individual, corporate, etc.), recipient, and purpose.

Impact

The deduction for charitable contributions reduces the net cost of contributing. The tax benefit increases in value with the donor's marginal tax bracket. Those individuals who use the standard deduction or who pay no taxes receive no benefit from the provision.

A limitation applies to the itemized deductions of high-income taxpayers. Under this provision, in 1994, otherwise allowable deductions are reduced by three percent of the amount by which a taxpayer's adjusted gross income (AGI) exceeds $111,800 (adjusted for inflation in future years). The table below provides the distribution of all charitable contributions, including those for education and health.

               DISTRIBUTION BY INCOME CLASS OF THE TAX

 

              EXPENDITURE FOR CHARITABLE CONTRIBUTIONS

 

              AT 1994 TAX RATES AND 1994 INCOME LEVELS

            Income Class                 Percentage

 

            (in thousands of $)          Distribution

 

            _________________________________________

               Below $10                     0.0

 

               $10 to $20                    0.3

 

               $20 to $30                    1.7

 

               $30 to $40                    4.0

 

               $40 to $50                    5.1

 

               $50 to $75                   15.7

 

               $75 to $100                  13.4

 

               $100 to $200                 17.2

 

               $200 and over                42.7

 

            _________________________________________

Rationale

This deduction was added by passage of the War Revenue Act of October 3, 1917. Senator Hollis, the sponsor, argued that the high wartime tax rates would absorb the surplus funds of wealthy taxpayers, which were generally contributed to charitable organizations.

It was also argued that many colleges would lose students to the military and charitable gifts were needed by educational institutions. The deduction was extended to estates and trusts in 1918 and to corporations in 1935.

Assessment

Supporters note that contributions finance socially desirable activities. Further, the Federal Government would be forced to step in to assume some activities currently provided by charitable, nonprofit organizations if the deduction were eliminated. However, public spending might not be allowed to make up all of the difference. In addition, many believe that the best method of allocating general welfare resources is through a dual system of private philanthropic giving and governmental allocation.

Economists have generally held that the deductibility of charitable contributions provides an incentive effect which varies with the marginal tax rate of the giver. There are a number of studies which find significant behavioral responses.

Types of contributions may vary substantially among income classes. Contributions to religious organizations are far more concentrated at the lower end of the income scale than contributions to hospitals, the arts, and educational institutions, with contributions to other types of organizations falling between these levels. However, the volume of donations to religious organizations is greater than to all other organizations as a group.

Those who support eliminating this deduction note that deductible contributions are made partly with dollars which are public funds. Helping out private charities may not be the optimal way to spend Government money. The Congress does not routinely review this deduction.

Opponents further claim that the present system allows wealthy taxpayers to indulge special interests and hobbies. To the extent that charitable giving is independent of tax considerations, Federal revenues are lost without having provided any additional incentive for charitable gifts. It is generally argued that the charitable contributions deduction is difficult to administer and complex for taxpayers to comply with.

Selected Bibliography

Broman, Amy J. "Statutory Tax Rete Reform and Charitable Contributions: Evidence from a Recent Period of Reform," Journal of the American Taxation Association. Fall 1989, pp. 7-21.

Cain, James E., and Sue A. Cain. "An Economic Analysis of Accounting Decision Variables Used to Determine the Nature of Corporate Giving," Quarterly Journal of Business and Economics, v. 24. Autumn 1985, pp. 15-28.

Clotfelter, Charles L. The Impact of Tax Reform on Charitable Giving: A 1989 Perspective. Cambridge, MA: National Bureau of Economic Research, 1990 (Working Paper no. 3273).

Clymer, John H. "The Private Foundation: A New Marketing Opportunity?" Trusts & Estates, v. 125. August 1986, pp. 31-37.

Feenberg, Daniel. "Are Tax Price Models Really Identified: The Case of Charitable Giving," National Tax Journal, v. 40, no. 4. December 1987, pp. 629-633.

Fullerton, Don. Tax Policy Toward Art Museums. Cambridge, MA: National Bureau of Economic Research, 1990 (Working Paper no. 3379).

Gergen, Mark P. "The Case for a Charitable Contributions Deduction," Virginia Law Review, v. 74. November 1988, pp. 1393-1450.

Hilgert, Cecelia, and Paul Amsberger. "Charities and Other Tax- exempt Organizations, 1989," Statistics of Income Bulletin, v. 13, Winter 1993-1994, pp. 80-103.

Izzo, Todd. "A Full Spectrum of Light: Rethinking the Charitable Contribution Deduction," University of Pennsylvania Law Review, v. 141, June 1993, pp. 2371-2402.

Krumwiede, Tim, David Beausejour, and Raymond Zimmerman. "Reporting and Substantiation Requirements for Charitable Contributions," Taxes, v. 72, January 1994, pp. 14-18.

Robinson, John R. "Estimates of the Price Elasticity of Charitable Giving: A Reappraisal Using 1985 Itemizer and Nonitemizer Charitable Deduction Data," Journal of the American Taxation Association. Fall 1990, pp. 39-59.

Schiff, Jerald. "Does Government Spending Crowd Out Charitable Contributions?" National Tax Journal, v. 38. December 1985, pp. 535- 546.

"The Demographics of Giving," American Enterprise, v. 2, September-October 1991, pp. 101-104.

        Education, Training, Employment, and Social Services:

 

                           Social Services

            CREDIT FOR CHILD AND DEPENDENT CARE EXPENSES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

     Fiscal year     Individuals       Corporations      Total

 

     ___________     ___________       ____________      _____

        1995             2.7                -             2.7

 

        1996             2.8                -             2.8

 

        1997             2.8                -             2.8

 

        1998             2.9                -             2.9

 

        1999             3.0                -             3.0

Authorization

Section 21.

Description

A taxpayer who maintains a household is allowed a tax credit for employment-related expenses incurred for the care of a dependent child (or a disabled dependent or spouse). The maximum credit is 30 percent of expenses up to $2,400 ($720) for one child, and up to $4,800 ($1,440) for two or more children. The credit rate is reduced by one percentage point for each $2,000 of income, or fraction thereof, above $10,000, until the credit rate of 20 percent is reached for taxpayers with incomes above $28,000.

Employment-related expenses incurred outside the household are eligible if they are for a dependent under 13, or for a physically or mentally incapacitated spouse or dependent who regularly spends eight hours a day in the taxpayer's household. Dependent care centers must comply with State and local laws and regulations to qualify. The credit is permitted for payments to relatives (who are not dependents) of the taxpayer.

Impact

The credit benefits qualified taxpayers with sufficient tax liability to take advantage of it, without regard to whether they itemize their deductions. The credit does not benefit persons with incomes so low that they have no tax liability.

Because the credit rate phases down from 30 to 20 percent as incomes rises from $10,000 to $28,000, the credit is designed to target greater benefits toward low- and moderate-income taxpayers.

DISTRIBUTION BY INCOME CLASS OF THE

 

TAX EXPENDITURE FOR

 

CHILD AND DEPENDENT CARE SERVICES

 

AT 1994 TAX RATES AND 1994 INCOME LEVELS

Income Class Percentage

 

(in thousands of $) Distribution

 

___________________ ____________

Below $10 0.0

 

$10 to $20 5.6

 

$20 to $30 15.1

 

$30 to $40 15.5

 

$40 to $50 12.3

 

$50 to $75 27.2

 

$75 to $100 15.1

 

$100 to $200 8.0

 

$200 and over 1.2

 

!EN

 

Rationale

The deduction for child and dependent care services was first enacted in 1954. The allowance was limited to $600 per year and was phased out for families with income between $4,500 and $5,100. The intent of the provision recognized the similarity of child care expenses to employee business expenses and provided a limited benefit. Some believe compassion and the desire to reduce welfare costs contributed to the enactment of this allowance.

The provision was made more generous in 1964, and was revised and broadened in 1971. Several new justifications in 1971 included encouraging the hiring of domestic workers, encouraging the care of incapacitated persons at home rather than in institutions, providing relief to middle-income taxpayers as well as low-income taxpayers, and providing relief for employment-related expenses of household services as well as for dependent care.

The Tax Reduction Act of 1975 substantially increased the income limits ($18,000 to $35,000) for taxpayers who could claim the deduction.

In 1976, the deduction was replaced by a nonrefundable credit. Congress believed that such expenses are a cost of earning income for all taxpayers and that it was wrong to deny the benefits to those taking the standard deduction. Also, the tax credit would provide relatively more benefit than the deduction to taxpayers in the lower tax brackets.

The Revenue Act of 1978 provided that the child care credit was available for payments made to relatives. The stated rationale was that, in general, relatives provide better attention and the allowance would help strengthen family ties.

In 1981, the provision was converted into the current sliding- scale credit and increased. The Congressional rationale for increasing the maximum amounts was due to substantial increases in costs for child care. The purpose of switching to a sliding-scale credit was to target the increases in the credit toward low- and middle-income taxpayers because the Congress felt that group was in greatest need of relief.

The Family Support Act of 1988 modified the dependent care tax credit. First, the credit is available for care of children under 13 rather than 15. Second, a dollar-for-dollar offset is provided against the amount of expenses eligible for the dependent care credit for amounts excluded under an employer-provided dependent care assistance program. Finally, the act provides that the taxpayer must report on his or her tax return the name, address, and taxpayer identification number of the dependent care provider.

Assessment

One argument made for the child care credit is that it is a cost of earning income; in this case, however, the amount should be a deductible expense available to all taxpayers. In practice there are many expenses (e.g., commuting) that could be considered a cost of earning income that are not deductible. Moreover, some economists have argued that children, and the expenses associated with them, are part of a taxpayer's consumption.

An alternative argument is that allowing a child care credit offsets certain other inequities in the tax law, including the failure to tax imputed income of parents who do not work in order to provide child care, and the failure of the earned income tax credit to adjust adequately for family size.

Selected Bibliography

Carlson, Allan. "A Pro-Family Income Tax," Public Interest, no. 99. Winter 1989, pp. 69-76.

Dunbar, Amy, and Susan Nordhauser. "Is the Child Care Credit Progressive?" National Tax Journal, v. 44, December 1991, pp. 519- 528.

Goedde, Harold. "Steps That Will Maximize the Dependent Care Credit," Taxation for Accountants, v. 49, November 1992, pp. 284-287, 290.

Gravelle, Jane G. Federal Income Tax Treatment of the Family, Library of Congress, Congressional Research Service Report 91-694 RCO. Washington, DC: September 25, 1991.

Hargrave, Eugenia. "Income Tax Treatment of Child and Dependent Care Costs: 1981 Amendments," Texas Law Review, v. 60. February 1982, pp. 321-354.

Iezzi, Patsy Anthony., Jr, "Child and Dependent Care Benefits Available to More Taxpayers Under Tax Reform Act of 1976," Taxation for Accountants, v. 18. February 1977, pp. 92-95.

Klerman, Jacob Alex. and Arleen Leibowitz. Child Care and Women's Return to Work After Childbirth. Santa Monica, CA: RAND, 1991.

Krashinsky, Michael. "Subsidies to Child Care: Public Policy and Optimality," Public Finance Quarterly, v. 9. July 1981, pp. 243-269.

McIntyre, Michael J. "Evaluating the New Tax Credit for Child Care and Maid Service," Tax Notes, v. 5. May 23, 1977, pp. 7-9.

Steuerle, C. Eugene. "Tax Credits for Low-Income Workers With Children: Policy Watch," Journal of Economic Perspectives, v. 4. Summer 1990, pp. 201-212.

Vihtelic, Jill Lynn. "Allocating Child Care Expenses Between a Salary Reduction Plan and the Tax Credit," Taxes, v. 67. February 1989, pp. 83-87.

Wolfman, Brian. "Child Care, Work, and the Federal Income Tax," The American Journal of Tax Policy, v. 3. Spring 1984, pp. 153-193.

U.S. Congress, House Committee on Ways and Means. Overview of Entitlement Programs. July 15, 1994, pp. 531-580.

Education, Training, Employment, and Social Services:

 

Social Services

EXCLUSION FOR EMPLOYER-PROVIDED CHIlD CARE

Estimated Revenue Loss

 

[In billions of dollars]

Fiscal year Individuals Corporations Total

 

___________ ___________ ____________ _____

1995 0.6 -- 0.6

 

1996 0.7 -- 0.7

 

1997 0.8 -- 0.8

 

1998 0.9 -- 0.9

 

1999 1.0 -- 1.0

 

!EN

 

Authorization

Section 129.

Description

Payments by an employer for dependent care assistance provided to an employee are excluded from the employees's income and, thus, not subject to individual Federal income tax. Likewise, such employer expenditures are not counted as wages subject to employment taxes.

However, such employer assistance must be provided under a plan which meets certain conditions, including eligibility conditions which do not discriminate in favor of owners, officers, highly compensated individuals or their dependents, and availability to a broad class of employees. The law provides that reasonable notification of the availability and terms of the program must be made to eligible employees.

Impact

The exclusion provides an incentive for employers to provide, and employees to receive compensation in the form of dependent care assistance rather than cash. The assistance is free from income tax while the cash is subject to it. As is the case with all deductions and exclusions, this benefit is higher for taxpayers in high tax brackets than those in low tax brackets. To the extent dependent care assistance is provided rather than increases in salaries or wages, the Social Security Trust Fund loses receipts.

Rationale

This provision, enacted in the Economic Recovery Tax Act of 1981, was intended to provide an incentive for employers to become more involved in the provision of dependent care for their employees.

Assessment

Since all employers will not provide dependent care benefits, the provision violates horizontal equity principles, in that all taxpayers with similar incomes are not treated equally. Employer dependent-care plans are typically offered by large employers, so that those likely to participate are employees of large firms. Since upper-income taxpayers will receive a greater subsidy than lower- income taxpayers because of their higher tax rate, the tax subsidy is inverse to need.

Nontaxable benefits reduce the tax base, thus contributing to high marginal tax rates on income that remains taxable, since the ultimate effect is a loss of Federal revenues. If employers substitute benefits for wage or salary increases, that affects the Social Security Trust Fund, since benefits are not taxed for Social Security purposes either.

On the positive side, it is generally believed that the availability of dependent care can reduce employee absenteeism and unproductive work time. Employer involvement is needed as more women have entered the work force. Those employers that may gain most by the provision of dependent-care services are those whose employees are predominantly female, younger, and whose industries have high personnel turnover.

Selected Bibliography

Buchsbaum, Susan. "Sending 'Care' Packages to the Workplace," Business & Health, v. 9, May 1991, pp. 58, 60-62, 64, 66, 68-69.

Burud, Sandra L., Pamela R. Aschbacher, and Jacquelyn McCroskey. Employer-Supported Child Care: Investing in Human Resources. Boston: Auburn House Publishing Co., c. 1984.

Employee Benefit Research Institute. Dependent Care: Meeting the Needs of a Dynamic Work Force, no. 85. December 1988.

Krashinsky, Michael. "Subsidies to Child Care: Public Policy and Optimality," Public Finance Quarterly, v. 9. July 1981, pp. 243-269.

Low, Richard. "Should Corporations Care About Child Care? Business and Society Review, no. 80, Winter 1992, pp. 56-64.

Magid, Renee Yablans. "The Consequences of Employer Involvement in Child Care," Teachers College Record, v. 90. Spring 1989, pp. 434- 443.

Meyers, Marcia K. "The ABCs of Child Care in a Mixed Economy: A Comparison of Public and Private Sector Alternatives," Social Service Review, v. 64. December 1990, pp. 559-579.

Minc, Gabriel J. "Providing a Section 129 Dependent Care Assistance Program Through A Section 125 Cafeteria Plan," Taxes -- The Tax Magazine. May 1988, pp. 361-372.

Morris, Marie B. Tax Provisions Which Benefit Employed Parents With Children. Library of Congress, Congressional Research Service Report 89-169 A. Washington, DC: March 15, 1989.

Nolan, John S. "Taxation of Fringe Benefits," National Tax Journal, v. 31. September 1977, pp. 359-368.

Scott, Miriam Basch. "Dependent Care," Employee Benefit Plan Review, no. 2, August 1991, pp. 8-9, 12-14, 16-17, 20-22, 24-26, 28- 29.

U.S. Congress, Joint Committee. General Explanation of the Economic Recovery Tax Act of 1981 (H.R. 4242, 97th Congress; Public Law 97-34). Washington, DC: U.S. Government Printing Office, December 31, 1981, pp. 53-56.

Whigham-Desir, Marjorie. "Business and Child Care," Black Enterprise, v. 24, December 1993, pp. 86-88, 90, 92-93, 95.

        Education, Training, Employment, and Social Services:

 

                           Social Services

             EXCLUSION FOR CERTAIN FOSTER CARE PAYMENTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

     Fiscal year     Individuals       Corporations      Total

 

     ___________     ___________       ____________      _____

        1995             /1/                --            /1/

 

        1996             /1/                --            /1/

 

        1997             /1/                --            /1/

 

        1998             /1/                --            /1/

 

        1999             /1/                --            /1/

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 131.

Description

A qualified foster care payment is paid to the provider for caring for the foster individual in the foster care provider's home. Such payments (made by a State or political subdivision or by a State-licensed tax exempt child-placement agency) are excluded from the foster care provider's income. The exclusion is limited to payments for no more than five foster care individuals over age 18, but is unlimited for younger children.

"Difficulty of care" payments are compensation approved by the State for additional care necessitated by an individual's physical, mental, or emotional handicap. The exclusion is available for no more than ten individuals under the age of nineteen, and no more than five individuals over the age of eighteen.

Impact

Both foster care payments and "difficulty of care" payments qualify for tax exclusion; cash foster care payments are not included in the gross income of the foster care provider. Since these exclusions are not counted as part of income, the tax savings are a percentage of the amount excluded, depending on the marginal tax bracket of the foster care provider. Thus, the exclusion will have greater value for taxpayers with high incomes than for those with lower incomes. In general, those providers who have other income, such as from a spouse's earnings, are those who receive the greatest tax benefit.

Rationale

In 1977 the Internal Revenue Service, in Revenue Ruling 77-280, 1977-2 CB 14, held that payments made by charitable child-placing agencies or governments (such as child welfare agencies) were reimbursements or advances for expenses incurred on behalf of the agencies or governments by the foster parents and therefore not taxable.

In the case of payments made to providers which exceed reimbursed expenses, the Service ruled that the foster providers were engaged in a trade or business with a profit motive and dollar amounts which exceed reimbursements were taxable income.

The principle of exemption of foster care payments entered the tax law officially with the passage of the Periodic Payments Settlement Act, P.L. 97-473. That 1982 tax act not only codified the tax treatment of foster care payments but also provided an exclusion from taxation for "difficulty of care payments." Such payments are made to foster parents who care for physically, mentally, or emotionally handicapped children.

In the Tax Reform Act of 1986, the provision was modified to exempt all qualified foster care payments from taxation. This change was made to relieve foster care providers from the detailed record- keeping requirements of prior law. The Congress feared that detailed and complex record-keeping requirements might deter families from accepting foster children or from claiming the full tax exclusion to which they were entitled. This Act also extended the exclusion of foster care payments to adults placed in a taxpayer's home by a government agency.

Assessment

It is generally conceded that the tax law treatment of foster care payments provides administrative convenience for the Internal Revenue Service, and prevents unnecessary accounting and record- keeping burdens for foster care providers. The trade-off is that to the extent foster care providers receive payments over actual expenses incurred, monies which should be taxable as income are provided an exemption from taxation.

In addition, "difficulty of care" payments resemble the earned income of other occupations, where such income is taxable. For example, a similarity between the wages paid to staff in a nursing home and "difficulty of care payments" for foster care providers is obvious, since many similar tasks are performed. In the case of "difficulty of care" payments, pay levels could be adjusted and payments made a part of taxable income to provide similar tax treatment to all taxpayers.

Selected Bibliography

Kasper, Larry J. "Tax Considerations for Adopted Children and Foster Children," Child Welfare, v. 72, March-April 1993, pp. 99-112.

Morris, Marie B. Under Internal Revenue Code Section 131 Is Any Payment Designated as Reimbursements for Foster Parents' Expenses of Caring for a Qualified Child Excludable From Income or Only those Payments Which Can be Shown to be Reimbursements? Library of Congress, Congressional Research White Paper report. August 1, 1984.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington, DC: U.S. Government Printing Office, May 4, 1987, pp. 1346-1347.

        Education, Training, Employment, and Social Services:

 

                           Social Services

              EXPENSING COSTS OF REMOVING ARCHITECTURAL

 

                              BARRIERS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year      Individuals     Corporations        Total

 

____________________________________________________________________

        1995              /1/             /1/              /1/

 

        1996              /1/             /1/              /1/

 

        1997              /1/             /1/              /1/

 

        1998              /1/             /1/              /1/

 

        1999              /1/             /1/              /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 190.

Description

The removal of architectural and transportation barriers can be treated as a deductible expense, rather than as an expenditure which is capitalized and depreciated over the useful life of the asset. The maximum deduction permitted a business taxpayer (either individual, corporation, or a controlled group of corporations) is $15,000 per year.

Eligible expenses are those incurred to make facilities, or transportation vehicles owned or leased for use in the trade or business, more accessible to, and usable by, the handicapped and persons over 65. To be entitled to the deduction, the taxpayer must establish that the barrier removal meets standards set by the Treasury with the concurrence of the Architectural and Transportation Barriers Compliance Board. Handicaps include blindness and deafness, as well as individuals having difficulty in walking or in using their hands.

Impact

The provision lessens the after-tax cost to business for removal of architectural and transportation barriers to the elderly and the handicapped, by accelerating the deduction for such expenditures, subject to the $15,000 cap per year.

The accelerated deduction allowed for the costs of removing architectural barriers operates to defer tax liability. The value to the business of current expense treatment is the amount by which the present value of the immediate deduction exceeds the present value of periodic deductions which otherwise could be taken over the useful life of the capital expenditure. The direct beneficiaries of this provision are businesses that remove architectural barriers.

Rationale

When first adopted in the Tax Reform Act of 1976 the qualifying expenditures were limited to $25,000 per year. The Congress indicated a concern that barriers remained widespread in both business and industry. The hope was that a tax expenditure for a three-year period would promote rapid modification of business facilities to a more barrier-free environment for both employees and customers, which could increase the involvement in economic, social, and cultural activities of the elderly and handicapped.

A three-year extension of the provision was provided under an act known as Fringe Benefit Regulations-Issuance-Prohibition (P.L. 96-167). The deduction was reinstated, and the maximum deduction increased from $25,000 to $35,000 in the Deficit Reduction Act of 1984.

The Congress decided to make the Code provision permanent (Tax Reform Act of 1986) since businesses tended not to take into account the social benefits for barrier-removal expenditures when making benefit and cost calculations. The Revenue Reconciliation Act of 1990 reduced the ceiling from $35,000 to $15,000, to help provide funding for a new Code provision that allows a tax credit for public accommodation expenditures, designed to help small businesses comply with the requirements of the previously passed Americans With Disabilities Act of 1990.

Assessment

This tax incentive may not be the most efficient method for providing a more barrier-free society, because the tax incentive is probably not enough in and of itself for businesses to undertake costly modifications of facilities. It does provide some relief for firms that are making such adjustments.

Selected Bibliography

Eisenstadt, Deborah E. "Current Tax Planning for Rehabilitation Expenses, Low-Income Housing, and Barrier Removal Costs," Taxation for Accountants, v. 34. April 1985, pp. 234-238.

Talley, Louis Alan. Federal Tax Code Provisions of Interest to the Disabled and Handicapped, Library of Congress, Congressional Research Service Report 91-21 E. January 4, 1991.

--. Business Tax Provisions of Benefit to the Handicapped, Library of Congress, Congressional Research Service Report 93-783 E. September 3, 1993.

Lofton, J. David, Anne K. Judice, and Ellen D. Cook. "Generating Significant Tax Savings for Complying with Title III of the Americans with Disabilities Act," Real Estate Law Journal, v. 2, Fall 1993, pp. 94-115.

U.S. Congress, House Committee on Education and Labor. Oversight Hearing on the Equal Employment Opportunity Commission's Implementation of the Americans with Disabilities Act (Title III Employment and Title V Covering Miscellaneous Provisions). Hearing, 102nd Congress, 1st session. Washington, DC: U.S. Government Printing Office, October 30, 1991.

--, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (H.R. 4170, 98th Congress; Public Law 98-369). Washington, DC: U.S. Government Printing Office, December 31, 1984, pp. 1176-1177.

--. General Explanation of the Tax Reform Act of 1976 (H.R. 10612, 94th Congress, Public Law 94-455). Washington, DC: U.S. Government Printing Office, December 29, 1976, pp. 639-640.

--. General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress; Public Law 99-514). Washington, DC: U.S. Government Printing Office, May 4, 1987, p. 147.

        Education, Training, Employment, and Social Services:

 

                           Social Services

             TAX CREDIT FOR DISABLED ACCESS EXPENDITURES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals     Corporations        Total

 

____________________________________________________________________

        1995              /1/             /1/              /1/

 

        1996              /1/             /1/              /1/

 

        1997              /1/             /1/              /1/

 

        1998              /1/             /1/              /1/

 

        1999              /1/             /1/              /1/

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 44.

Description

A nonrefundable tax credit equal to 50 percent of eligible access expenditures is provided to small businesses, defined as those with gross receipts of less than $1 million or those with no more than 30 full-time employees. Eligible access expenditures must exceed $250 in costs to be eligible but expenditures which exceed $10,250 are not eligible for the credit.

The credit is included as a general business credit and subject to present law limits. No further deduction or credit is permitted for amounts allowable as a disabled-access credit. No increase in the property's adjusted basis is allowable to the extent of the credit. The credit may not be carried back to tax years before the date of enactment.

Impact

The provision lessens the after-tax cost to small businesses for expenditures to remove architectural, communication, physical, or transportation access barriers for persons with disabilities by providing a tax credit for expenditures (which exceed $250 but are less than $10,250). The tax credit allowed for the costs of qualified expenditures operates to reduce tax liability, but not to less than zero because the credit is nonrefundable.

The value of this tax treatment is twofold. First, a 50-percent credit is greater than the tax rate of small businesses. Thus, a greater reduction in taxes is provided than through immediate expensing of access expenditures. Second, the value to small businesses is increased by the amount which the present value of the tax credit exceeds the present value of periodic deductions which typically could be taken over the useful life of the capital expenditure. The direct beneficiaries of this provision are small business that make access expenditures.

Rationale

This tax credit was added to the Code with the passage of the Revenue Reconciliation Act of 1990. The purpose is to provide financial assistance to small businesses for compliance with the Americans With Disabilities Act of 1990. For example, that Act requires restaurants, hotels, and department stores that are either newly constructed or renovated to provide facilities that are accessible to persons with disabilities, and calls for removal of existing barriers when readily achievable in facilities previously built.

Assessment

The tax credit may not be the most efficient method for accomplishing the objective because some of the tax benefit will go for expenditures the small business would have made absent the tax benefit and because there is arguably no general economic justification for special treatment of small business over large businesses.

The requirements of the Americans With Disabilities Act placed capital expenditure burdens that may be a hardship to small businesses. These rules are designed primarily for social objectives, i.e. to accommodate persons with disabilities; thus some subsidy may be justified in this instance.

Selected Bibliography

Lofton, J. David, Anne K. Judia, and Ellen D. Cook. "Generating Significant Tax Savings for Complying with Title III of the Americans With Disabilities Act," Real Estate Law Journal, v. 2, Fall 1993, pp. 94-115.

Talley, Louis Alan. Business Tax Provisions of Benefit to the Handicapped, Library of Congress, Congressional Research Service Report 93-783 E. Washington, DC: September 3, 1993.

--. Federal Tax Code Provisions of Interest to the Disabled and Handicapped, Library of Congress, Congressional Research Service Report 91-21 E. Washington, DC: January 4, 1991.

                               Health

               EXCLUSION OF EMPLOYER CONTRIBUTIONS FOR

 

             MEDICAL INSURANCE PREMIUMS AND MEDICAL CARE

                       Estimated Revenue Loss

 

                       [In billions of dollars]

___________________________________________________________________

    Fiscal year       Individuals    Corporations         Total

 

___________________________________________________________________

        1995              45.8            --               45.8

 

        1996              49.9            --               49.9

 

        1997              53.8            --               53.8

 

        1998              57.9            --               57.9

 

        1999              62.3            --               62.3

 

____________________________________________________________________

Authorization

Sections 105 and 106.

Description

Employees are not taxed on compensation received in the form of employer-paid health care coverage. The exclusion applies to medical benefits provided under either an accident or health plan, and whether the employer self-insures or purchases a third-party insurance contract for a group plan or individual plans. There are no limits on the dollar amount of the eligible exclusion per employee for medical benefits, unlike some other fringe benefits.

Impact

The exclusion from taxation of employer contributions to employee health insurance plans benefits all taxpayers who participate in employer-subsidized plans. Beneficiaries may include retirees as well as present employees, along with their spouses and dependents. Approximately 63 percent of the non-aged U.S. population receives health coverage through such plans.

Although the tax exclusion benefits a wide range of the population, it provides proportionately greater benefits to taxpayers with higher incomes, because high-wage employees tend to have larger amounts of employer-paid health insurance and because they are in higher marginal tax brackets.

Nondiscrimination rules apply to plans self-insured by employers, but not to fully insured plans purchased from third-party insurers, which can still offer more generous benefits to selected employees (often the company's more highly compensated employees).

Some groups of employees are far less likely to receive health insurance from their employers. These include workers under age 25, workers in firms with fewer than 25 employees, part-time workers, and workers in certain industries. The least-covered industry groups include agriculture, forestry, and fisheries; personal and household services; construction; retail trade; business and repair services; and entertainment and recreation services. Lower-wage workers are also typically less likely to receive employer-provided health benefits.

The accompanying table presents statistics for 1992 on the pattern of health insurance coverage by family-income group for the entire noninstitutionalized population of the United States. Income is expressed as a percentage of the Federal poverty income level.

The percentage of the income group covered by health insurance from their own job (column 2) or a family member's job (column 3) climbs dramatically, from 6.3 percent in the group whose income is less than half of the poverty-income level, to 73.2 percent for people whose family income is 2-1/2 times or more than the poverty level.

Conversely, the percentage covered by Medicaid (column 3) or uninsured (column 4) declines from 78.8 percent in the lowest family- income group to 8.1 percent in the highest-income group.

  PERCENT OF U.S. NONINSTITUTIONALIZED POPULATION OBTAINING HEALTH

 

  INSURANCE COVERAGE FROM SPECIFIED SOURCES, BY FAMILY INCOME AS A

 

                PERCENT OF THE FEDERAL POVERTY LEVEL,

                                1992

 

_____________________________________________________________________

 

Income as

 

Percent               Family

 

of Poverty     Own   Member's                                    Un-

 

Level          Job     Job    Medicare  Medicaid     Other    insured

 

_____________________________________________________________________

Under 50       2.3      4.0       6.1      49.2       8.7       29.6

 

50 to 99       5.3      8.6      17.7      32.2       8.4       27.8

 

100 to 133    10.5     17.1      21.3      13.8       9.5       27.8

 

134 to 185    16.7     24.5      18.6       6.7       9.3       24.3

 

186 to 249    24.0     33.1      14.8       2.5       9.0       16.7

 

250 and       39.2     34.0       8.0       0.7       8.8        7.4

 

              ____     ____      ____      ____      ____       ____

Total         28.0     28.9      11.5       7.9       8.9       14.7

 

____________________________________________________________________

     Note: The poverty threshold for a family of four in 1992 was

 

$14,343. Rows may not sum to 100.0 due to rounding. Source: CRS

 

analysis of data from the March 1993 Current Population Survey

 

prepared for the 1994 Green Book, Table C-27, p. 945.

Rationale

The exclusion of compensation for personal injuries or sickness received by individuals through accident or health insurance plans was first provided in the Revenue Act of 1918.

In 1943, the Internal Revenue Service (IRS) ruled that employer contributions to group health insurance policies were not taxable to the employee. Employer contributions to individual health insurance policies, however, were declared to be taxable income in an IRS revenue ruling in 1953. Section 106, enacted in 1954, reversed the 1953 ruling. The legislative history of section 106 indicates that its purpose was principally to make uniform the tax treatment of employer contributions to group and individual health insurance plans.

The Revenue Act of 1978 added the nondiscrimination provisions of section 105(h), which provide that the benefits payable to highly compensated employees under a self-insured medical reimbursement plan are taxable if the plan discriminates in favor of the highly compensated employees. The Tax Reform Act of 1986 repealed section 105(h) and, under a new section 89 of the Internal Revenue Code, extended nondiscrimination rules to group health insurance plans. In 1989, P.L. 101-140 repealed section 89 and reinstated the pre-1986 Act rules under section 105(h).

Assessment

The tax-favored treatment of employer-provided health insurance has been an important factor in encouraging health insurance coverage for a large fraction of middle- and upper-income workers and their dependents. The tax subsidy distorts the choice in favor of health benefits instead of taxable wages.

The exclusion allows employers to provide their employees with health insurance coverage at lower cost than if they had to pay the employees additional taxable wages sufficient to purchase the same insurance from their after-tax income. Employees may choose more health insurance than they would without the subsidy, in preference to wages or other taxable compensation.

Measured as a percent of wages and salaries, employer contributions for group health insurance rose from 0.8 percent in 1955, to 1.6 percent in 1965, 3.1 percent in 1975, and 5.4 percent in 1985, and 7.6 percent in 1993. Many observers believe that the increase in tax-subsidized health insurance coverage has led to excessive use of health care services, which in turn has helped to drive up health care costs.

Workers and their dependents covered by employer-provided health insurance receive a much more generous subsidy from this exclusion than people who purchase health insurance themselves, or than those who pay their own medical expenses and take the medical-expense itemized income tax deduction.

Employer-paid health care is completely excluded from taxable income for all recipients. In contrast, relatively few taxpayers qualify to take advantage of the medical expense deduction: they must be itemizers and must have self-paid medical expenses in excess of 7.5 percent of their adjusted gross income.

Employer-paid plans often provide close to "first-dollar coverage" for basic health care, rather than being restricted to catastrophic expenses, as the medical expense deduction attempts. In addition to the income tax benefits, employer-paid health insurance is excluded from payroll taxation.

Various proposals have been offered to limit the amount of health insurance benefits per employee that can be excluded from taxable income. Assigning a taxable value to the health insurance benefits available to a particular employee could be administratively complicated and numerically imprecise, depending on the design of the limit.

Selected Bibliography

Blinder, Alan S., and Harvey S. Rosen. Notches, Working Paper No. 1416. Cambridge, Mass.: National Bureau of Economic Research, 1984.

Burman, Leonard E., and Jack Rodgers. "Tax Preferences and Employment-Based Health Insurance," National Tax Journal, v. 45, no. 3. September 1992, pp. 331-46.

Davis, Karen. National Health Insurance. Benefits, Costs and Consequences. Washington, DC: The Brookings Institution, 1975.

Employee Benefit Research Institute. Revising the Federal Tax Treatment of Employer Contributions to Health Insurance. A Continuing Debate, EBRI issue brief No. 21. Washington, DC: Employee Benefit Research Institute, 1983.

Feldstein, Martin, and Bernard Friedman. "Tax Subsidies, the Rational Demand for Insurance and the Health Care Crisis," Journal of Public Economics, v. 7. April 1977, pp. 155-78.

Feldstein, Martin, and Elizabeth Allison. "The Tax Subsidies of Private Health Insurance: Distribution, Revenue Loss and Effect," U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs, part 8, "Selected Subsidies." July 29, 1974, pp. 977-94.

Fuchs, Beth, and Mark Merlis. Taxation of Employer-Provided Health Benefits, Library of Congress, Congressional Research Service Report 90-507 EPW. Washington, 1990.

Goode, Richard. The Individual Income Tax, rev. ed. Washington, DC: The Brookings Institution, 1976, pp. 156-60.

Nolan, John S. "Taxation of Fringe Benefits," National Tax Journal, v. 30, no. 3. September 1977, pp. 359-68.

Pauly Mark V. "Taxation, Health Insurance, and Market Failure in the Medical Economy," Journal of Economic Literature, v. 24, no. 2. June 1986, pp. 629-75.

Steuerle, Eugene, and Ronald Hoffman. "Tax Expenditures for Health Care," National Tax Journal, v. 32. June 1979, pp. 101-14.

U.S. Congress, Congressional Budget Office. Tax Subsidies for Medical Care: Current Policies and Possible Alternatives. Washington, DC: 1980.

__. The Tax Treatment of Employment-Based Health Insurance. Washington, DC: March 1994.

--, House Committee on the Budget, Subcommittee on Oversight, Task Force on Tax Expenditures and Tax Policy. Tax Expenditures for Health Care, Hearings, 96th Congress, 1st session. July 9-10, 1979.

--, House Committee on Ways and Means. 1994 Green Book. Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means. Overview of Entitlement Programs, Committee Print WMCP 103-27, 103rd Congress, 2nd session. Washington, DC: U.S. Government Printing Office, July 15, 1994, pp. 689-92, 943- 50.

--, Joint Committee on Taxation. Overview of Administration Proposal to Cap Exclusion for Employer Provided Medical Care and Tax Treatment of Other Fringe Benefits. Committee Print, 98th Congress, 1st session. June 21, 1983.

Vogel, Ronald. "The Tax Treatment of Health Insurance Premiums as a Cause of Overinsurance," National Health Insurance. What Now, What Later, What Never? ed. M. Pauly. Washington, DC: American Enterprise Institute for Public Policy Research, 1980.

Wilensky, Gail R. "Government and the Financing of Health Care," American Economic Review, v. 72, no. 2. May 1982, pp. 202-07.

--, and Amy K. Taylor. Tax Expenditures and Health Insurance: Limiting Employer-Paid Premiums," Public Health Reports, v. 97. September-October 1982, pp. 438-44.

                               Health

                EXCLUSION OF MEDICAL CARE AND CHAMPUS

 

              HEALTH INSURANCE FOR MILITARY DEPENDENTS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals       Corporations      Total

 

____________________________________________________________________

        1995             0.4                --            0.4

 

        1994             0.5                --            0.5

 

        1995             0.5                --            0.5

 

        1996             0.5                --            0.5

 

        1997             0.5                --            0.5

 

____________________________________________________________________

Authorization

Sections 112 and 134 and court decisions [see Jones v. United States, 60 Ct. Cl. 552 (1925)].

Description

Military personnel are provided with a variety of in-kind benefits (or cash payments given in lieu of such benefits) that are not taxed. Among these benefits are medical and dental benefits, which include dependents as well.

Some military care for dependents is provided directly in military facilities and by military doctors on a space-available basis. There is also a program, the Civilian Health and Medical Program (CHAMPUS), which operates as a health insurance plan for dependents and for retirees and their dependents until they become eligible for Medicare.

Impact

As in the case of the general exclusion for health care benefits, the benefits are greater for higher income individuals who have higher marginal tax rates.

An individual in the 15-percent tax bracket (Federal tax law's lowest tax bracket) would not pay taxes equal to $15 for each $100 excluded. Likewise, an individual in the 28-percent tax bracket (Federal law's highest tax bracket) would not pay taxes of $28 for each $100 excluded. Hence, the same exclusion can be worth different amounts to different military personnel, depending on their marginal tax bracket. By providing military compensation in a form not subject to tax, the benefits have greater value for members of the armed services with high income than for those with low income.

Rationale

In 1925, the United States Court of Claims in Jones v. United States, 60 Ct. Cl. 552 (1925), drew a distinction between the pay and allowances provided military personnel. The court found that housing and housing allowances were reimbursements similar to other non- taxable expenses authorized for the executive and legislative branches.

Prior to this court decision, the Treasury Department had held that the rental value of quarters, the value of subsistence, and monetary commutations were to be included in taxable income. This view was supported by an earlier income tax law, the Act of August 27, 1894, (later ruled unconstitutional by the Courts) which provided a two-percent tax "on all salaries of officers, or payments to persons in the civil, military, naval, or other employment of the United States."

The principle of exemption of armed forces benefits and allowances evolved from the precedent set by Jones v. United States, through subsequent statutes, regulations, or long-standing administrative practices.

The Tax Reform Act of 1986 consolidated these rules so that taxpayers and the Internal Revenue Service could clearly understand and administer the tax law consistent with fringe benefit treatment enacted as part of the Deficit Reduction Act of 1984.

These medical benefits would also be excludable in the absence of specific military exclusions through the general rules allowing exclusion of medical payments (Sections 105 and 106).

Assessment

Some military benefits are akin to the "for the convenience of the employer" benefits provided by private enterprise, such as the allowances for housing, subsistence, payment for moving and storage expenses, overseas cost-of-living allowances, and uniforms. Other benefits are similar to employer-provided fringe benefits such as medical and dental benefits, education assistance, group term life insurance, and disability and retirement benefits. While the argument can be made that health and dental care for active duty personnel is essential to the military mission, health care for dependents is much more like a fringe benefit.

Many of the issues associated with military health benefits are similar to those of the civilian and private sector benefits discussed above, i.e., the tax benefit encourages individuals to substitute medical care for taxable wages and to consume too much medical care.

There are, however, some unusual aspects to the military benefits. Direct care provided in military facilities would be difficult to value for tax purposes, and yet may be necessary for dependents accompanying the service member to isolated areas that do not have adequate medical facilities.

In the absence of a general revision in the tax treatment of health benefits, a change in the treatment for military dependents would be likely to require an increase in military pay to maintain the current attractiveness of the military for those individuals with dependents and with adequate income to encounter income tax liability.

Selected Bibliography

Best, Richard A. Military Medicine and National Health Care Reform. Library of Congress, Congressional Research Service, Report 94-570, July 15, 1994.

Binkin, Martin. The Military Pay Muddle. Washington, DC: The Brookings Institution, April 1975.

Owens, William L. "Exclusions From, and Adjustments to, Gross Income," Air Force Law Review, v. 19. Spring 1977, pp. 90-99.

U.S. Congress, Congressional Budget Office. The Tax Treatment of Employment Based Health Insurance. Washington, DC: March 1994.

U.S. Congress, House. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, Public Law 99-514. Washington, DC: U.S. Government Printing Office, 1987, pp. 828-830.

                               Health

             DEDUCTIBILITY OF MEDICAL INSURANCE PREMIUMS

 

                        BY THE SELF-EMPLOYED

                     Estimated Revenue Loss /*/

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals       Corporations      Total

 

____________________________________________________________________

        1995             --                 --             --

 

        1996             --                 --             --

 

        1997             --                 --             --

 

        1998             --                 --             --

 

        1999             --                 --             --

 

____________________________________________________________________

                          FOOTNOTE TO TABLE

     /*/ At the time of publication, this provision had expired. As

 

part of the analysis of health care reform proposals, the revenue

 

cost of extending the 25-percent deduction was estimated at $0.5

 

billion for FY95 and $0.6 billion for FY96.

                      END OF FOOTNOTE TO TABLE

Authorization

Section 162(1). This provision expired as of December 31, 1993.

Description

A self-employed individual may deduct 25 percent of the amount paid for health insurance for a taxable year on behalf of the individual and the individual's spouse and dependents. The deduction is available to sole proprietors, working partners in a partnership, and employees of an S corporation who own more than 2 percent of the corporation's stock. No deduction is permitted if the self-employed individual is eligible to participate on a subsidized basis in a health plan of an employer of the self-employed individual or the individual's spouse, determined on a monthly basis. The deduction from gross income may not exceed the self-employed individual's earned income from the business in which the insurance plan was established.

The 25 percent deduction is treated as an adjustment to income, also known as an above-the-line deduction permitted in calculating adjusted gross income. (The remaining 75 percent of the health insurance costs can be included with other medical expenses, subject to the 7.5 percent of adjusted gross income [AGI] floor governing the itemized deduction for medical expenses.)

Impact

For tax year 1992, 2.8 million tax returns claimed the 25 percent deduction for the self-employed. Estimates from 1988 tax data indicate that less than half of the self-employed tax filers in most income classes claimed the health insurance deduction.

The following table shows the percentage distribution of the total deductions claimed by adjusted gross income class for 1992. The distribution of the special health insurance deduction for the self- employed is more concentrated in the higher income classes than the itemized deductions for medical expenses.

The corresponding tax expenditure values, where the deductions would be weighted by the marginal tax rates applicable to the respective income classes, would be even more heavily distributed toward the higher income groups. For self-employed owners of the many small businesses that generate little or no taxable income, the deduction provides little or no tax subsidy.

           DISTRIBUTION BY ADJUSTED GROSS INCOME CLASS OF

 

            THE 25 PERCENT DEDUCTION OF MEDICAL INSURANCE

 

                 PREMIUMS BY THE SELF-EMPLOYED, 1992

____________________________________________________________________

 

     Adjusted Gross                           Percentage

 

     Income Class                             Distribution

 

     (in thousands of $)                      of Deductions

 

____________________________________________________________________

        Below $10                                   8.1

 

        $10 to $20                                 15.4

 

        $20 to $30                                 14.6

 

        $30 to $40                                 11.2

 

        $40 to $50                                  9.7

 

        $50 to $75                                 11.6

 

        $75 to $100                                 7.3

 

        $100 to $200                               13.1

 

        $200 and over                               9.0

 

        Total                                     100.0

 

____________________________________________________________________

Note: This is NOT a distribution of tax expenditure values. Derived from data in: Gross, Edward B., Jr. "Individual Income Tax Returns, Preliminary Data, 1992," Statistics of Income Bulletin, Spring 1994. Washington, DC: 1994, p. 24.

Rationale

The 25 percent health insurance deduction for the self-employed was first enacted as a temporary three-year provision by the Tax Reform Act of 1986. The Technical and Miscellaneous Revenue Act of 1988 made certain technical corrections to the provision.

The Omnibus Budget Reconciliation Act of 1989 extended the deduction for 9 months (through September 30, 1990) and clarified that the deduction is available to certain S corporation shareholders. The Omnibus Budget Reconciliation Act of 1990 extended the deduction through December 31, 1991. The Tax Extension Act of 1991 extended the deduction through June 30, 1992. The Omnibus Budget Reconciliation Act of 1993 extended the deduction through December 31, 1993.

When the deduction was first established in 1986, Congress expressed concern that the disparity in tax treatment of health benefits between the owners of unincorporated businesses and the owners of corporations created inefficient incentives for incorporation. Congress was also aware that health coverage was particularly low among small businesses operated by the self- employed. Congress also expressed the belief that the exclusion for the self-employed should be accompanied by nondiscrimination rules applying to health insurance coverage for employees of the business. The nondiscrimination requirements accompanying the deduction were removed in 1989 by P.L. 101-140, which also repealed section 89 of the Internal Revenue Code, the nondiscrimination rules that had been enacted in 1986 regarding employee benefit plans.

Assessment

The 25 percent deduction for the health insurance expenses of self-employed individuals is intended to provide them some portion of the favorable tax treatment for health insurance given to employees covered under an employer-provided health plan. The deduction helps offset the higher insurance costs that typically face small-group or individual insurance plans. On the other hand, the special partial deduction provides the self-employed with a tax subsidy not available to other individuals who pay health insurance premiums on their own. To date only limited evidence has been assembled on how much the deduction has encouraged the purchase of health insurance for the formerly uninsured self-employed and their employees.

Some argue that a deduction closer to 100 percent would help equalize treatment under the tax laws between the employed and self- employed. Those who oppose a 100 percent deduction express concern that self-employed individuals would be free to purchase very generous insurance plans with low deductibles or copayments and with extensive service coverage.

Others, who agree that treatment should be more equal, would restrict the amount of tax-free health benefits under employer- provided plans. Like the other subsidies provided to health insurance by the tax code, the special deduction for the self-employed acts to increase the purchase of health insurance which, in turn, encourages higher expenditures for health care services.

Essentially all of the health care reform plans advanced during the 1994 debate would have extended the 25 percent deduction from its expiration date on December 31, 1993, until a permanent new provision could take effect. Several of the proposals, including the Clinton Administration's, would have increased the deduction limit to 100 percent of the insurance premium cost of the nationally defined standard benefits package (or the fraction the self-employed person actually paid on behalf of his or her own employees, if lower). Some of the proposals that included an employer mandate would have increased the special deduction only up to the share that an employer would otherwise be required to pay (50 percent under Senate Majority Leader Mitchell's plan or 80 percent under the Gephardt House Leadership Plan, for example). To avoid subsidizing high-cost insurance plans, some of the reform proposals would have further limited the maximum amount of the deduction to some percentage of the average cost of such an insurance package in the community-rated market area.

Relative to the self-employed, recipients of employer-provided health insurance (including in this respect more than two percent shareholder-employees of S corporations) receive an additional advantage under payroll taxes. Their health benefits are generally not counted in the FICA wage bases for social security and Medicare tax contributions.

In contrast, self-employed sole proprietors and partners cannot deduct their health insurance expenses when calculating their Self- Employment Contributions Act (SECA) taxes. Thus, the overall tax treatment of health insurance benefits still creates a sizeable incentive to work for an employer who provides insurance, rather than to work only for oneself, even with the 25 percent deduction for the self-employed.

Selected Bibliography

Gruber, Jonathan and James Poterba. "Tax Incentives and the Decision to Purchase Health Insurance: Evidence from the Self- Employed," The Quarterly Journal of Economics, vol. 109, issue 3, August 1994, pp. 701-33. An earlier version was published as Working Paper No. 4435, National Bureau of Economic Research, Cambridge, MA, August 1994.

Mayer, Gerald. Taxation of Health Insurance for the Self- Employed. Library of Congress, Congressional Research Service Report 92-251 E. Washington, DC: March 4, 1992.

U.S. Congress, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986, H.R. 3838, 99th Congress, P.L. 99-514, Joint Committee Print JCS-10-87. Washington, DC: U.S. Government Printing Office, May 4, 1987, pp. 815-17.

--. Description and Analysis of Tax Provisions Expiring in 1992, Scheduled for Hearings before the House Committee on Ways and Means Committee on Jan. 28-29 and Feb. 26, 1992, Joint Committee Print JCS- 2-92. Washington, DC: U.S. Government Printing Office, January 27, 1992, pp. 11-13.

                               Health

                  DEDUCTIBILITY OF MEDICAL EXPENSES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

     Fiscal year     Individuals       Corporations      Total

 

____________________________________________________________________

        1995             4.1                --            4.1

 

        1996             4.5                --            4.5

 

        1997             5.0                --            5.0

 

        1998             5.5                --            5.0

 

        1999             6.0                --            6.0

 

____________________________________________________________________

Authorization

Section 213.

Description

Unreimbursed medical expenses paid by an individual may be itemized and deducted from income to the extent they exceed 7.5 percent of adjusted gross income (AGI). Expenses eligible for the deduction include amounts paid by the taxpayer on behalf of the taxpayer, spouse, and eligible dependents, for

(1) health insurance premiums, including after-tax employee contributions to employer-sponsored health plans, Medicare Part B premiums, the portion of the premium that does not qualify for the special deduction for the self-employed, and other self-paid premiums;

(2) diagnosis, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body, including dental care;

(3) prescription drugs and insulin;

(4) transportation primarily for and essential to medical care; and

(5) lodging away from home primarily for and essential to medicare care, up to $50 per night.

Expenses paid for the general improvement of health are not eligible for the deduction unless prescribed by a physician to treat a specific illness.

Impact

For taxpayers who can itemize their deductions, the deduction eases the financial burden of extraordinary medical expenses. These have been viewed as largely involuntary expenses that reduce the taxpayer's ability to pay taxes.

The deduction is not limited to involuntary expenses, however; it also covers some costs of preventive care, rest cures, and other discretionary expenses. Despite the substantial expansion of health insurance coverage in recent years, a significant share of the out- of-pocket medical expenses now deducted is for procedures and care not covered by commonly available insurance policies (such as orthodontia).

Like all deductions, the medical expense deduction produces higher tax savings per dollar of deduction for taxpayers in higher income tax brackets.

Relative to other itemized deductions, a larger percentage of tax expenditure benefits for the medical expense deduction goes to taxpayers in the lower-middle income brackets, for several possible reasons. Lower-income households are less likely to be well insured, either through their employment or through separately purchased insurance. A given dollar amount of medical expenditures represents a larger fraction of their typical income, and thus is more likely to exceed the 7.5-percent-of-AGI floor. If serious medical problems cause taxpayers to lose time from work, their incomes may fall temporarily in the same year that medical expenses are high.

               DISTRIBUTION BY INCOME CLASS OF THE TAX

 

                  EXPENDITURE FOR MEDICAL EXPENSES

 

              AT 1994 TAX RATES AND 1994 INCOME LEVELS

____________________________________________________________________

 

    Income Class                                  Percentage

 

    (in thousands of $)                          Distribution

 

____________________________________________________________________

       Below $10                                      0.1

 

       $10 to $20                                     2.2

 

       $20 to $30                                     7.7

 

       $30 to $40                                    12.4

 

       $40 to $50                                    13.2

 

       $50 to $75                                    27.4

 

       $75 to $100                                   16.8

 

       $100 to $200                                  13.2

 

       $200 and over                                  7.0

 

____________________________________________________________________

Rationale

Since 1942, there have been numerous adjustments to the rules for deducting medical expenses. These alterations have involved the percentage of AGI at which the floor was set, limits on the maximum amount deductible, whether the maximum would be higher for taxpayers aged 65 and over and disabled, whether medicine and drug expenses would be subject to a separate floor, whether health insurance premiums would be subject to the combined floor, and what types of expenses are eligible for the deduction.

Health costs exceeding a given floor were first allowed as a deduction in 1942. The rationale then was to help maintain high standards of public health and to ease the burden of high wartime tax rates.

Originally the deduction was allowed only to the extent that medical expenses exceeded 5 percent of net income (considered to be the average family medical-expense level) and was subject to a $2,500 maximum ($1,250 for a single individual).

In 1948, the maximum deduction was increased to $1,250 times the number of exemptions, with a ceiling of $5,000 for joint returns and $2,500 for other returns. In 1951, the 5 percent floor was removed if the taxpayer or spouse was age 65 or over.

In 1954, when the Internal Revenue Code was substantially revised, the percentage-of-AGI floor was reduced to 3 percent and a 1 percent floor was imposed on drugs and medicines. The maximum deduction was increased to $2,500 per exemption, with a ceiling of $5,000 per individual return and $10,000 for joint and head of household returns.

In 1959 the maximum deduction was increased to $15,000 if a taxpayer was 65 or over and disabled, and $30,000 if the spouse also was. In 1960 the floor was removed on deductions for dependents age 65 or over.

In 1962, the maximum deduction was increased to $5,000 per exemption with a limit of $10,000 for individual returns, $20,000 for joint and head of household returns, and $40,000 for joint returns where both the taxpayer and spouse are 65 or over and disabled.

In 1964 the one-percent floor on medicine and drug expenses was eliminated for those age 65 or older (taxpayer, spouse, or dependent). In 1965, both the three-percent medical expense and one- percent drug floors were reinstated for taxpayers and dependents aged 65 and over. The maximum deduction limitations were removed, and a separate deduction of up to $150 was permitted for one-half of medical insurance premium costs, without regard to the three percent floor.

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) raised the floor from three to five percent of adjusted gross income. It eliminated the separate deduction for health insurance payments but permitted them to be combined with other medical expenses.

TEFRA also eliminated the separate one-percent floor for drug costs, made nonprescription drugs ineligible for the deduction, and combined the deduction for prescription drugs and insulin together with other medical expenses.

The Tax Reform Act of 1986 (TRA86) raised the floor under the combined medical expenses deduction from 5 to 7.5 percent of AGI.

The Omnibus Budget Reconciliation Act of 1990 disallowed deductions for the cost of cosmetic surgery, with certain exceptions. The medical expense deduction is exempt from the overall limit on itemized deductions for high-income taxpayers which took effect in 1991.

Assessment

Changes in the tax laws during the 1980s substantially reduced the number of tax returns claiming an itemized deduction for medical and dental expenses.

In 1980, 19.5 million returns, 67.2 percent of all itemized returns, claimed the deduction. In 1983, after TEFRA, it was 9.7 million returns, 27.6 percent of itemized returns. In 1992, representative of the years following TRA86, 5.5 million returns, 16.8 percent of itemized returns, claimed the deduction.

The deduction is now more focused on taxpayers with high unreimbursed medical expenses relative to their income during a given year. Taxpayers may be more able to use the deduction if they can bunch large medical expenditures into a single tax year.

Restricting the deduction reduces the income tax offset available for uninsured medical expenses and should thereby discourage middle- and upper-income taxpayers from remaining uninsured. The current deduction does not actively help many taxpayers purchase insurance, however.

Although health insurance premiums that individuals pay on their own are technically eligible for deduction, in practice few taxpayers are able to claim the deduction. First, relatively few taxpayers are itemizers, particularly in the lower-income groups. Second, even among itemizers, few with health insurance coverage are likely to qualify for the deduction because their unreimbursed medical expenses are unlikely to exceed 7.5 percent of AGI.

Taxpayers with employer-provided health insurance still have a substantial tax advantage over taxpayers who purchase health insurance on their own or self-insure. Employer-paid health care is fully excluded from taxable income, not subject to any floor or ceiling limit.

Selected Bibliography

Davis, Karen. National Health Insurance: Benefits, Costs, and Consequences. Washington, DC: The Brookings Institution, 1975.

Feldstein, Martin, and Elizabeth Allison. "The Tax Subsidies of Private Health Insurance: Distribution, Revenue Loss and Effect," U.S. Congress, Joint Economic Committee, The Economics of Federal Subsidy Programs, part 8, "Selected Subsidies." July 29, 1974, pp. 977-94.

Goode, Richard. The Individual Income Tax, rev. ed. Washington, DC: The Brookings Institution, 1976, pp. 156-60.

Kaplow, Louis. "The Income Tax as Insurance: The Casualty Loss and Medical Expense Loss Deductions and the Exclusion of Medical Insurance Premiums," California Law Review, v. 79. December 1991, pp. 1485-1510.

Mitchell, B. M., and R. J. Vogel. Health and Taxes: An Assessment of the Medical Deduction, R-1222-OEO. Santa Monica, Calif.: The Rand Corp., August 1973.

Pauly Mark V. "Taxation, Health Insurance, and Market Failure in the Medical Economy," Journal of Economic Literature, v. 24, no. 2. June 1986, pp. 629-75.

Steuerle, Eugene, and Ronald Hoffman. "Tax Expenditures for Health Care," National Tax Journal, v. 32, no. 2. June 1979, pp. 101- 15.

U.S. Congress, Congressional Budget Office. Tax Subsidies for Medical Care. Current Policies add Possible Alternatives. Washington, DC: 1980.

--, House Committee on the Budget. Tax Expenditures for Health Care, Hearings, 96th Congress 1st session. July 9-10, 1979.

Vogel, Ronald. "The Tax Treatment of Health Insurance Premiums as a Cause of Overinsurance," National Health Insurance: What Now, What Later, What Never? ed. M. Pauly. Washington: American Enterprise Institute for Public Policy Research, 1980.

Wilensky, Gail R. "Government and the Financing of Health Care" American Economic Review, v. 72, no. 2. May 1982, pp. 202-07.

                               Health

              EXCLUSION OF INTEREST ON STATE AND LOCAL

 

                          GOVERNMENT BONDS

 

                  FOR NONPROFIT HOSPITAL FACILITIES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

     Fiscal year     Individuals       Corporations      Total

 

        1995             1.2               0.4            1.6

 

        1996             1.3               0.4            1.7

 

        1997             1.4               0.5            1.9

 

        1998             1.4               0.5            1.9

 

        1999             1.5               0.5            2.0

Authorization

Section 103, 141, 145, 146, and 501(c)(3) of the Internal Revenue Code of 1986.

 

Description

Interest income on State and local bonds used to finance the construction of nonprofit hospitals and nursing homes is tax exempt. These bonds are classified as private-activity bonds rather than governmental bonds because a substantial portion of their benefits accrues to individuals or businesses rather than to the general public. For more discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

These nonprofit hospital bonds are not subject to the State private-activity bond annual volume cap. Neither are these bonds subject to the $150 million cap on the amount of tax-exempt bonds any nonprofit institution can have outstanding.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low interest rates enable issuers to finance hospitals and nursing homes at reduced interest rates. Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and users of the hospitals and nursing homes, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Pre-dating the enactment of the first Federal income tax, an early decision of the U.S. Supreme Court, Dartmouth College v. Woodward (17 U.S. 518 [1819]), confirmed the legality of government support for charitable organizations that were providing services to the public.

The income tax adopted in 1913, in conformance with this principle, exempted from taxation virtually the same organizations now included under Section 501(c)(3). In addition to their tax-exempt status, these institutions were permitted to receive the benefits of tax-exempt bonds.

Almost all States have established public authorities to issue tax-exempt bonds for nonprofit hospitals and nursing homes. Where issuance by public authority is not feasible, Revenue Ruling 63-20 allows nonprofit hospitals to issue tax-exempt bonds "on behalf of" State and local governments.

Prior to enactment of the Revenue and Expenditure Control Act of 1968, States and localities were able to issue bonds to finance construction of capital facilities for private (proprietary or for- profit) hospitals, as well as for public sector and nonprofit hospitals.

After the 1968 Act, tax-exempt bonds for proprietary (for- profit) hospitals had to be issued as small-issue industrial development bonds, which limited the amount for any institution to $5 million over a six-year period. The Revenue Act of 1978 raised this amount to $10 million.

The Tax Equity and Fiscal Responsibility Act of 1982 established a December 31, 1986, sunset date for tax-exempt small-issue IDBs. The Deficit Reduction Act of 1984 extended the sunset date for bonds used to finance manufacturing facilities, but left in place the December 31, 1986 sunset date for nonmanufacturing facilities, thereby ending the practice of using tax-exempt bonds to finance capital facilities of for-profit hospitals and nursing homes.

The Tax Reform Act of 1986 established a $150 million cap on the stock of bonds that may be outstanding for any nonprofit institution. Hospitals were exempted from this cap. The private-activity bond status of these bonds subjects them to more severe restrictions in some areas, such as arbitrage rebate and advance refunding, than would apply if they were classified as governmental bonds.

Assessment

Efforts have been made to reclassify nonprofit bonds as governmental bonds. Central to this issue is the extent to which nonprofit organizations are fulfilling their public purpose rather than using their tax-exempt status to convert tax subsidies into subsidized goods and services for groups that might receive more critical scrutiny if their subsidy were provided through the spending side of the budget.

Questions have been raised about the extent to which nonprofit hospitals are fulfilling their charitable purpose, and whether it is justifiable to continue to allow them to enjoy the below-market capital financing rates provided by their unlimited access to tax- exempt bonds.

Even if a case can be made for subsidy of these nonprofit organizations, it is important to recognize the costs that accrue. As one of many categories of tax-exempt private-activity bonds, bonds issued for these organizations have increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

Barker, Thomas R. "Re-Examining the 501(c)(3) Exemption of Hospitals as Charitable Organizations," The Exempt Organization Tax Review. July 1990, pp. 539-553.

Copeland, John and Gabriel Rudney. "Federal Tax Subsidies for Not-for-Profit Hospitals," Tax Notes. March 26,1990, pp. 1559-1576.

Odendahl, Teresa. Charity Begins at Home: Generosity and Self- Interest Among the Philanthropic Elite. New York: Basic Books, 1990.

Weisbrod, Burton A. The Nonprofit Economy. Cambridge, Mass.: Harvard University Press, 1988.

U.S. Congress, Congressional Budget Office. Tax Subsidies for Medical Care: Current Policies and Possible Alternatives. 1980, pp. 47-61.

Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax Policy," National Tax Journal. September 1991, pp. 341-349.

--. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activities. Washington, DC: The Urban Institute Press, 1991.

                               Health

                 TAX CREDIT FOR ORPHAN DRUG RESEARCH

                       Estimated Revenue Loss

 

                      [In billions of dollars] /*/

 

     Fiscal year     Individuals       Corporations      Total

 

       1993              --                 --             --

 

       1994              --                 --             --

 

       1995              --                 --             --

 

       1996              --                 --             --

 

       1997              --                 --             --

                          FOOTNOTE TO TABLE

     /*/ This provision is scheduled to expire at the end of calendar

 

year 1994. Its cost per year is less than $50 million.

                      END OF FOOTNOTE TO TABLE

Authorization

Sections 28, 41(b), and 280C.

Description

A tax credit is available for 50 percent of the qualified expenses incurred in testing drugs used to treat rare diseases ("orphan" drugs). Eligible diseases defined by the Federal Food, Drug, and Cosmetic Act consist of illnesses affecting fewer than 200,000 persons, or occurring so infrequently that developing a drug used to treat the disease is not economical.

Outlays that qualify are supplies and salaries, but not depreciable property. Expenses that qualify for the orphan drug research credit cannot also qualify for the research expenditure credit. And while qualified testing expenses that count towards the orphan drug credit can generally be deducted in the year incurred ("expensed"), the amount of deductible expenses is reduced by the orphan drug credit.

Impact

The orphan drug tax credit reduces the cost of investment in qualified drug research. Most of this effect is registered by pharmaceutical firms, which account for nearly 80 percent of all orphan drug credits claimed.

In the long run, however, the burden of the corporate income tax (and the benefit from reductions in it) probably spreads far beyond corporate stockholders to owners of capital in general. (See the related discussion in the Introduction.) To the extent that the credit results in the development of orphan drugs, the credit probably also benefits persons with diseases classified as rare.

Rationale

The orphan drug tax credit was first enacted as part of the Orphan Drug Act of 1983. Its purpose was to provide an incentive for firms to develop drugs for diseases that are so rare that there would be little hope of recovering the drug's development costs without Federal support.

The 1983 Act provided two other forms of Government support: grants for the testing of drugs, and a seven-year market exclusivity for orphan drugs approved for use. Under the initial Act, the only test for a drug's eligibility was that there be no reasonable expectation of recovering the costs of development.

This test, however, proved difficult to administer, and in 1984 Public Law 98-551 added the 200,000-person test described above. The tax credit was initially scheduled to expire at the end of 1987, but was subsequently extended by the Tax Reform Act of 1986, the Omnibus Budget Reconciliation Act of 1990, the Tax Extension Act of 1991, and the Omnibus Budget Reconciliation Act of 1993. Under the 1993 Act, the credit is scheduled to expire on December 31, 1994.

Assessment

As of September, 1992, 494 drugs qualified as orphans under the 1983 Act; 64 have been approved for the market. Supporters of the Act in general view these data as proof that the Act's incentives are accomplishing their goal of developing drugs that would not otherwise be produced.

However, it has been pointed out that a number of drugs developed and marketed under the Orphan Drug Act have proved to be profitable and probably would have been developed without Government support. Supporters of the Act note, however, that it is only with hindsight that these particular drugs are known to be profitable.

Others have criticized the design of the Orphan Drug Act's incentives without questioning the desirability of Government support. For example, it is argued that the current rules permit firms to classify drugs with multiple uses as being useful for only a narrow range of applications, thereby making it easier for the drugs to qualify as orphans.

To the extent that the orphan drug tax credit accomplishes its purpose, it diverts resources from other uses to the development of drugs for rare diseases. This effect presents the most general issue raised by the credit and perhaps the most painful one: is it appropriate to divert resources from uses that benefit many persons to uses that benefit only a few, albeit in a sometimes dramatic way?

Selected Bibliography

Asbury, Carolyn H. "The Orphan Drug Act: the First 7 Years," Journal of the American Medical Association, v. 265. February 20, 1991, pp. 893-897.

Brumbaugh, David L. Expiring Tax Provisions. Library of Congress, Congressional Research Service Issue Brief No. IB92119. Washington, D.C.: 1994. 4p.

Thomas, Cynthia A. "Re-Assessing the Orphan Drug Act," Columbia Journal of law and Social Problems, v. 23, No. 3. 1990, pp. 413-440.

U.S. Congress, Joint Committee on Taxation. Description and Analysis of Tax Provisions Expiring in 1992. Washington, U.S. Govt. Print. Off. 1992. 109 p.

                               Health

              DEDUCTIBILITY OF CHARITABLE CONTRIBUTIONS

 

                       TO HEALTH ORGANIZATIONS

                       Estimated Revenue loss

 

                      [In billions of dollars]

     Fiscal year     Individuals       Corporations      Total

 

     ___________     ___________       ____________      _____

 

        1995             1.4               0.3            1.7

 

        1996             1.5               0.3            1.8

 

        1997             1.6               0.3            1.9

 

        1998             1.6               0.4            2.0

 

        1999             1.7               0.4            2.1

Authorization

Section 170 and 642(c).

Description

Subject to certain limitations, charitable contributions may be deducted by individuals, corporations, and estates and trusts. The contributions must be made to specific types of organizations, including organizations whose purpose is to provide medical or hospital care, or medical education or research. To be deductible, contributions of $250 or more must be substantiated.

Individuals who itemize may deduct qualified contributions of up to 50 percent of their adjusted gross income (AGI) (30 percent for gifts of capital gain property). For contributions to nonoperating foundations and organizations, deductibility is limited to the lesser of 30 percent of the taxpayer's contribution base, or the excess of 50 percent of the contribution base for the tax year over the amount of contributions which qualified for the 50-percent deduction ceiling (including carryovers from previous years). Gifts of capital gain property to these organizations are limited to 20 percent of AGI. A corporation can deduct up to 10 percent of taxable income (with some adjustments).

If a contribution is made in the form of property, the deduction depends on the type of taxpayer (i.e., individual, corporate, etc.), recipient, and purpose.

Impact

The deduction for charitable contributions reduces the net cost of contributing. In effect, the Federal Government provides the donee with a matching grant that increases in value with the donor's marginal tax bracket. Those individuals who use the standard deduction or who pay no taxes receive no benefit from the provision.

A limitation applies to the itemized deductions of high-income taxpayers. Under this provision, in 1994, otherwise allowable deductions are reduced by three percent of the amount by which a taxpayer's adjusted gross income (AGI) exceeds $111,800 (adjusted for inflation in future years). The table below provides the distribution of all charitable contributions, not just those to health organizations.

               DISTRIBUTION BY INCOME CLASS OF THE TAX

 

              EXPENDITURE FOR CHARITABLE CONTRIBUTIONS

 

              AT 1994 TAX RATES AND 1994 INCOME LEVELS

 

____________________________________________________________________

 

        Income Class                                   Percentage

 

     (in thousands of $)                              Distribution

 

____________________________________________________________________

        Below $10                                          0.0

 

        $10 to $20                                         0.8

 

        $20 to $30                                         2.2

 

        $30 to $40                                         4.4

 

        $40 to $50                                         6.1

 

        $50 to $75                                        19.8

 

        $75 to $100                                       14.5

 

        $100 to $200                                      19.5

 

        $200 and over                                     32.6

 

___________________________________________________________________

Rationale

This deduction was added by passage of the War Revenue Act of October 3, 1917. Senator Hollis, the sponsor, argued that the high wartime tax rates would absorb the surplus funds of wealthy taxpayers, which were generally contributed to charitable organizations. It was also argued that many colleges would lose students to the military, and charitable gifts were needed by educational institutions. The deduction was extended to estates and trusts in 1918 and to corporations in 1935.

Assessment

Supporters note that contributions finance desirable activities such as hospital care for the poor. Further, the Federal Government would be forced to step in to assume more of these activities currently provided by health care organizations if the deduction were eliminated; however, public spending might not be allowed to make up all of the difference. In addition, many believe that the best method of allocating general welfare resources is through a dual system of private philanthropic giving and governmental allocation.

Economists have generally held that the deductibility of charitable contributions provides an incentive effect which varies with the marginal tax rate of the giver. There are a number of studies which find significant behavioral responses.

Types of contributions may vary substantially among income classes. Contributions to religious organizations are far more concentrated at the lower end of the income scale than are contributions to health organizations, the arts, and educational institutions, with contributions to other types of organizations falling between these levels.

However, the volume of donations to religious organizations is greater than to all other organizations as a group. It has been estimated by the AAFRC Trust for Philanthropy, Inc. that giving to health care providers and associations amounted to $10.24 billion in 1992, accounting for 7.9 percent of all philanthropic contributions. As a share of total giving, gifts to health organizations has declined since 1974, when they accounted for 12.7 percent of total giving.

There has been recent debate concerning the amount of charity care being provided by health care organizations with tax-exempt status.

Those who support eliminating charitable deductions note that deductible contributions are made partly with dollars which are public funds. Helping out private charities may not be the optimal way to spend Government money. The Congress does not routinely review this deduction.

Opponents further claim that the present system allows wealthy taxpayers to indulge special interests and hobbies. To the extent that charitable giving is independent of tax considerations, Federal revenues are lost without having provided any additional incentive for charitable gifts. It is generally argued that the charitable contributions deduction is difficult to administer and that taxpayers have difficulty complying with it because of complexity.

Selected Bibliography

Bennett, James T. and Thomas J. DiLorenzo. Unhealthy Charities: Hazardous to Your Health and Wealth, New York: Basic Books, c. 1994.

Clark, Robert Charles. "Does the Nonprofit Form Fit the Hospital Industry?" Harvard Law Review, v. 93. May 1980, pp. 1419-1489.

Feenberg, Daniel. "Are tax price models really identified: the case of charitable giving," National Tax Journal, v. 40, no. 4. December 1987, pp. 629-633.

Gergen, Mark P. "The Case for a Charitable Contributions Deduction," Virginia Law Review, v. 74. November 1988, pp. 1393-1450.

Hall, Mark A. and John D. Colombo. "The Charitable Status of Nonprofit Hospitals: Toward a Donative Theory of Tax Exemption," Washington Law Review, v. 66. April 1991, pp. 307-411.

Herzlinger, Regina E. and William S. Krasker. "Who Profits from Nonprofits?" Harvard Business Review, v. 65. January-February 1987, pp. 93-106.

Hudson, Terese. "Not-for-Profit Hospitals Fight Tax-Exempt Challenges," Hospitals, v. 64. October 20, 1990, pp. 32-37.

Hyman, David A. "The Conundrum of Charitability: Reassessing Tax Exemption for Hospitals," American Journal of Law and Medicine, v. 16, no. 3. 1990, pp. 327-380.

Schiff, Jerald. "Does Government Spending Crowd Out Charitable Contributions?" National Tax Journal, v. 38. December 1985, pp. 535- 546.

"The Demographics of Giving," American Enterprise, v. 2, September-October 1991, pp. 101-104.

U.S. Congress, House Select Committee on Aging. Hospital Charity Care and Tax Exempt Status: Resorting the Commitment and Fairness. Washington, DC: U.S. Government Printing Office, June 28, 1990.

U.S. General Accounting Office. Nonprofit Hospitals: Better Standards Needed for Tax Exemption. Washington, DC: General Accounting Office, May 30, 1990.

Weber, Nathan, ed. Giving USA, The Annual Report on Philanthropy for the Year 1991. New York, NY: American Association of Fund-Raising Counsel Trust for Philanthropy, 1991.

Zimmerman, Dennis. "Nonprofit Organizations, Social Benefits, and Tax Policy," National Tax Journal, v. 44. September 1991, pp. 341-349.

                              Medicare

 

               Exclusion of Untaxed Medicare Benefits

                     HOSPITAL INSURANCE (PART A)

                       Estimated Revenue Loss

 

                      [In billions of dollars]

___________________________________________________________________

    Fiscal year       Individuals    Corporations         Total

 

___________________________________________________________________

        1995               8.0            --               8.0

 

        1996               9.2            --               9.2

 

        1997              10.8            --              10.8

 

        1998              12.6            --              12.6

 

        1999              14.8            --              14.8

 

____________________________________________________________________

Authorization

Rev. Rul. 70-341, 1970-2 C.B. 31.

Description

Part A of Medicare, also known as hospital insurance or HI, pays for certain in-patient hospital care, skilled nursing facility care, home health care, and hospice care for eligible individuals age 65 or over or disabled.

The Medicare Part A program is financed primarily by a Federal Insurance Contributions Act (FICA) payroll tax on wage and salary income and self-employment income, levied at 1.45 percent on both the employee and employer, and paid into a trust fund. There is no cap on taxable earnings. The individual is viewed as contributing during his or her working years in exchange for receiving insurance benefits during his or her retirement years.

The employer portion of the payroll tax is not included in the employee's reportable compensation for tax purposes. In addition, because the Medicare contribution period began relatively recently (in 1966), the expected lifetime value of the hospital insurance benefits exceeds the amount of payroll tax contributions made by, or on behalf of the current cohort of beneficiaries. The subsidy components of the insurance benefits are not taxable to the beneficiaries.

Impact

All Medicare Part A beneficiaries are considered to receive the same average dollar value of in-kind insurance benefits per year. There is substantial variation among individuals, however, in the portion of those benefits covered by the person's own employee payroll tax contributions and, conversely, the remaining portion considered untaxed benefits.

This depends on the person's taxable earnings history and life expectancy over the benefits period. The untaxed benefits are likely to be larger for persons who became eligible in the earliest years of the Medicare program, who had low taxable wages or who qualified as a spouse with little or no payroll contributions of their own, and who have a long life expectancy. Beyond this, the tax expenditure value of any dollar of untaxed insurance benefits depends upon the beneficiary's marginal income tax rate during retirement.

Rationale

The exclusion of Medicare benefits from income taxation has never been expressly established by statute. The Medicare program was enacted in 1965. An IRS ruling in 1970 (Rev. Rul. 70-341) provided that the benefits under Part A of Medicare are not includable in gross income because they are in the nature of disbursements made in furtherance of the social welfare objectives of the Federal Government.

The ruling also stated that for purposes of determining an individual's gross income under section 61 of the Internal Revenue Code, basic Medicare benefits (Part A) were not legally distinguishable from the monthly social security payments to an individual. A separate ruling (Rev. Rul. 70-217, 1970-1 C.B. 13) had provided for the excludability of these social security or OASDI (old age and survivors insurance and disability insurance) benefits.

Assessment

The tax subsidy for Medicare HI lowers the apparent cost of the provision of hospital care for the elderly. It may, therefore, cause more resources to be devoted to this program than might otherwise be the case.

There are several administrative considerations that make it difficult to reduce this subsidy in a fair way among individuals. Medicare benefits remain untaxed, like most other health insurance benefits. Taxing the value of the health care benefits actually received is not considered a serious option. Expenditures on behalf of individuals who suffer serious illnesses can be very large. Taxing people heavily precisely at the time of their health misfortune is generally not considered fair.

In fact, the typical tax treatment of insurance purchased by individuals (e.g., life and property insurance) is that insurance payouts to cover reimbursable expenses are not considered taxable income. In exchange, however, the premiums paid for non-health insurance are not deductible from the individual's taxable income. One difference here is that the employer's half of the HI payroll tax contribution is free from individual income taxation. This follows the convention for the OASDI social security taxes.

Even if the average annual insurance value of the Medicare HI coverage is used as the standardized measure of benefits, there is a difference in the size of the subsidy depending upon each beneficiary's length and level of annual contributions to the HI trust fund. In general, today's cohort of beneficiaries receives a large subsidy simply because their contribution period was short and many married women had no covered earnings.

For middle and high income current beneficiaries, an additional portion of their social security payments is now subject to income taxation, with the associated revenues going to the Medicare HI trust fund. This provision of the Omnibus Budget Reconciliation Act of 1993 (P.L. 101-508), effective in 1994, applies to taxpayers with provisional income greater than adjusted base amounts of $34,000 for unmarried taxpayers or $44,000 for married taxpayers filing joint returns. For these taxpayers, up to 85 percent of their social security benefits can be included in the calculation of their gross income. The same rules apply to railroad retirement tier 1 benefits. Fewer than 10 percent of beneficiaries are expected to pay taxes on 85 percent of their social security benefits for 1994. Because the base amounts are not indexed to rise with inflation, over time a growing fraction of beneficiaries is likely to face income taxes on their social security benefits to help pay for Medicare HI.

For future retirees, the portion of the subsidy measured as HI benefits in excess of payroll tax contributions is expected to gradually decrease as the contribution period covers more of their work years. In addition, the removal of the cap on covered earnings for Medicare HI means that today's high wage earners will contribute more during their working years and consequently receive a lower (and possibly negative) subsidy as Medicare beneficiaries in the future.

Prior to 1991, the taxable earnings base for Medicare HI was the same as for social security (OASDI). The Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508) raised the cap on the maximum amount of employee earnings subject to the Medicare HI tax to $125,000 in 1991, indexed for inflation thereafter; the cap reached $130,200 for 1992 and $135,000 for 1993. The Omnibus Budget Reconciliation Act of 1993 repealed the cap on wages and self- employment income subject to the Medicare HI tax, effective in 1994. All revenues from the HI payroll tax go into the Medicare Hospital Insurance Trust Fund.

These 1990 and 1993 changes in the tax law reflect an effort to increase the financing of Medicare HI in a more progressive way than the standard alternative of raising the HI payroll tax rates on the social security earnings base.

Selected Bibliography

Christensen, Sandra. "The Subsidy Provided Under Medicare to Current Enrollees," Journal of Health Politics, Policy, and Law, v. 17, no. 2. Summer 1992, pp. 255-64.

U.S. Congressional Budget Office. Reducing Entitlement Spending. Washington, DC: September 1994, pp. 25-27, 31-38, 43-45, 52-53.

--. Subsidies Under Medicare and the Potential for Disenrollment Under a Voluntary Catastrophic Program. Washington, DC: September 1989.

                              Medicare:

 

                   Exclusion of Medicare Benefits

              SUPPLEMENTARY MEDICAL INSURANCE (PART B)

                       Estimated Revenue Loss

 

                      [In billions of dollars]

__________________________________________________________________

    Fiscal year       Individuals   Corporations         Total

 

__________________________________________________________________

        1995               5.1            --              5.1

 

        1996               6.1            --              6.1

 

        1997               7.3            --              7.3

 

        1998               8.7            --              8.7

 

        1999              10.4            --             10.4

 

____________________________________________________________________

Authorization

Rev. Rul. 70-341, 1970-2 C.B. 31.

Description

Part B of Medicare, also known as supplementary medical insurance or SMI, covers certain doctors' services, outpatient services, and other medical services (such as laboratory tests) for persons age 65 and over (or qualifying disabled individuals) who voluntarily elect to pay the required monthly premium ($4.10 per month in 1994, $46.10 per month in 1995). Currently, these premiums cover about 25 percent of the program's costs. The remaining 75 percent is covered by general revenues. The value of the general fund subsidy is not included in the gross income of enrollees for income tax purposes.

Impact

The tax expenditure benefit of the exclusion is in direct proportion to the enrollee's marginal tax rate. Unlike many other tax expenditure items where the underlying dollar amount of the deduction or exclusion can vary widely among individual taxpayers, the dollar value of the Medicare Part B general fund subsidy is the same for all enrollees. All enrollees are considered to receive the same average dollar value of in-kind insurance benefits and are charged the same monthly premium. Consequently, they receive the same subsidy measured as the difference between the value of insurance benefits and the premium. The income tax savings are greater, however, for enrollees in higher tax rate brackets.

Rationale

The exclusion of Medicare benefits has never been expressly established by statute. An IRS ruling in 1970, Rev. Rul. 70-341, repeats the findings stated in Rev. Rul. 66-216 that benefits under Part B of Medicare are excludable from taxable income under provisions of IRC section 104 as amounts received through accident and health insurance. This reasoning clearly applies to the premium- financed portion of the SMI program, but not equally to the portion financed by the general Treasury.

The exclusion of the subsidized portion of Medicare Part B benefits has been supported by the same argument that Rev. Rul. 70- 341 applied explicitly to Part A of Medicare: the benefits are not includible in gross income because they are in the nature of disbursements made in furtherance of the social welfare objectives of the Federal Government.

Assessment

Medicare benefits remained untaxed, like most other privately and publicly financed health insurance benefits.

The Part B premiums were initially intended to cover 50 percent of SMI program costs. Between 1975 and 1983 that share fell to less than 25 percent. For 1984 through 1995 the premiums were set to cover 25 percent of average benefits, under successive laws. The Omnibus Budget Reconciliation Act of 1993 (P.L. 101-508) set the premium to be equal to 25 percent of program costs for 1996 through 1998, but did not specify the dollar amount.

The tax subsidy for Medicare SMI reduces the cost of supplementary medical insurance for retirees and may cause individuals to consume too much health care. Because this transfer is not means-tested, the benefit is received by many higher income individuals and thus differs from other transfer programs.

There are no obvious administrative limitations on including the value of these subsidies in income; they could simply be assigned to individuals and reported as income on their tax return. Such a change could, however, impose a burden on older individuals of moderate means who have little flexibility to adapt to the additional tax.

Legislation reducing the size of the subsidy itself for higher income individuals would accomplish the same effect as taxation. Several health insurance reform plans advanced during 1994 contained a provision to effectively raise the Part B premiums for high income enrollees to a level that would cover 75 percent of average Medicare Part B insurance benefits per enrollee. The mechanism would be a recapture through the individual income tax. The associated revenues would be appropriated to the Medicare SMI Trust Fund. (The individual could deduct the recapture amount to the same extent as other health insurance premiums. Any employer reimbursement of the recapture amount would be excludable from the recipient's taxable income.)

Under the Clinton Administration's plan, high income was defined as modified adjusted gross income (AGI) above a threshold amount -- $90,000 for single filers, $115,000 for married couples filing jointly, and $0 for married couples filing separately. There would be a phase-in over an income range of $15,000 for single returns and $30,000 for joint returns. The proposed income thresholds were not indexed for inflation.

Selected Bibliography

Christensen, Sandra. "The Subsidy Provided Under Medicare to Current Enrollees," Journal of Health Politics, Policy, and Law, v. 17, no. 2. Summer 1992, pp. 255-64.

U.S. Congressional Budget Office. Reducing Entitlement Spending. Washington, DC: September 1994, pp. 25-27, 31-38, 43-45, 52-53.

--. Subsidies Under Medicare and the Potential for Disenrollment Under a Voluntary Catastrophic Program. Washington, DC: September 1989.

U.S. President, 1993- (Clinton). Health Security Act, Section- by-Section Analysis. Washington, DC: December 1993, pp. 239-40. (Refers to section 7131 of S. 1757, 103rd Congress, 1st session, "Recapture of Certain Health Care Subsidies Received by High-Income Individuals.")

                           Income Security

             EXCLUSION OF WORKERS' COMPENSATION BENEFITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

___________________________________________________________________

    Fiscal year       Individuals   Corporations          Total

 

___________________________________________________________________

        1995              3.9             --               3.9

 

        1996              4.0             --               4.0

 

        1997              4.2             --               4.2

 

        1998              4.4             --               4.4

 

        1999              4.6             --               4.6

 

____________________________________________________________________

Authorization

Section 104(a)(1).

Description

Workers' compensation benefits to employees in cases of work- related injury, and to survivors in cases of work-related death, are not taxable. However, workers' compensation cash benefits are counted in determining whether social security or railroad retirement benefits are taxed and may lead to taxation of those benefits. Employers finance benefits through insurance or self-insurance arrangements (with no employee contribution), and their costs are treated as a business expense and not taxed.

Benefits are provided as directed by various State and Federal laws and consist of cash earnings-replacement payments, payment of injury-related medical costs, special payments for physical impairment (regardless of lost earnings), and coverage of certain injury or death-related expenses (e.g., burial costs). Employees and survivors receive compensation if the injury or death is work- related; no proof of employer negligence is needed, and workers' compensation is treated as the sole remedy for work-related injury or death.

Cash earnings replacement payments typically are set at two- thirds of lost pre-tax earning capacity, up to legislated maximum amounts. They are provided for both total and partial disability, generally last for the term of the disability, may extend beyond normal retirement age, and are paid as periodic (e.g., monthly) payments or lump-sum settlements.

Impact

In 1991, workers' compensation benefits totaled $40.8 billion, 59 percent ($24.1 billion) of which represented cash payments to replace earnings. Employer costs of nearly $55 billion in 1991 represented 2.4 percent of covered payrolls.

The Census Bureau's current population survey gives the following profile of those who reported receiving workers' compensation in 1990:

o Total family income (including workers' compensation) was

 

below $15,000 for 16 percent of recipients, between $15,000

 

and $30,000 for 30 percent, between $30,000 and $45,000 for 26

 

percent, and above $45,000 for 28 percent; 7 percent had

 

family income below the Federal poverty thresholds.

o Recipients' income (including workers' compensation) was below

 

$15,000 for 40 percent, between $15,000 and $30,000 for 38

 

percent, between $30,000 and $45,000 for 16 percent, and above

 

$45,000 for 6 percent.

o Workers' compensation cash benefits were less than $5,000 for

 

73 percent of recipients, between $5,000 and $10,000 for 15

 

percent, between $10,000 and $15,000 for 8 percent, and more

 

than $15,000 for 4 percent.

Rationale

This exclusion was first codified in the Revenue Act of 1918. But the committee reports accompanying the Act suggest that workers' compensation payments were not subject to taxation before the 1918 Act. No rationale for the exclusion is found in the legislative history. But it has been maintained that workers' compensation should not be taxed because it is in lieu of court-awarded damages for work- related injury or death that, before enactment of workers' compensation laws (beginning shortly before the 1918 Act), would have been payable under tort law for personal injury or sickness and not taxed.

While the legislative history of the requirement for taxing some social security and railroad retirement benefits shows no rationale for indirectly "taxing" workers' compensation payments through their effect on taxation of social security and railroad retirement benefits, it is argued for on grounds of equity: providing the same tax treatment of disability benefits to those with and without workers' compensation.

Assessment

Exclusion of workers' compensation benefits from taxation increases the value of these benefits to injured employees and survivors, without direct cost to employers, through a tax subsidy. Taxation of workers' compensation would put it on a par with the earned income it replaces and other employer-provided accident and sickness benefits. It also would place the "true" cost of workers' compensation on employers. Unless compensation benefits were increased in response to taxation, employer costs would likely remain unchanged, and it is possible that "marginal" claims would be reduced.

Furthermore, exclusion of workers' compensation payments from taxation is a relatively inefficient subsidy, replacing more income for (and worth more to) those with higher earnings and other taxable income than poorer households. While States have tried to correct for this with legislated maximum benefits and by calculating payments based on replacement of after-tax income, the maximums provide only a rough adjustment and few jurisdictions have moved to after-tax income replacement.

On the other hand, a case can be made for tax subsidies for workers' compensation because the Federal and State Governments have required provision of this "no-fault" benefit. Moreover, because most workers' compensation benefit levels, especially the legal maximums, have been established knowing there would be no taxes levied, it is likely that taxation of compensation would lead to considerable pressure to increase payments.

If workers' compensation earnings replacement payments were to be subjected to taxation, those with short-term or partial disabilities enabling them to continue working and those with other taxable income would likely be most affected. These groups form the overwhelming majority of beneficiaries. By and large, those who receive only workers' compensation payments, such as totally disabled long-term beneficiaries, would be affected much less.

Some administrative issues would arise in implementing a tax on workers' compensation. Although most workers' compensation awards are made as periodic cash income replacement payments and separate payments for medical and other expenses, a noticeable proportion of the awards are in the form of lump-sum settlements. In some cases, the portion of the settlement attributable to income replacement can be distinguished from that for medical and other costs, in others it cannot. A procedure for pro-rating lump-sum settlements over time would be called for, and, if taxation of compensation were targeted on income replacement payments, some method of identifying them in lump-sum settlements where they are not would have to be devised. In addition, a reporting system would have to be established for insurers (who pay most benefits), State workers' compensation insurance "funds," and self-insured employers (e.g., a new kind of "1099"), and a way of withholding taxes might be needed.

Equity questions also would arise in taxing compensation. Some of the work force is not covered by traditional workers' compensation laws. For example, interstate railroad employees and seafaring workers have a special court remedy that allows them to sue their employer for negligence damages, similar to the system for work- related injury and death benefits that workers' compensation laws replaced for most workers. Their jury-awarded compensation is not taxed. Some workers' compensation awards are made for physical impairment, without regard to lost earnings. Under current tax law, employer-provided accident and sickness benefits generally are taxable, but payments for loss of bodily functions are excludable. Here, equity might call for continuing to exclude those workers' compensation payments that are made for loss of bodily functions as opposed to lost earnings. Finally, States would face a decision on taxing compensation, jurisdictions that use after-tax income replacement would be called on to change, and the current indirect taxation of workers' compensation through taxation of disability benefits would have to be revised or ended.

Selected Bibliography

Burton, John F., and Timothy P. Schmidle, eds. Workers' Compensation Desk Book. Horsham, PA: LRP Publications, 1992, pp. I 88-95.

Nelson, William J. "Workers' Compensation: Coverage, Benefits, and Costs, 1990-91," Social Security Bulletin, v. 56. Fall 1993, pp. 68-74.

Richardson, Joe. Workers' Compensation. Library of Congress, Congressional Research Service Report 91-396 EPW. Washington, DC: May 6, 1991.

Social Security Administration, Office of Research and Statistics. Social Security Programs in the United States, v. 54, no. 9. Social Security Bulletin, September 1991, pp. 28-37.

Wentz, Roy. "Appraisal of Individual Income Tax Exclusions," Tax Revision Compendium. U.S. Congress, House Committee on Ways and Means Committee Print. 1959, pp. 329-340.

Yorio, Edward. "The Taxation of Damages: Tax and Non-Tax Policy Considerations," Cornell Law Review, v. 62. April 1977, pp. 701-736.

                           Income Security

                    EXCLUSION OF SPECIAL BENEFITS

 

                      FOR DISABLED COAL MINERS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

    Fiscal year      Individuals    Corporations        Total

 

____________________________________________________________________

        1995              0.1             --              0.1

 

        1996              0.1             --              0.1

 

        1997              0.1             --              0.1

 

        1998              0.1             --              0.1

 

        1999              0.1             --              0.1

 

____________________________________________________________________

Authorization

30 U.S.C. 924(c), 104(a)(1), Revenue Ruling 72-400, 1972-2 C.B. 75.

Description

Benefits to coal mine workers or their survivors for total disability or death resulting from coal workers' pneumoconiosis (black lung disease) paid under the Black Lung Benefits Act generally are not taxable; comparable benefits under State workers' compensation laws also are not taxed.

However, as with workers' compensation, certain black lung payments (part C benefits, see below) can affect the taxation of social security and railroad retirement disability benefits if a beneficiary receives both black lung and disability payments. Black lung benefits consist of monthly cash payments and payment of black- lung-related medical costs.

There are two distinct programs providing black lung benefits, although the benefits are the same: monthly cash payments and coverage of black-lung-related medical costs. The part B program is financed by annual Federal appropriations, and benefits are provided to those who filed claims prior to June 30, 1973 (or December 31, 1973, in the case of survivors). The part C program applies to claims filed after the part B deadlines; these benefits are paid either by the "responsible" coal mine operator or, in most cases, by the Black Lung Disability Trust Fund (BLDTF).

To pay their obligations, coal mine operators may set up special "self-insurance trusts," contributions to which are tax deductible, or otherwise fund their liability (typically, through insurance arrangements) and avoid tax for the cost of providing benefits. The BLDTF is financed by an excise tax on coal and borrowing from the Federal Treasury; it also pays the medical costs of part B beneficiaries.

Black lung claims must meet the following general conditions: the worker must be totally disabled from, or have died of, pneumoconiosis arising out of coal mine employment. However, there are certain statutory "presumptions" of eligibility, and it is possible for a beneficiary to be working outside the coal industry (although earnings tests apply in some cases). Part C payments are considered workers' compensation and, in some instances, affect any social security or railroad retirement disability benefits; part B benefits do not.

Impact

Part B cash payments to 177,000 beneficiaries totaled $794 million in fiscal year 1993. However, virtually all recipients are over 65 years old, and this caseload is declining by over 20,000 a year; more than 75 percent of beneficiaries are single widows or other survivors. Part C cash payments to some 90,000 primary beneficiaries (disabled coal mine workers, widows, and other surviving dependents) totaled approximately $490 million in 1993. Disabled workers make up just over half the part C primary beneficiaries. As with part B, the part C rolls are declining, but at a much slower rate because new claims continue to be approved. In 1994, black lung cash payments range between $5,129 and $10,258 a year (depending on the number of dependents).

Rationale

Part B payments are excluded under the terms of title IV of the original Federal Coal Mine Health and Safety Act of 1969 (now entitled the Black Lung Benefits Act). No specific rationale for this exclusion is found in the legislative history. Part C benefits have been excluded because they are considered to be in the nature of workers' compensation under a 1972 revenue ruling and fall under the workers' compensation exclusion of section 104(a)(1).

Assessment

Excluding black lung payments from taxation increases their value to some beneficiaries, those with other taxable income; the payments themselves fall well below Federal income tax thresholds. However, the effect of taxing black lung benefits and the factors to be considered in deciding on their taxation differ between part B and part C payments.

Part B benefits could be viewed as earnings replacement payments and, thus, appropriate for taxation, as with workers' compensation. However, it would be difficult to argue for their taxation, especially now that practically all recipients are elderly retirees. When part B benefits were enacted, the legislative history emphasized that they were not workers' compensation, but rather a "limited form of emergency assistance." They also were seen as a way of compensating for the lack of health and safety protections for coal miners prior to the 1969 Act and the fact that existing workers' compensation systems rarely compensated for black lung disability or death.

Furthermore, it can be maintained that, in effect, taxation of part B payments takes back with one hand what Federal appropriations give with the other, although almost no beneficiaries would likely be affected given their age and retirement status.

A stronger argument can be made for taxing part C benefits, and, if workers' compensation were to be made taxable, they would automatically be taxed because their tax-exempt status flows from their treatment as workers' compensation. Taxing part C payments would give them the same treatment as the earnings they replace and remove a relatively inefficient governmental subsidy to those with other taxable income (a noticeable proportion of part C recipient households, unlike part B households), although, because those on the part C rolls are aging, the effect of taxing their benefits should decline over time. On the other hand, black lung benefits are legislatively established (a percentage of minimum Federal salaries, not directly reflective of a worker's pre-injury earnings as in workers' compensation) and can be viewed as a special kind of disability or death "grant" that should not be taxed.

Finally, equity would call for taxing black lung payments only if workers' compensation also were taxed, and the current indirect "taxation" of black lung benefits through rules for taxing disability payments would have to be revised or ended.

Selected Bibliography

Barth, Peter S. The Tragedy of Black Lung: Federal Compensation for Occupational Disease. Kalamazoo, Mich.: W.E. Upjohn Institute for Employment Research, 1987.

McClure, Barbara. Federal Black Lung Disability Benefits Program. Library of Congress, Congressional Research Service Report 81-239 EPW. Washington, DC: October 27, 1981.

--. Summary and Legislative History of P.L. 97-119, Black Lung Benefits Revenue Act of 1981. Library of Congress, Congressional Research Service Report 82-59 EPW. Washington, DC: March 29, 1982.

U.S. Congress, House Committee on Education and Labor. Black Lung Benefits Reform Act and Black Lung Benefits Revenue Act of 1977. Committee Print, 96th Congress, 1st session, February 1979.

--, Committee on Ways and Means. Black Lung Benefits Trust Report to Accompany H.R. 13167. House Report No. 95-1656, 95th Congress, 2nd session, 1978.

--. Overview of Entitlement Programs: 1993 Green Book. Committee Print No. 103-18. 103d Congress, 1st session, July 7, 1993, pp. 1715- 1720.

--, Senate Committee on Finance. Tax Aspects of Black Lung Benefits Legislation. Hearing, 94th Congress, 2nd session, on H.R. 10706, September 21, 1976.

--, Committee on Finance, Subcommittee on Taxation and Debt Management Generally. Tax Aspects of the Black Lung Benefits Reform Act of 1977. Hearing, 95th Congress, 1st session, on S. 1538, June 17, 1977.

Walter, Douglas H. "Tax Changes Effected by the Black Lung Revenue Act of 1977." Taxes, v. 56. May 1978, pp. 251-254.

                           Income Security

               EXCLUSION OF PUBLIC ASSISTANCE BENEFITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

__________________________________________________________________

    Fiscal year      Individuals     Corporations        Total

 

__________________________________________________________________

        1995              0.5             --              0.5

 

        1996              0.5             --              0.5

 

        1997              0.6             --              0.6

 

        1998              0.6             --              0.6

 

        1999              0.7             --              0.7

 

____________________________________________________________________

Authorization

The exclusion of public assistance payments is not specifically authorized by law. However, a number of revenue rulings under section 61 of the Internal Revenue Code, which defines "gross income," have declared specific types of means-tested benefits to be nontaxable.

Description

The Government provides public assistance benefits tax free to individuals either in the form of cash welfare or as in-kind benefits (certain goods and services received free or for an income-scaled charge). Cash payments come from the Federal-State programs of Aid to Families with Dependent Children (AFDC), Supplemental Security Income (SSI) for the aged, blind, or disabled, and State-local programs of General Assistance (GA), known also by other names such as Home Relief.

(In addition, certain payments for foster care of children, including those made on behalf of children eligible for AFDC, are tax free, as are "difficulty-of-care" payments for foster children. Exclusion of these foster care payments from taxation is required by section 131 of the Internal Revenue Code. They are discussed elsewhere in this report, under "Social Services.")

Traditionally, the tax benefits from in-kind payments have NOT been included in the tax expenditure budget because of the difficulty of determining their value to recipients. (However, the Census Bureau publishes estimates of the value and distribution of major noncash welfare benefits.)

Impact

Exclusion of public assistance cash payments from taxation gives no benefit to the poorest recipients and has scant impact on the incomes of many. This is because welfare payments are relatively low and many recipients have little if any non-transfer cash income. For example, 80 percent of AFDC families in 1992 reported having zero other cash income, and AFDC payments that year averaged $383 monthly per family (three persons), far below the tax threshold. If AFDC payments were made taxable, most recipients still would owe no tax.

However, some welfare recipients do benefit from the exclusion of public assistance cash payments. They are persons who receive relatively high cash aid (including aged, blind, and disabled persons enrolled in SSI in States that supplement the basic Federal income guarantee, which is $446 monthly per individual and $669 per couple in 1994) and persons who have earnings for part of the year and public assistance for the rest of the year (and whose actual annual cash income would exceed the taxable threshold if public assistance were not excluded). Public assistance benefits are based on monthly income and thus families whose fortunes improve during the year generally keep welfare benefits received earlier.

The Census Bureau has estimated, on the basis of information collected in the March 1993 Current Population Survey, that in 1992, $34.9 billion was received in means-tested cash transfers from the programs of AFDC, SSI, GA, and veterans' pensions. (Note: The Bureau indicates that this estimate is below actual payments, as income was underreported in the survey.) Veterans' pensions were grouped with AFDC because they are income-tested, but in this tax expenditure report they are discussed elsewhere, under "veterans' benefits and services."

Analysis of the Census Bureau report (P60-186RD), which

 

focussed on measuring the effect of benefits and taxes on income and

 

poverty, indicates that 55 percent of these means-tested cash

 

transfers went to the Nation's poorest households, that is, to those

 

in the bottom fifth of the pre-tax money income distribution; 20

 

percent went to households in the second quintile, 11 percent to the

 

middle quintile, 8 percent to the fourth quintile, and 6 percent to

 

the top quintile. Thus, if cash transfers were made taxable, some

 

households would have to pay higher income taxes.

The Census Bureau's estimate of the 1992 value of major NONCASH means-tested benefits ($49.5 billion) exceeded that of cash aid. The Bureau estimated the fungible value of medicaid at $19.6 billion ($1,595 on average per recipient household) and the value of other noncash aid at $26.3 billion: food stamps, $13.3 billion ($1,564 on average per recipient household); housing assistance, $9 billion ($2,022 per recipient household), and free or reduced-price school lunches, $3.9 billion ($553 per recipient household).

The fungible value approach counts medicaid benefits as income only "to the extent that they free up resources that could have been spent on medical care." Thus, the estimated value of medicaid is zero unless family income exceeds the cost of food and housing requirements. The Bureau sets the income value of food stamps equal to their face value and that of school lunches at their full subsidy value. Income value of housing subsidies is calculated by a complex procedure that is based on the 1985 American Housing Survey.

In Fiscal Year 1994, a monthly average of about 14.31 million persons in 5.1 million families are expected to receive $22.7 billion in AFDC benefits ($10.2 billion funded by States and localities), and a monthly average of 6.3 million persons are expected to receive $29 billion in federally administered SSI benefits ($3.5 billion funded by States as SSI supplements). Most of these recipients of cash aid also receive noncash aid. All AFDC recipients and most SSI recipients automatically are eligible for medicaid, and most also receive food stamps.

Rationale

Revenue rulings generally exclude government transfer payments from income because they have been considered to have the nature of "gifts" in aid of the general welfare. While no specific rationale has been advanced for this exclusion, the reasoning may be that the Congress did not intend to tax with one hand what it gives with the other.

Assessment

Several reasons are advanced for treating means-tested cash payments as taxable income. First, excluding these cash payments results in treating persons with the same cash income differently. Second, removing the exclusion would not harm the poorest because their total cash income still would be below the tax threshold. Third, the Nation's general view of cash welfare has changed.

Cash benefits to AFDC families now widely are regarded not as "gifts" but as payments that impose obligations on able-bodied parents to work or prepare for work through schooling or training, and many GA programs require work. Thus, it may no longer be appropriate to treat cash welfare transfers as gifts. (The SSI program imposes no work obligation, but offers a financial reward for work.)

Fourth, the exclusion of cash welfare from taxation increases the work disincentives inherent in need-tested aid. A welfare recipient who goes to work replaces some nontaxable cash with taxable income. This increases his/her potential "marginal tax" rate. (When recipients work, they face reduction in need-tested benefits, and the benefit-loss rate acts like a form of marginal tax rate.)

Fifth, the 1986 decision to tax all unemployment compensation (and the earlier decision to tax a portion of social security benefits of higher income recipients) began a reform, on grounds of equity, for social insurance benefits that should be extended to means-tested cash aid. Sixth, using the tax system to subsidize needy persons without direct spending masks the total cost of aid and is inefficient, benefiting primarily those with other income.

Several objections are made to the removal of the tax exemption from means-tested cash transfers. First, cash welfare programs provide guarantees of minimum cash income that presumably represent target levels of disposable income. Making these benefits taxable might reduce disposable income below the targets.

Second, in every State unless the tax threshold were set high enough, some persons deemed needy by their State might be harmed by the change. Third, AFDC and SSI minimum income guarantees differ by State, but the Federal tax threshold is uniform for taxpayers with the same filing status and family size. If cash welfare payments were made taxable, the actual effect would vary among the States.

For instance, an aged person whose only cash income was SSI would become subject to 1994 Federal income tax in California, Alaska, and Connecticut, all of which provide large SSI supplements. But in States with no supplement, or one smaller than $150 monthly, recipients would remain free of the income tax. Although AFDC income guarantees in all States are below tax thresholds, the shortfall varies widely, ranging from $156 monthly in Alaska to $959 in Mississippi for the average AFDC family, a mother with two children.

Third, if cash welfare were made taxable, it is argued that noncash welfare also should be counted (raising difficult measurement issues). Further, if noncash means-tested benefits were treated as income, it is argued that noncash income (ranging from employer-paid health insurance to tax deductions for home mortgage interest) also should be counted, raising new problems. Fourth, the public might perceive the change as violating the social safety net, and, thus, object.

Two other issues are raised by the proposal. New administrative machinery would be needed; at the least, welfare offices would have to prepare annual reports (Form 1099) on cash payments made to recipients. Also, States that gear their income tax to the Federal income tax system would be affected by the change.

Selected Bibliography

deSeve, Charles W., and Thomas E. Vasquez. "The Impact of Changes in the Federal Tax Code on State Tax Revenues," National Tax Journal, v. 37, no. 3. September 1984, pp. 393-409.

Goode, Richard. The Individual Income Tax. Rev. ed. Washington, DC: The Brookings Institution, 1976, pp. 100-105.

Hall, Robert E., and Alvin Rabushka. Low Tax, Simple Tax, Flat Tax. McGraw-Hill, 1983, pp. 96-101.

Howard, Christopher. "The Hidden Side of the American Welfare State." Political Science Quarterly, v. 108, no. 3, Fall 1993: 403- 436.

Lewis, Gordon H., and Richard J. Morrison. Interactions Among Social Welfare Programs. Discussion Paper #866-88, University of Wisconsin-Madison, Institute for Research on Poverty.

Sunley, Emil M. Jr. "Employee Benefits and Transfer Payments," Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 102-106.

U.S. Dept. of Commerce, Bureau of the Census. Measuring the Effect of Benefits and Taxes on Income and Poverty: 1990. Current Population Reports. Consumer Income Series P-60, No. 176-RD. August 1991.

                           Income Security

             NET EXCLUSION OF PENSION CONTRIBUTIONS AND

 

                    EARNINGS PLANS FOR EMPLOYEES

 

               AND SELF-EMPLOYED INDIVIDUALS (KEOUGHS)

                       Estimated Revenue Loss

 

                      [In billions of dollars]

____________________________________________________________________

    Fiscal year       Individuals    Corporations         Total

 

____________________________________________________________________

        1995              72.5            --               72.5

 

        1996              76.8            --               76.8

 

        1997              81.5            --               81.5

 

        1998              86.5            --               86.5

 

        1999              91.8            --               91.8

 

____________________________________________________________________

Authorization

Sections 401-407, 410-418E, and 457.

Description

Employer contributions to qualified pension, profit-sharing, stock-bonus, and annuity plans on behalf of an employee are not taxable to the employee. The employer is allowed a current deduction for these contributions (within limits). Earnings on these contributions are not taxed until distributed.

The employee or the employee's beneficiary is generally taxed on benefits when benefits are distributed. (In some cases, employees make direct contributions to plans that are taxed to them as wages; these previously taxed contributions are not subject to tax when paid as benefits).

A pension, profit-sharing, or stock-bonus plan is a qualified plan only if it is established by an employer for the exclusive benefit of employees or their beneficiaries. In addition, a plan must meet certain requirements, including standards relating to nondiscrimination, vesting, requirements for participation, and survivor benefits. Nondiscrimination rules are designed to prevent the plans from primarily benefitting highly paid, key employees. Vesting refers to the period of employment necessary to obtain non- forfeitable pension rights.

Tax-favored pension plans, referred to as Keogh plans, are also allowed for the self-employed; they account for only a small portion of the cost ($3.1, $3.3, $3.5, $3.7, and $3.9 billion in 1995-1999).

There are two major types of pension plans: defined-benefit plans, where employees are ensured of a certain benefit on retirement, and defined-contribution plans, where employees have a right to accumulated contributions (and earnings on those contributions).

The tax expenditure is measured as the tax revenue that the government does not currently collect on contributions and earnings amounts, offset by the taxes paid by on pensions by those who are currently receiving retirement benefits.

Impact

Pension plan treatment allows an up-front tax benefit by not including contributions in wage income. In addition, earnings on invested contributions are not taxed, although tax is paid on both original contributions and earnings when amounts are paid as benefits. The net effect of these provisions, assuming a constant tax rate, is effectively tax exemption on the return. (That is, the rate of return on the after-tax contributions is equal to the pre-tax rate of return). If tax rates are lower during retirement years than during the years of contribution and accumulation, there is a "negative" tax. (In present value terms, the government loses more than it receives in taxes).

The employees who benefit from this provision consist of taxpayers whose employment is covered by a plan and whose service has been sufficiently continuous for them to qualify for benefits in a company or union-administered plan. The benefit derived from the provision by a particular employee depends upon the level of tax that would have been paid by the employee if the provision were not in effect.

Munnell (1992) reports that pensions as a share of income for households over age 65 constituted 2.5 percent of the lowest quintile of households, 6.2 percent for the second quintile, 13.7 percent for the middle quintile, and approximately twenty percent for the top two quintiles.

There are several reasons that the tax benefit accrues disproportionately to higher-income individuals. First, employees with lower salaries are less likely to be covered by an employer plan. For example, in 1988, only 13 percent of individuals earning less than $10,000 and 39 percent of individuals earning between $10,000 and $15,000 were covered by retirement plans; the ratio rises until 73 percent of individuals earning over $30,000 are covered.

Although some of these differences reflect the correlation between low income and age, the Congressional Budget Office (1987) found differences in coverage to hold across age groups (data are for 1983). For example, in the 45-64 age group, where overall coverage was 63 percent, only 34 percent of employees with incomes under $10,000 were covered, 57 percent with incomes from $10,000 to $15,000 were covered, 71 percent for incomes from $15,000 to $20,000 were covered, and 80 percent or more of the remaining employees were covered.

In addition to lower numbers of lower-income individuals being covered by the plans, the dollar contributions are much larger for higher-income individuals. This disparity occurs not only because of their higher salaries, but also because of the integration of many plans with social security. Under a plan that is integrated with social security, employer-derived social security benefits or contributions are taken into account as if they were provided under the plan in testing whether the plan discriminates in favor of employees who are officers, shareholders, or highly compensated. These integration rules allow a smaller fraction of income to be allocated to pension benefits for lower-wage employees.

Finally, higher-income individuals derive a larger benefit from tax benefits because their tax rates are higher and thus the value of tax reductions are greater.

In addition to differences across incomes, workers are more likely to be covered by pension plans if they work in certain industries, if they are employed by large firms, or if they are unionized.

Rationale

The first income tax law did not address the tax treatment of pensions, but Treasury Decision 2090 in 1914 ruled that pensions paid to employees were deductible to employers. Subsequent regulations also allowed pension contributions to be deductible to employers, with income assigned to various entities (employers, pension trusts, and employees). Earnings were also taxable. The earnings of stock- bonus or profit-sharing plans were exempted in 1921 and the treatment was extended to pension trusts in 1926.

Like many early provisions, the rationale for these early decisions was not clear, since there was no recorded debate. It seems likely that the exemptions may have been adopted in part to deal with technical problems of assigning income. In 1928, deductions for contributions to reserves were allowed.

In 1938, because of concerns about tax abuse (firms making contributions in profitable years and withdrawing them in loss years), restrictions were placed on withdrawals unless all liabilities were paid.

In a major development, in 1942 the first anti-discrimination rules were enacted, although these rules allowed integration with social security. These regulations were designed to prevent the benefits of tax deferral from being concentrated among highly compensated employees. Rules to prevent over-funding (which could allow pension trusts to be used to shelter income) were adopted as well.

Non-tax legislation in the Taft-Hartly Act of 1947 affected collectively bargained multi-employer plans and the Welfare and Pensions Plans Disclosure Act of 1958 added various reporting, disclosure and other requirements.

In 1962, the Self-Employed Individuals Retirement Act allowed self-employed individuals to establish tax-qualified pension plans, known as Keogh (or H.R. 10) plans, which also benefitted from deferral.

Another milestone in the pension area was the Employee Retirement Income Security Act of 1974, which provided minimum standards for participation, vesting, funding, and plan asset management, along with creating the Pension Benefit Guaranty Corporation (PBGC) to provide insurance of benefits. Limits were established on the amount of benefits paid or contributions made to the plan, with both dollar limits and percentage-of-pay limits.

A variety of changes have occurred since this last major revision. In 1978, simplified employee pensions (SEPS) and tax- deferred savings (401(k)) plans were allowed. The limits on SEPS and 401(k)'s were raised in 1981. In 1982, limits on pensions were cut back and made the same for all employer plans, and special rules were established for "top-heavy" plans. The 1982 legislation also eliminated disparities in treatment between corporate and noncorporate (i.e., Keogh) plans, and introduced further restrictions on vesting and coverage.

The Deficit Reduction Act of 1984 maintained lower limits on contributions, and the Retirement Equity Act of that same year revised rules regarding spousal benefits, participation age, and treatment of breaks in service.

In 1986, a variety of changes were enacted, including substantial reductions in the maximum contributions under defined- contribution plans, and a variety of other changes (anti- discrimination rules, vesting, integration rules). In 1987, rules to limit under-funding and over-funding of pensions were adopted.

Assessment

To tax defined-benefit plans can be very difficult since it is not always easy to allocate pension accruals to specific employees. It might be particularly difficult to allocate accruals to individuals who are not vested. This complexity would not, however, preclude taxation of trust earnings at some specified rate.

The major economic justification for the favorable tax treatment of pension plans is that they are argued to increase savings and increase retirement security. The effects of these plans on savings and overall retirement income are, however, subject to some uncertainty.

The incentive to save relies on an individuals realizing tax benefits on savings about which he can make a decision. Since individuals cannot directly control their contributions to plans in many cases (defined-benefit plans), or are subject to a ceiling, the tax incentives to save may not be very powerful, because tax benefits relate to savings that would have taken place in any case. At the same time, pension plans may force saving and retirement income on employees who otherwise would have total savings less than their pension-plan savings. The empirical evidence is mixed, and it is not clear to what extent forced savings is desirable.

There has been some criticism of tax benefits to pension plans, because they are only available to individuals covered by employer plans. Thus they violate the principle of horizontal equity (equal treatment of equals). They have also been criticized for disproportionately benefitting high-income individuals.

Selected Bibliography

Cagan, Philip. The Effect of Pension Plans on Aggregate Savings. New York: Columbia University Press, 1965.

Gravelle, Jane G. Economic Effects of Taxing Capital Income, Chapter 8. Cambridge, MA: MIT Press, 1994.

Hubbard, R. Glenn. "Do IRAs and Keoghs Increase Savings?" National Tax Journal, v. 37. March 1984, pp. 43-54.

Ippolito, Richard. "How Recent Tax Legislation Has Affected Pension Plans," National Tax Journal, v. 44. September 1991, pp. 405- 417.

Katona, George. Private Pensions and Individual Savings, Survey Research Center, Institute for Social Research, University of Michigan, 1965.

Lindeman, David, and Larry Ozanne. Tax Policy for Pensions and Other Retirement Savings. U.S. Congress, Congressional Budget Office. Washington, DC: U.S. Government Printing Office, April 1987.

Munnell, Alicia. "Are Pensions Worth the Cost?" National Tax Journal, v. 44. September 1991, pp. 406-417.

--. "Current Taxation of Qualified Plans: Has the Time Come?" New England Economic Review. March-April 1992, pp. 12-25.

--. "The Impact of Public and Private Pension Schemes on Saving and Capital Formation, Conjugating Public and Private: The Case of Pensions. Geneva: International Social Security Association, Studies and Research No. 24, 1987.

--. "Private Pensions and Saving: New Evidence," Journal of Political Economy, v. 84. October 1976, pp. 1013-1032.

U.S. Congress, House Committee on Ways and Means. Overview of Entitlement Programs: 1994 Green Book, Committee Print, 103rd Congress, 2nd session. July 15, 1994, pp. 680-686.

U.S. Department of Labor, Pension and Welfare Benefits Administration, Trends in Pensions. Washington, DC: U.S. Government Printing Office, 1989.

U.S. Department of Treasury. Report to Congress on the Effect of the Full Funding Limit on Pension Benefit Security. Department of the Treasury, May 1991.

U.S. General Accounting Office. Effects of Changing the Tax Treatment of Fringe Benefits. Washington, DC: U.S. Government Printing Office, April 1992.

Utgoff, Kathleen. "Public Policy and Pension Regulation," National Tax Journal, v. 44. September 1991, pp. 383-391.

                           Income Security

                     INDIVIDUAL RETIREMENT PLANS

 

              (EXCLUSION OF CONTRIBUTIONS AND EARNINGS)

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

            Fiscal year  Individuals  Corporations  Total

 

_____________________________________________________________________

               1995          8.4           --        8.4

 

               1996          8.7           --        8.7

 

               1997          9.2           --        9.2

 

               1998          9.7           --        9.7

 

               1999         10.2           --       10.2

 

_____________________________________________________________________

Authorization

Sections 219 and 408.

Description

An individual generally is entitled to deduct from gross income the amount contributed to an individual retirement account (IRA). Earnings are not taxable, although withdrawals from the plan will be taxed upon receipt.

The deduction for contributions is phased out for active participants in a pension plan at adjusted gross incomes of $40,000 to $50,000 for a joint return, and $25,000 to $35,000 for a single return. These individuals are still eligible for deferral of tax on earnings, which will not be taxed until withdrawn. Withdrawals from these non-deductible IRAs allow tax-free recovery of original contributions.

The annual deduction limit for IRA contributions is the lesser of $2,000 or 100 percent of compensation. An individual is eligible for the deduction so long as the individual has compensation includable in gross income and has not attained age 70 1/2 before the close of the taxable year.

A married taxpayer who is eligible to set up an IRA is permitted to make deductible contributions to an IRA for the benefit of the nonworking spouse. The maximum combined annual contribution for both spouses to the two IRAs is 100 percent of earned income or $2,250, whichever is less. In no event may a deductible contribution in excess of $2,000 be made to the account of either spouse for a year.

Distributions made before age 59 1/2 (other than those attributable to disability or death) are subject to an additional 10- percent income tax unless they are rolled over to another IRA or to an employer plan.

If an individual borrows from an IRA or uses amounts in an IRA as security for a loan, then the transaction is treated as a distribution and the usual tax rules for distributions apply. Distributions must begin after age 70 1/2.

The tax expenditure estimates reflect the net of tax losses due to failure to tax contributions and current earnings in excess of taxes paid on withdrawals.

Impact

Deductible IRAs allow an up-front tax benefit by deducting contributions along with not taxing earnings, although tax is paid when earnings are withdrawn. The net overall effect of these provisions, assuming a constant tax rate, is the equivalent of tax exemption on the return. (That is, the individual earns the pre-tax rate of return on his after-tax contribution). If tax rates are lower during retirement years than they were during the years of contribution and accumulation, there is a "negative" tax on the return. Non-deductible IRAs benefit from a postponement of tax rather than an effective forgiveness of taxes, as long as they incur some tax on withdrawal.

IRAs tend to be less focused on higher-income levels than some types of capital tax subsidies, in part because they are capped at a dollar amount. Their benefits do tend, nevertheless, to accrue more heavily to the upper half of the income distribution. This effect occurs in part because of the low participation rates at lower income levels. In 1985, only 2.3 percent of taxpayers with incomes below $10,000 participated and 13.6 percent of taxpayers with incomes of $10,000 to $30,000 participated. Participation rates rose until they equaled about three-quarters at income levels over $75,000. Further, the lower marginal tax rates at lower income levels make the tax benefits less valuable.

The current tax expenditure reflects three types of revenue losses. The first is due to the pre-1987 deductible IRAs, which were available either to all individuals (1982 to 1986) or to individuals with pension plans (1974-1981). The tax expenditure is the foregone taxes on earnings of these IRAs offset by the taxes paid on withdrawal. The distribution table below (based on Stevens and Shaffer (1992) shows the distribution of tax savings from IRA contributions in 1986. This distribution is probably typical of the tax benefits accruing to 1987 IRAs. (The median tax return in 1986 had adjusted gross income of less than $20,000.)

The second is the benefit for those eligible after 1986, a distribution less concentrated at higher income levels because of the dollar ceiling. This part of the tax expenditure is the foregone taxes on earnings plus up-front deductions, offset by any tax on benefits. This distribution is also shown in the table below, by applying the same marginal tax rates to the 1987 distribution of IRA deductions. This activity is more limited, as contributions fell from $38 billion in 1986 to $14 billion in 1987.

A final source is contributions to non-deductible IRAs. This part of the tax expenditure would simply be foregone earnings on these non-deductible IRAs. There is little information about the extent of this activity. These IRAs would be concentrated at the upper end of the income distribution.

          ESTIMATED PERCENTAGE DISTRIBUTION OF IRA BENEFITS

_____________________________________________________________________

 

          Income Class             1986           1987

 

_____________________________________________________________________

          less than $10,000         1.4            1.9

 

          $10,000-$30,000          15.3           28.2

 

          $30,000-$50,000          36.4           44.7

 

          $50,000-$75,000          26.9           12.1

 

          $75,000-$100,000          9.8            5.6

 

          Over $100,000            10.2            6.5

 

____________________________________________________________________

Rationale

The provision for IRAs was enacted in 1974, but it was limited to individuals not covered by pension plans. The purpose of IRAs was to reduce discrimination against these individuals.

In 1976, the benefits of IRAs were extended to a limited degree to the nonworking spouse of an eligible employee. It was thought to be unfair that the nonworking spouse of an employee eligible for an IRA did not have access to a tax-favored retirement program.

In 1981, the deduction limits for all IRAs were increased to the lesser of $2,000 or 100 percent of compensation ($2,250 for spousal IRAs). The 1981 legislation extended the IRA program to employees who are active participants in tax-favored employer plans, and permitted an IRA deduction for qualified voluntary employee contributions to an employer plan.

The current rules limiting IRA deductions for higher-income individuals not covered by pension plans were enacted as part of the Tax Reform Act of 1986. Part of the reason for this restriction arose from the requirements for revenue and distributional neutrality. The broadening of the base at higher income levels through restrictions on IRA deductions offset the tax rate reductions.

Assessment

The tendency of capital income tax relief to benefit higher- income individuals has been reduced in the case of IRAs by the dollar ceiling on the contribution, and by the phase-out of the deductible IRAs as income rises for those not covered by a pension plan. Providing IRA benefits to those not covered by pensions may also be justified as a way of providing more equity between those covered and not covered by an employer plan.

Another economic justification for IRAs is that they are argued to increase savings and increase retirement security. The effects of these plans on savings and overall retirement income are, however, subject to some uncertainty, and this issue has been the subject of a considerable literature.

Selected Bibliography

Burman, Leonard, Joseph Cordes, and Larry Ozanne. "IRAs and National Savings," National Tax Journal, v. 43. September 1990, pp. 123-128.

Congressional Budget Office. Tax Policy for Pensions and Other Retirement Savings, by David Lindeman and Larry Ozanne. Washington, DC: U.S. Government Printing Office, April 1987.

Feenberg, Daniel, and Jonathan Skinner. "Sources of IRA Savings," Tax Policy and the Economy 1989, ed. Lawrence H. Summers. Cambridge, Mass.: M.I.T. Press, 1989, pp. 25-46.

Gale, William G., and John Karl Scholz. "IRAs and Household Savings." Mimeograph, July 1990.

Gravelle, Jane G. "Do Individual Retirement Accounts Increase Savings?" Journal of Economic Perspectives, v. 5. Spring 1991, pp. 133-148.

--. Economic Effects of Taxing Capital Income, Chapter 8. Cambridge, MA: MIT Press, 1994.

Hubbard, R. Glenn. "Do IRAs and Keoghs Increase Savings?" National Tax Journal, v. 37. March 1984, pp. 43-54.

Kotlikoff, Laurence J. "The Crisis in U.S. Saving and Proposals to Address the Crisis," National Tax Journal, v. 43. September 1990, pp. 233-246.

Stevens, Kevin T., and Raymond Shaffer. "Expanding the Deduction for IRAs and Progressivity," Tax Notes. August 24, 1992, pp. 1081- 1085.

Venti, Steven F., and David A. Wise. "Have IRAs Increased U.S. Savings?" Quarterly Journal of Economics, v. 105. August 1990, pp. 661-698.

U.S. Congress, House Committee on Ways and Means. Overview of Entitlement Programs: 1994 Green Book, Committee Print, 103rd Congress, 2nd session. July 15, 1994, pp. 686-688.

--, Joint Committee on Taxation. Present Law, Proposals, and Issues Relating to Individual Retirement Arrangements and Other Savings Incentives, Joint Committee Print, 101st Congress, 2nd session. March 26, 1990.

--. Description and Analysis of S. 612 (Savings and Investment Incentive Act of 1991), Joint Committee Print.

--, Senate Committee on Finance. Hearing on Bentson-Roth IRA, 102nd Congress, 1st session. May 16, 1991.

                           Income Security

                EXCLUSION OF OTHER EMPLOYEE BENEFITS:

 

                PREMIUMS ON GROUP TERM LIFE INSURANCE

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

            Fiscal year  Individuals  Corporations  Total

 

_____________________________________________________________________

               1995          2.0           --        2.0

 

               1996          2.0           --        2.0

 

               1997          2.1           --        2.1

 

               1998          2.2           --        2.2

 

               1999          2.2           --        2.2

 

_____________________________________________________________________

Authorization

Section 79 and L.O. 1014, 2 C.B. 8 (1920).

Description

The cost of group-term life insurance purchased by an employer for an employee is excluded from the employee's gross income to the extent that the insurance is less than $50,000.

If a group-term life insurance plan discriminates in favor of any key employee (generally an individual who is an officer, a five- percent owner, a one-percent owner earning more than $150,000, or one of the top 10 employee-owners), the full cost of the group-term life insurance for any key employee is included in the gross income of the employee.

The cost of an employee's share of group-term life insurance generally is determined on the basis of uniform premiums, computed with respect to five-year age-brackets and provided in a table furnished by the tax authorities. In the case of a discriminatory plan, however, the amount included in income will be measured by the actual cost rather than by the table cost prescribed by the Treasury.

Impact

These insurance plans, in effect, provide additional income to employees. Because the full value of the insurance coverage is not taxable, this income can be provided at less cost to the employer than the gross amount of taxable wages that would have to be paid to an employee to purchase an equal amount of insurance. Group term life insurance is a significant portion of total life insurance. However, since neither the value of the insurance coverage nor the life insurance proceeds are included in gross income, the value of this fringe benefit is never subject to income tax.

Individuals who are self-employed or who work for an employer without such a plan do not have the advantage of this tax subsidy for life insurance protection. While there is little information on the distributional consequence of this provisions, if the coverage is similar to that of other fringe benefits, higher-income individuals are more likely to be covered by group life insurance.

Rationale

This exclusion was originally allowed, without limitation of coverage, by administrative legal opinion (L.O. 1014, 2 C.B. 8 (1920)). The reason for the ruling is unclear, but it may have related to supposed difficulties in valuing the insurance to individual employees, since the value is closely related to age and other mortality factors. Studies later indicated valuation was not a problem.

The $50,000 limit on the amount subject to exclusion was enacted in 1964. Reports accompanying that legislation reasoned that the exclusion would encourage the purchase of group life insurance and assist in keeping the family unit intact upon death of the breadwinner.

The further limitation on the exclusion available for key employees in discriminatory plans was enacted in 1982, and expanded in 1984 to apply to post-retirement life insurance coverage. In 1986, more restrictive rules regarding anti-discrimination were adopted, but were repealed in the debt limit legislation (P.L. 101-140) of 1989.

Assessment

There may be some justification for encouraging individuals to purchase more life insurance than they would otherwise do on their own. Since society is committed to providing a minimum standard of living for dependent individuals, it may be desirable to subsidize life insurance coverage.

There is, however, no evidence on the extent to which the subsidy increases the amount of insurance rather than substituting for insurance that would be privately purchased. Moreover, by restricting this benefit to employer-provided insurance, the subsidy is only available to certain individuals, depending on their employer, and probably disproportionally benefits high-income individuals. These limitations in coverage may raise questions of both horizontal and vertical equity.

Selected Bibliography

Employee Benefit Research Institute. Fundamentals of Employee Benefit Programs, 4th ed. Washington, DC: Employee Benefit Research Institute, 1990, pp. 229-235.

Sunley, Emil. "Employee Benefits and Transfer Payments," Comprehensive Income Taxation, ed. Joseph A. Pechman. Washington, DC: The Brookings Institution, 1977, pp. 75-106.

U.S. Congress, House Committee on Ways and Means. Hearings on the President's 1963 Tax Message, 88th Congress, 1st session. 1963: pp. 108-113.

                           Income Security

                EXCLUSION OF OTHER EMPLOYEE BENEFITS:

 

            PREMIUMS ON ACCIDENT AND DISABILITY INSURANCE

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

            Fiscal year  Individuals  Corporations  Total

 

_____________________________________________________________________

               1995          0.2           --        0.2

 

               1996          0.2           --        0.2

 

               1997          0.2           --        0.2

 

               1998          0.2           --        0.2

 

               1999          0.2           --        0.2

 

_____________________________________________________________________

Authorization

Sections 105 and 106.

Description

Premiums paid by employers for employee accident and disability insurance plans are not included in the gross income of employees. Although benefit payments to employees generally are taxable, an exclusion is provided for payments related to permanent injuries and computed without regard to the period the employee is absent from work.

Impact

As with term life insurance, since the value of this insurance coverage is not taxable, the employer's cost is less than he would have to pay in wages that are taxable, to confer the same benefit on the employee. Employers thus are encouraged to buy such insurance for employees. Because some proceeds from accident and disability insurance plans, as well as the premiums paid by the employer, are not included in gross income, the value of the fringe benefit is never subject to income tax.

While there is little information on the distributional effects of this provisions, if the coverage is similar to that of other fringe benefits, higher-income individuals are more likely to be covered by accident and disability insurance.

Rationale

This provision was enacted in 1954. Previously, only payments for plans contracted with insurance companies could be excluded from gross income. The committee report indicated this provision equalized the treatment of employer contributions regardless of the form of the plan.

Assessment

Since public programs (social security and workman's compensation) provide a minimum level of disability payments, it is not clear what justification there is for providing a subsidy for additional benefits. Moreover, by restricting this benefit to employer-provided insurance, the subsidy is only available to certain individuals, depending on their employer, and probably disproportionally benefits high-income individuals. These limitations in coverage may raise questions of both horizontal and vertical equity.

The computation of the value of the premiums could, however, be difficult to calculate, especially if they are combined with health plans.

Selected Bibliography

Guttentag, Joseph F., E. Deane Leonard, and William Y. Rodewald. "Federal Income Taxation of Fringe Benefits: A Specific Proposal," National Tax Journal, v. 6. September 1953, pp. 250-272.

McDermott, William T. and George Bauernfeind. "Wage Continuation Plans Permit Employer to Deduct Tax Free Payments to Employee," Taxation for Accountants, v. 11. September 1973, pp. 138-143.

"Taxation of Employee Accident and Health Plans Before and Under the 1954 Code," Yale Law Journal, v. 64, no. 2. December 1954, pp. 222-247.

U.S. Congress, House Committee on Ways and Means, "An Appraisal of Individual Income Tax Exclusions" (Roy Wentz), Tax Revision Compendium. Committee Print, 1959, pp. 329-40.

                           Income Security

                   EXCLUSION OF EMPLOYER-PROVIDED

 

                           DEATH BENEFITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

        Fiscal year    Individuals    Corporations     Total

 

_____________________________________________________________________

           1995            /1/             --           /1/

 

           1996            /1/             --           /1/

 

           1997            /1/             --           /1/

 

           1998            /1/             --           /1/

 

           1999            /1/             --           /1/

 

_____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 101(b); Reg. section 1.101.2.

Description

Payments made by an employer to the surviving spouse of a deceased employee are normally considered to be income earned by the employee when alive (and therefore taxable). However the first $5,000 paid by or on behalf of an employer because of an employee's (or former employee's) death is excluded from the income of the employee's beneficiaries or estate.

If two or more beneficiaries receive benefits aggregating more than $5,000, then the exclusion must be apportioned. The exclusion does not apply to amounts that the employee had a nonforfeitable right to receive as compensation during his life, such as bonuses, payments for unused leave, and uncollected salary.

This income exclusion may also apply to the first $5,000 paid from an employer-provided welfare fund, or trust, or qualified pension plan of a self-employed individual, if the amounts were forfeitable and the distribution is made in a lump sum.

Impact

This provision provides a limited exclusion for certain noninsured employer-provided death benefits. Although the value of the excluded $5,000 amount is greater for beneficiaries or estates in higher marginal tax brackets than those in low tax brackets, the very small dollar limit probably confines the benefit largely to lower- income workers. (Employers may provide INSURED death benefits of up to $50,000 tax-free.)

Rationale

The provision permitting a limited exclusion for noninsured employer-provided death benefits was added by the Revenue Act of 1951. The Senate report accompanying that legislation notes that the exclusion was needed to correct the hardship caused by taxing employer-provided death benefits. (Death benefits paid by insurance companies had always been tax-exempt.) The $5,000 limitation was necessary to prevent abuse.

Assessment

Since all employers will not provide a death benefit, the provision violates horizontal equity principles, in that all taxpayers with similar incomes are not treated equally. Unlike many other employer-provided benefits, employer-provided death benefits are not subject to a nondiscrimination test and so may be provided only to highly compensated employees. In addition, upper-income taxpayers will receive a greater subsidy than lower-income taxpayers because of their higher tax rate. Thus, this tax subsidy may be inverse to need.

Recent reform efforts have called for the repeal of this section because it adds complexity to the tax law. Many taxpayers are confused between gifts and the employer-provided death benefit, while other taxpayers become confused as to eligibility under pension and annuity provisions of current tax law.

Selected Bibliography

Linkous, William Jr. "Death Benefits to Spouse: New Rules Make It Harder to Obtain Maximum Tax Benefits," Taxation for Accountants. September 1978, pp. 172-176.

Schmid, James S. "Distributions from Plans upon the Participant's Death," Taxation for Accountants. November 1989, pp. 298-302.

U.S. Dept. of the Treasury, Office of the Secretary. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. November 1984, pp. 31-32.

U.S. President (1981-1989: Reagan) The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity. 1985, pp. 30-31.

                           Income Security

                    ADDITIONAL STANDARD DEDUCTION

 

                    FOR THE BLIND AND THE ELDERLY

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          1.9            --         1.9

 

              1996          2.0            --         2.0

 

              1997          2.1            --         2.1

 

              1998          2.2            --         2.2

 

              1999          2.4            --         2.4

 

_____________________________________________________________________

Authorization

Section 63(f).

Description

Blind and aged taxpayers are eligible for an added standard deduction of $750 (married or surviving spouse) or $950 (unmarried individual) for tax year 1994. A couple could receive $3,000 if both are blind and elderly. These amounts are adjusted for inflation.

Impact

The additional standard deduction amounts raise the threshold at which taxpayers begin to pay taxes. The benefit depends on the tax rate of the individual. Most benefits go to taxpayers with incomes under $50,000.

               Distribution by Income Class of the Tax

 

               Expenditure for the Additional Standard

 

             Deduction Amount for the Blind and Elderly

 

              at 1994 Tax Rates and 1994 Income Levels

 

_____________________________________________________________________

 

               Income Class                 Percentage

 

              (in thousands of $)          Distribution

 

_____________________________________________________________________

                  Below $10                    0.2

 

                  $10 to $20                   4.0

 

                  $20 to $30                  15.7

 

                  $30 to $40                  18.0

 

                  $40 to $50                  20.8

 

                  $50 to $75                  24.2

 

                  $75 to $100                 10.1

 

                  $100 to $200                 6.1

 

                  $200 and over                0.9

 

_____________________________________________________________________

Rationale

Special tax treatment for the blind first appeared in 1943 when additional benefits were available through an itemized deduction. The deduction's purpose was to help cover the additional expenses many blind faced, such as the hiring of readers and guides. The Revenue Act of 1948 changed the deduction to an additional personal exemption, so all blind taxpayers could claim the tax benefits.

Relief was also provided to the elderly because of a heavy concentration of small incomes in that population, the rise in the cost of living, and to counterbalance changes in the tax system resulting from World War II. It was argued that those who were retired could not adjust to these changes and that a general personal exemption was preferable to piecemeal exclusions for particular types of income received by the elderly.

As part of the Tax Reform Act of 1986, these personal exemptions were replaced by an additional standard deduction amount to target benefits to low- and moderate-income taxpayers who frequently use the standard deduction.

Assessment

Other taxpayers with disabilities (deafness, paralysis, loss of limbs) are not eligible. The additional amount does not benefit the blind whose incomes are so low that they pay no tax nor does it benefit blind taxpayers who itemize.

Selected Bibliography

Chen, Yung-Ping. "Income Tax Exemptions for the Aged as a Policy Instrument," National Tax Journal, v. 16, no. 4. December 1963, pp. 325-336.

Groves, Harold M. Federal Tax Treatment of the Family. Washington, DC: The Brookings Institution, 1963, pp. 52-55.

Lightman, Gary P. "Tax Expenditure Analysis of I.R.C. section 151(d), The Additional Exemption for the Blind: Lack of Legislative Vision?" Temple Law Quarterly, v. 50, no. 4. 1977, pp. 1086-1104.

Livsey, Herbert C. "Tax Benefits for the Elderly: A Need for Revision." Utah Law Review, v. 1969, No. 1. 1969, pp. 84-117.

Tate, John. "Aid to the Elderly: What Role for the Income Tax?" University of Cincinnati Law Review, v. 41, no. 1. 1972, pp. 93-115.

U.S. Congress, House Committee on Ways and Means. Overview of Entitlement Programs. May 15, 1992, pp. 1035-1037.

U.S. President (Reagan). The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity. Washington, DC: U.S. Government Printing Office, 1985, pp. 11-14.

                           Income Security

               TAX CREDIT FOR THE ELDERLY AND DISABLED

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          /1/            --         /1/

 

              1996          /1/            --         /1/

 

              1997          /1/            --         /1/

 

              1998          /1/            --         /1/

 

              1999          /1/            --         /1/

 

_____________________________________________________________________

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Section 22.

Description

Individuals who are 65 or over may claim a tax credit equal to 15 percent of a base amount. The credit is also available to those permanently and totally disabled and retired on disability. The maximum base amount for a married couple where both spouses are 65 or over is $7,500. When one spouse is 65 or over and the other spouse is under 65 but disabled, the maximum amount is the lesser of $7,500 or $5,000 plus "disability income" (income from wages, or payments in lieu of wages, due to disability).

A maximum base amount of $5,000 is provided for a single taxpayer 65 or over and a married couple where only one spouse is over 65. Where both are under 65 and both are disabled, the maximum base amount is the lesser of $7,500 or total "disability income." When one is disabled but neither is 65 or over or in the case of a single disabled individual under 65, the maximum base amount is the lesser of $5,000 or "disability income." For a married individual filing separately the maximum base amount is $3,750 (the lesser of $3,750 or the "disability income" received if disabled).

The maximum base amount is reduced by certain amounts received as pensions or disability benefits which are excluded from gross income (such as social security benefits, railroad retirement, and veterans benefits). Also, a reduction from the maximum base amount is made by one-half of the excess over the following amounts: $7,500 adjusted gross income (AGI) for a single individual, $10,000 for a joint return, or $5,000 for a married individual filing a separate return.

Impact

The maximum credit per individual is $750 (15 percent of $5,000) and $1,125 in the case of a married couple both 65 or over (15 percent of $7,500). Because the base amount is reduced by social security benefits, the primary beneficiaries are persons with disabilities and retirees who are not eligible to receive tax-exempt social security benefits.

Because the provision is a credit, its value to the taxpayer is affected only by the level of benefits and the credit rate, and not by the tax bracket of the taxpayer. However, the adjusted gross income phaseout serves to limit relief to low- and moderate-income taxpayers.

The following table was derived from data prepared by the Joint Committee on Taxation which appears in the 1992 Ways and Means Overview of Entitlement Programs, p. 1040.

              Preliminary Distribution by Income Class

 

                  of the Tax Expenditure for Credit

 

                    for the Elderly and Disabled

 

              at 1992 Tax Rates and 1992 Income Levels

_____________________________________________________________________

 

               Income Class                 Percentage

 

              (in thousands of $)          Distribution

 

_____________________________________________________________________

                  Below $10                   24.4

 

                  $10 to $20                  51.2

 

                  $20 to $30                  23.2

 

                  $30 to $40                   1.2

 

                  $40 and over                 0.0

 

_____________________________________________________________________

Rationale

The retirement income credit enacted in 1954 was intended to remove the inequity between individuals who received taxable retirement income with those who received tax-exempt social security payments. In 1976, the retirement income credit was redesigned into the tax credit for the elderly.

In the Social Security Amendments of 1983, social security benefits were made taxable above certain income levels. In response to this change the tax credit's base amounts were increased to provide some coordination with the level at which social security benefits became taxable. In addition, the credit for the elderly was expanded to include those permanently and totally disabled. This change was designed to provide the same tax relief to aged and disabled taxpayers who do not receive tax-free social security retirement or disability payments.

Assessment

While the tax credit affords some elderly and disabled taxpayers receiving taxable retirement or disability income a measure of comparability with those receiving tax-exempt (or partially tax- exempt) social security benefits, it does so only at low-income levels because of the adjusted gross income phaseout. The provision has been criticized for being relatively complex.

Selected Bibliography

Commerce Clearing House. "An Increase in Age Can Mean a Reduction in Taxes," Standard Federal Tax Reports; Tax Focus, v. 73, no. 42. September 25, 1986.

Talley, Louis Alan. Federal Income Tax Treatment of the Elderly. Library of Congress, Congressional Research Service Report 92-277 E. March 12, 1992.

Tate, John. "Aid to the Elderly: What Role for the Income Tax?" University of Cincinnati Law Review, v. 41, no. 1. 1972, pp. 93-115.

U.S. Congress, House Committee on Ways and Means. Overview of Entitlement Programs; 1992 Green Book; Background Material and Data on Programs Within the Jurisdiction of the Committee on Ways and Means. Washington, DC: U.S. Government Printing Office, May 15, 1992, pp. 1037-1039.

--, Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1976 (H.R. 10612, 94th Congress, Public Law 94-455). Washington, DC: U.S. Government Printing Office, December 29, 1976, pp. 117-123.

U.S. President (1981-1989: Reagan). The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity. 1985, pp. 11-14.

Winschel, William F. "New Credit for the Elderly to Provide More Benefits and Cover More Taxpayers in 1984," Taxation for Accountants, v. 32, no. 2. February 1984, pp. 90-93.

                           Income Security

                DEDUCTIBILITY OF NONBUSINESS CASUALTY

 

                          AND THEFT LOSSES

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          0.1            --         0.1

 

              1996          0.1            --         0.1

 

              1997          0.1            --         0.1

 

              1998          0.1            --         0.1

 

              1999          0.1            --         0.1

 

_____________________________________________________________________

Authorization

Section 165(c)(3).

Description

An individual may claim an itemized deduction for unreimbursed personal casualty or theft losses in excess of $100 per event and in excess of 10 percent of adjusted gross income (AGI) for combined net losses during the tax year. Eligible losses are those arising from fire, storm, shipwreck, or other casualty, or from theft. The cause of the loss should be considered a sudden, unexpected, and unusual event.

Impact

The deduction grants some financial assistance to taxpayers who suffer substantial casualties and itemize deductions. It shifts part of the loss from the property owner to the general taxpayer and thus serves as a form of Government coinsurance. Use of the deduction is low for all income groups. According to IRS statistics for 1990, for each AGI class tabulated, 1.4 percent or less of itemized returns claimed the deduction.

There is no maximum limit on the casualty loss deduction. If losses exceed the taxpayer's income for the year of the casualty, the excess can be carried back or forward to another year without reapplying the $100 and ten percent floors. A dollar of deductible losses is worth more to taxpayers in higher income tax brackets because of their higher marginal tax rates.

Rationale

The deduction for casualty losses was allowed under the original 1913 income tax law without distinction between business-related and non-business-related losses. No rationale was offered then. The Revenue Act of 1964 placed a $100-per-event floor on the deduction for personal casualty losses, corresponding to the $100 deductible provision common in property insurance coverage at that time. The deduction was intended to be for extraordinary, nonrecurring losses which go beyond the average or usual losses incurred by most taxpayers in day-to-day living. The $100 floor was intended to reduce the number of small and often improper claims, reduce the costs of record keeping and audit, and focus the deduction on extraordinary losses.

The Tax Equity and Fiscal Responsibility Act of 1982 provided that the itemized deduction for combined nonbusiness casualty and theft losses would be allowed only in excess of 10 percent of the taxpayer's AGI.

The casualty loss deduction is exempt from the overall limit on itemized deductions for high-income taxpayers which took effect in 1991.

The Omnibus Budget Reconciliation Act of 1993 (P.L. 101-508) provided that, in the case of taxpayers whose principal residence or its contents is involuntarily converted as a result of a Presidentially declared disaster, no capital gain will be recognized on insurance proceeds for personal property that was part of the residence's contents if such property was not scheduled under the insurance policy.

Assessment

Critics have pointed out that when uninsured losses are deductible but insurance premiums are not, the income tax discriminates against those who carry insurance and favors those who do not. It similarly discriminates against people who take preventive measures to protect their property but cannot deduct their expenses. No distinction is made between loss items considered basic to maintaining the taxpayer's household and livelihood versus highly discretionary personal consumption. The taxpayer need not replace or repair the item in order to claim a deduction for an unreimbursed loss.

Up through the early 1980s, while tax rates were as high as 70 percent and the floor on the deduction was only $100, high income taxpayers could have a large fraction of their uninsured losses offset by lower income taxes, providing them reason not to purchase insurance. IRS statistics for 1980 show a larger percentage of itemized returns in higher income groups claiming a casualty loss deduction.

The imposition of the 10-percent-of-AGI floor effective in 1983, together with other changes in the tax code during the 1980s, substantially reduced the number of taxpayers claiming the deduction. In 1980, 2.9 million tax returns, equal to 10.2 percent of all itemized returns, claimed a deduction for casualty or theft losses. In 1992, only 117,000 returns, 0.1 percent of all returns and 0.35 percent of all itemized returns, claimed such a deduction.

Use of the casualty and theft loss deduction fluctuates widely from year to year. Deductions have risen substantially in years witnessing a major natural disaster -- such as a hurricane, flood, or earthquake. In some years (such as 1989) the increase in deductions is due to a jump in the number of returns claiming the deduction. In other years (such as 1992) it reflects a large increase in the average dollar amount of deductions per return claiming the loss deduction.

Selected Bibliography

Goetz, Joe F., Jr. "Some Real Property Casualty Losses and Consumption Preferences: Double Indemnification?" Taxes, v. 60, no. 7. July 1982, pp. 507-12.

Goode, Richard. The Individual Income Tax. Rev. ed. Washington, DC: The Brookings Institution, 1976, pp. 153-55.

Kaplow, Louis. "The Income Tax as Insurance: The Casualty Loss and Medical Expense Loss Deductions and the Exclusion of Medical Insurance Premiums," California Law Review, v. 79. December 1991, pp. 1485-1510.

--. "Income Tax Deductions for Losses as Insurance, American Economic Review, v. 82, no. 4. September 1992, pp. 1013-1017.

Newman, Joel S. "Of Taxes and Other Casualties," The Hastings Law Journal, 1983, vol. 34, no. 4, pp. 941-68.

                           Income Security

                      EARNED INCOME TAX CREDIT

                       Estimated Revenue Loss

 

                      [In billions of dollars]

 

_____________________________________________________________________

 

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          3.5            --         3.5

 

              1996          3.9            --         3.9

 

              1997          4.2            --         4.2

 

              1998          4.4            --         4.4

 

              1999          4.6            --         4.6

 

_____________________________________________________________________

Notes: The figures in the table show the effect of the basic earned income credit on receipts. Outlays for the basic credit are estimated at $18.6 billion in 1995, $20.6 billion in 1996, $21.6 billion in 1997, $22.2 billion in 1998, and $22.9 billion in 1999.

Authorization

Section 32.

Description

Eligible married couples and single individuals can claim a basic earned income tax credit (EITC). To qualify for the credit, a taxpayer must meet certain earned income and adjusted gross income (AGI) limits; those with a qualifying child can receive a larger credit. Earned income includes wages, salaries, tips, and net income from self employment. A qualifying child is a son or daughter, an adopted child, grandchild, stepchild, or foster child. The child must live with the taxpayer for more than half the year (the entire year in the case of a foster child) and be under age 19 (or age 24, if a full-time student) or permanently and totally disabled.

The EITC for 1994 is equal to 26.3 percent of the first $7,750 of earned income for one qualifying child and 30.0 percent of earned income up to $7,520 for two or more qualifying children. In 1994, the maximum basic credit is $2,038 for one qualifying child and $2,528 for two or more qualifying children. Beginning in 1994, the credit percentages will be 34 percent for one qualifying child and 36 percent for two or more qualifying children. The latter will increase to 40 percent in 1996.

Families with one child and earned income and AGI between $7,750 and $11,000 in 1992 are eligible for the maximum basic credit. These amounts will be $6,000 and $11,000 (in 1994 dollars) in 1995. Families with two or more children will receive the maximum credit at levels between $8,425 and $11,000. These amounts will be adjusted for inflation.

For 1994, the basic credit is phased out at a rate of 15.98 percent of AGI (or earned income, if greater) above $11,000. In 1995, the phaseout percentages will be 20.22 percent for two or more qualifying children; in 1996, it will be 21.06.

In 1994, married couples and individuals between 25 and 64 (without children) are eligible for a smaller EITC of 7.65 percent of the first $4,000 (phased out at 7.65 percent above $5,000). The maximum credit is $306. The income thresholds will be adjusted for inflation.

If the credit is greater than a family's Federal income tax, the difference is refunded. Working parents may arrange with their employers to receive the credit in advance through reduced tax withholding. The amount of the credit that offsets the amount of income tax owed is a tax expenditure, while the refundable portion is treated as an outlay.

Impact

The earned income tax credit increases the after-tax income of lower- and moderate-income working couples and individuals, particularly those with children. The credits also provide an incentive to work for those with little or no earned income. The credits raise the after-tax income of many families above the official poverty level of income.

The following table provides estimates of the distribution of the earned income credit by income level. The estimates include the refundable portion of the credit.

               Distribution by Income Class of the Tax

 

                Expenditure for the Earned Income Tax

 

                    Credit at 1994 Tax Rates and

 

                         1994 Income Levels

_____________________________________________________________________

 

               Income Class                 Percentage

 

              (in thousands of $)          Distribution

 

_____________________________________________________________________

                  Below $10                    26.2

 

                  $10 to $20                   49.7

 

                  $20 to $30                   21.4

 

                  $30 to $40                    2.4

 

                  $40 to $50                    0.2

 

                  $50 to $75                    0.1

 

                  $75 to $100                   0.0

 

                  $100 to $200                  0.0

 

                  $200 and over                 0.0

 

_____________________________________________________________________

Rationale

The earned income credit was enacted by the Tax Reduction Act of 1975 as a temporary refundable credit to offset the effects of the social security tax and rising food and energy costs on lower income workers and to provide a work incentive for parents with little or no earned income.

The credit was extended by the Revenue Adjustment Act of 1975, the Tax Reform Act of 1976, and the Tax Reduction and Simplification Act of 1977. The Revenue Act of 1978 raised the maximum amount of the credit, provided for advance payment of the credit, and made the credit permanent. The 1978 Act also granted the maximum credit to families with incomes in a range above the level at which the credit reaches a maximum amount.

The credit was expanded by both the Deficit Reduction Act of 1984 and the Tax Reform Act of 1986. The 1986 Act also indexed the income thresholds to inflation. The Omnibus Budget Reconciliation Act (OBRA) of 1990 increased the percentage used in calculating the credit, created a limited adjustment for family size, and created the supplemental credit for young children.

OBRA 1993 increased the credit, expanded the family-size adjustment, extended the credit to individuals without children, and repealed the supplemental credit for young children. This significant expansion of the credit reflected the desire to further encourage work and distributive concerns.

Assessment

The earned income credit raises the after-tax income of several million lower- and moderate-income families, especially those with with [sic] children. As an income transfer program, the credit increases the progressivity of the Federal individual income tax. In recent years, the credit has also been promoted as an alternative to raising the minimum wage and as a way of improving the ability of families to pay for child care.

The earned income credit creates an incentive to work because, up to the income threshold at which the credit reaches a maximum, the more a parent earns, the greater the amount of the credit. But within the income range over which the credit is phased out, the credit acts as a work disincentive.

While the credit encourages single parents to enter the work force, it discourages the spouse of a working parent from entering the work force. The earned income credit may also discourage marriage. Unlike other income transfer programs, the earned income credit does not fully adjust for differences in family size.

Because of incorrect or incomplete tax return information, or because they do not file, some eligible individuals do not receive the credit. The credit also differs from other transfer payments in that most individuals receive it as an annual lump sum rather than as a monthly benefit. Efforts have been made to remedy this problem by providing additional payments.

Selected Bibliography

Alstott, Anne L. "The Earned Income Tax Credit and Some Fundamental Institutional Dilemmas of Tax-Transfer Integration," National Tax Journal, vol. 47, no. 3 (September 1994), pp. 609-619.

Campbell, Colin D., and William L. Peirce. The Earned Income Credit. Washington, DC: American Enterprise Institute, 1980.

Ciccone, Charles V. Minimum Wage Earnings and the EITC: Making the Connection, Library of Congress, Congressional Research Service Report 88-736 E. Washington, DC: November 30, 1988.

Hoffman, Saul D., and Laurence S. Seidman. The Earned Income Tax Credit: Antipoverty Effectiveness and Labor Market Effects. Kalamazoo, Michigan: W.E. Upjohn Institute, 1990.

Holtzblatt, Janet, Janet McCubbin, and Robert Gillette. "Promoting Work Through the EITC," National Tax Journal, vol. 47, no. 3 (September 1994), pp. 591-607.

Scholz, John Karl. "The Earned Income Tax Credit: Participation, Compliance, and Antipoverty Effectiveness," National Tax Journal, vol. 47, no. 1 (March 1994), pp. 63-85.

Steuerle, C. Eugene. "Tax Credits for Low-Income Workers with Children," Journal of Economic Perspectives, v. 4. Summer 1990, pp. 201-12.

Storey, James R. The Earned Income Tax Credit: A Growing Form of Aid to Children, Library of Congress, Congressional Research Service Report 91-402 EPW. Washington, DC: May 3, 1991.

U.S. Congress, Senate Committee on Governmental Affairs, Subcommittee on Government Information and Regulation. An Examination of the Development of the Earned Income Credit Tax Forms, Hearings, 102nd Congress, 1st session. Washington, DC: U.S. Government Printing Office, September 17, 1991.

               Social Security and Railroad Retirement

                EXCLUSION OF UNTAXED SOCIAL SECURITY

 

                  AND RAILROAD RETIREMENT BENEFITS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

_____________________________________________________________________

 

           Fiscal year  Individuals   Corporations   Total

 

_____________________________________________________________________

              1995          23.1           --         23.1

 

              1996          24.1           --         24.1

 

              1997          25.1           --         25.1

 

              1998          26.1           --         26.1

 

              1999          27.1           --         27.1

 

_____________________________________________________________________

Authorization

Sec. 86 I.R.C. 1954 and I.T. 3194, 1938-1 C.B. 114 and I.T. 3229, 1938-2136, as superseded by Rev. Ruling 69-43, 1969-1 C.B. 310; I.T. 3447, 1941-1 C.B. 191, as superseded by Rev. Ruling 70-217, 1970-1 C.B. 12.

Description

In general, the social security and railroad retirement benefits of most recipients are not subject to tax. A portion of social security and certain (tier one) railroad retirement benefits is included in income for taxpayers whose "provisional income" exceeds certain thresholds.

Tier one railroad retirement benefits are those provided by the railroad retirement system that are equivalent to the social security benefit that would be received by the railroad worker were he or she covered by social security. "Provisional income" is adjusted gross income plus one-half the social security benefit and otherwise tax- exempt "interest" income (i.e., interest from tax-exempt bonds). The thresholds below which no social security or tier one benefits are taxable are $25,000 (single), $32,000 (couple filing joint return) and zero (couple filing separately).

The tax on benefits when income exceeds these thresholds depends on the level of the income. If it is between the $25,000 threshold ($32,000 for a couple) and a second-level threshold of $34,000 ($44,000 for a couple), the amount of benefits subject to tax is the lesser of: (1) 50 percent of benefits; or (2) 50 percent of income in excess of the first threshold. If income is above the second threshold, the amount of benefits subject to tax is the lesser of:

(1) 85 percent of benefits or

(2) 85 percent of income above the second threshold, plus the smaller of (a) $4,500 (single) or $6,000 (couple) or, (b) 50 percent of benefits.

For couples filing separately, taxable benefits are the lesser of 85 percent of benefits or 85 percent of provisional income.

This tax treatment differs from that of pension benefits, in which all benefits that exceed the amount of the employee's contribution are fully taxable.

The proceeds from taxation of social security and tier one benefits at the 50 percent rate are credited to the social security trust funds and the railroad retirement system, respectively. Proceeds from taxation of social security benefits and tier one benefits at the 85 percent rate are credited to the Hospital Insurance trust fund of Medicare.

Impact

Currently, about 76 percent of social security and railroad retirement tier one recipients pay no tax on their benefits. Clearly the elderly are favored by this exclusion, because they receive most social security and railroad retirement benefits. Middle-income recipients are advantaged because they pay no tax on 100 percent of their benefits, whereas higher-income recipients can exclude only 50 to 15 percent of their benefits. Low-income recipients also pay no tax on 100 percent of their benefits, but as the value of the exclusion depends on their marginal tax rate (which could be zero), they may be either advantaged or disadvantaged relative to middle and high-income recipients.

Also, the dollar value of the exclusion depends upon the amount of the social security benefit and the marginal tax bracket. The distribution of the tax expenditure is shown below.

                   Distribution by Income Class of

 

              Tax Expenditure, Untaxed Social Security

 

           Benefits: 1994 Tax Rates at 1994 Income Levels

_____________________________________________________________________

 

               Income Class                 Percentage

 

              (in thousands of $)          Distribution

 

_____________________________________________________________________

                  Below $10                     0.3

 

                  $10 to $20                   10.9

 

                  $20 to $30                   24.5

 

                  $30 to $40                   27.0

 

                  $40 to $50                   19.7

 

                  $50 to $75                   14.7

 

                  $75 to $100                   1.7

 

                  $100 to $200                  0.9

 

                  $200 and over                 0.4

 

_____________________________________________________________________

Rationale

Until 1984, social security benefits were exempt from the Federal income tax. The original exclusion arose from rulings made in 1938 and 1941 by the then Bureau of Internal Revenue (I.T. 3194, I.T. 3447). The reasons underpinning the rulings, although not stated in the rulings themselves, appear to be:

(1) Congress did not intend for social security benefits to be taxed, as implied by the lack of an explicit provision to tax them;

(2) the benefits were intended to be in the form of "gifts" made in aid of the general welfare, not annuities which replace earnings, and therefore were not to be considered as income for tax purposes; and

(3) subjecting benefits to taxation would tend to defeat the underlying purposes of the Social Security Act.

The exclusion of benefits paid under the railroad retirement system was enacted in the Railroad Retirement Act of 1935. The rationale for the exclusion was not separately stated, but is presumed to be similar to that for excluding social security benefits.

For years many program analysts questioned the basis for the rulings on social security and advocated that the treatment of social security benefits for tax purposes be the same as it is for other pension income. Pension benefits are fully taxable except for the proportion of projected lifetime benefits attributable to the worker's contributions. Financial pressures on the social security system in the early 1980s also increased interest in taxing benefits. The 1982 National Commission on Social Security Reform proposed taxing one-half of social security benefits received by persons whose income exceeded certain amounts and crediting the proceeds to the social security trust funds.

In enacting the 1983 Social Security Amendments (P.L. 98-21) in March 1983, Congress essentially adopted the Commission's recommendation, but modified it to phase in the tax on benefits gradually, as a person's income rose above threshold amounts. At the same time, it modified the tax treatment of tier one railroad retirement benefits to conform to the treatment of social security benefits.

In his FY 1994 budget, President Clinton proposed that the taxable proportion of social security benefits be increased to 85% effective in 1994, with the proceeds credited to Medicare's Hospital Insurance (HI) trust fund. The Congress approved this proposal as part of the 1993 omnibus budget reconciliation bill (P.L. 103-66), but limited it to recipients whose threshold incomes exceed $34,000 (single) or $44,000 (couple). Benefits taxable as under old (pre- 1994) law are limited to $4,500 (single) or $6,000 (couple) because the 50% rate applies only between the first and second tier thresholds (e.g., $34,000 - $25,000 = $9,000 x 1/2 = $4,500).

Assessment

Principles of horizontal equity (equal treatment of those in equal circumstances) generally support the idea of treating social security and railroad benefits similarly to other sources of retirement income. Horizontal equity suggests that equal income, regardless of source, represents equal ability to pay taxes, and therefore should be equally taxed. Just as the portion of private pensions, IRAs and investment income on which taxes have never been paid is fully taxable, so too should the portion of social security and railroad retirement not attributable to the individual's contributions be fully taxed.

It is estimated that if social security benefits received the same tax treatment as pensions, on average about 95 percent of benefits would be included in taxable income. However, social security benefits vary with individual circumstances, so the proportion applicable to particular recipients also varies. It has been estimated that the lowest proportion of retirement benefits that would be taxable for anyone in the work force today is 85 percent of benefits.

Because of the administrative complexities involved in calculating the proportion of each individual's benefits, and because in theory it would ensure that no one would receive less of an exclusion than entitled to, it has been proposed that the income thresholds be removed, and that a flat 85 percent of social security benefits be included in taxable income.

Removing the exclusion has also been proposed as the most equitable and effective way to implement de facto benefit reductions. Taxing benefits fully better aligns them with need, and is seen as an indirect "means test."

Opponents to increased taxation of social security and railroad retirement object on several grounds. First, it obviously would lower many persons' overall income. For many, it would appear to be simply a benefit reduction -- a loss of income to those who cannot change past work and savings decisions. The rules would have changed in the middle of the game, with the greatest effect on older workers and current beneficiaries who made retirement and other decisions based on old law, and who may be already living in large part on their social security and railroad retirement.

Some opponents of taxing benefits support the partial exclusion of social security benefits from tax on general philosophical grounds. They believe that, as the country's only national social insurance system, which provides a bedrock level of protection to nearly all workers and their families from loss of income due to the death, retirement, or disability of the worker, social security is special and should be so treated. They object to the analogy between social security and private pension benefits, saying that they serve different purposes.

Selected Bibliography

Brannon, Gerard M. "The Strange Precision in the Taxation of Social Security Benefits," Tax Notes. March 29, 1993.

Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. March, 1994.

Fellows, James A., and Haney, J. Edison. "Taxing the Middle Class," Taxes. October, 1993

Kollmann, Geoffrey C. Social Security: President Clinton's Proposal to Increase Taxation of Benefits. Library of Congress, Congressional Research Service Issue Brief IB93044. Washington DC: February 14, 1994.

Kollmann, Geoffrey C. Social Security: Issues in Taxing Benefits Under Current Law and Under Proposals to Tax a Greater Share of Benefits. Library of Congress, Congressional Research Report 89-40 EPW. Washington, DC: January 12, 1989.

U.S. Congress, House of Representatives. Omnibus Budget Reconciliation Act of 1993, Conference Report No. 103-213. August 4, 1993.

                   Veterans' Benefits and Services

            EXCLUSION OF VETERANS' BENEFITS AND SERVICES

         (1) EXCLUSION OF VETERANS' DISABILITY COMPENSATION

 

                 (2) EXCLUSION OF VETERANS' PENSIONS

 

                  (3) EXCLUSION OF GI BILL BENEFITS

                       Estimated Revenue Loss

 

                      [in billions of dollars]

_____________________________________________________________________

 

                           Individuals

 

             ___________________________________

 

                Veterans

 

               Disability

 

      Fiscal    Compen-     Veterans   GI Bill   Corpora-

 

      Year      sation      Pensions   Benefits   tions    Total

 

_____________________________________________________________________

      1995      1.6           0.1        0.1        --      1.8

 

      1996      1.6           0.1        0.1        --      1.8

 

      1997      1.7           0.1        0.1        --      1.9

 

      1998      1.7           0.1        0.1        --      1.9

 

      1999      1.8           0.1        0.1        --      2.0

 

_____________________________________________________________________

Authorization

38 U.S.C. section 3101.

Description

All benefits administered by the Department of Veterans Affairs are exempt from taxation. Such benefits include those for veterans' disability compensation, veterans' pension payments, and education payments.

Veterans' service-connected disability compensation payments are related to loss in civil-occupations earnings capacity which results from a service-related wound, injury, or disease. Typically, benefits increase with the severity of disability. There are special dependents' allowances. Veterans with a 60- to 90-percent disability may receive compensation at the 100-percent level if unemployable.

Veteran pensions are available to support veterans with a limited income who had at least one day of military service during a war period and at least 90 days of active duty service. Benefits are paid to veterans over age 65 or to veterans with disabilities unrelated to their military service.

Pension benefits are based on "countable" income (the larger the income, the smaller the pension) with no payments made to veterans whose assets may be used to provide adequate maintenance. For veterans coming on the rolls after December 31, 1978, countable income includes earnings of the veteran, spouse, and dependent children, if any. Veterans who were on the rolls prior to that date may elect coverage under prior law, which excludes from countable income the income of a spouse, among other items.

Veterans' educational assistance is provided under a number of different programs for veterans, servicepersons, and eligible dependents. These programs have varying eligibility requirements and benefits.

Impact

Beneficiaries of all three major veterans' programs pay less tax than other taxpayers with the same or smaller economic incomes. Since these exclusions are not counted as part of income, the tax savings are a percentage of the amount excluded, depending on the marginal tax bracket of the veteran. Thus the exclusion amounts will have greater value for veterans with high incomes than for those with lower incomes.

Rationale

The rationale for excluding veterans' benefits from taxation is not clear. The tax exclusion of benefits was adopted in 1917, during World War I.

Assessment

The exclusion of veterans' benefits alters the distribution of payments and favors higher-income individuals. It is typically argued that the differential that exists between veterans' service-connected disability compensation and the average salary of wage earners reflects the tax-exempt status of their benefits. If veterans' benefits were to become taxable, it would require higher benefit levels to replace lost income. Because benefits are excluded from taxation, the true cost of the military is understated in the Federal budget.

Selected Bibliography

Cullinane, Danielle. Compensation for Work-Related Injury and Illness. Santa Monica, CA, RAND, 1992. 60 p. (RAND Publication Series N-3343-FMP).

Goode, Richard. The Individual Income Tax, rev. edit. Washington, DC: The Brookings Institution, 1976, pp. 100-103.

Ogloblin, Peter K. Military Compensation Background Papers: Compensation Elements and Related Manpower Cost Items, Their Purposes and Legislative Backgrounds. Washington, DC: Department of Defense, Office of the Secretary of Defense, U.S. Government Printing Office, November 1991, pp. 633-645.

Owens, William L. "Exclusions From, and Adjustments To, Gross Income, Air Force Law Review, v. 19. Spring 1977, pp. 90-99.

U.S. Congressional Budget Office. Disability Compensation: Current Issues and Options for Change. Washington, DC: U.S. Government Printing Office, 1982.

U.S. Department of the Treasury, Office of the Secretary. Tax Reform for Fairness, Simplicity, and Economic Growth; the Treasury Department Report to the President. Washington, DC: November 1984, pp. 51-57.

                   Veterans' Benefits and Services

                        EXCLUSION OF INTEREST

 

                    ON STATE AND LOCAL GOVERNMENT

 

                       VETERANS' HOUSING BONDS

                       Estimated Revenue Loss

                      [In billions of dollars]

 

___________________________________________________________________

 

     Fiscal year     Individuals    Corporations        Total

 

___________________________________________________________________

 

        1995              0.1             /1/            0.1

 

        1996              0.1             /1/            0.1

 

        1997              0.1             /1/            0.1

 

        1998              0.1             /1/            0.1

 

        1999              0.1             /1/            0.1

                          FOOTNOTE TO TABLE

     /1/ Less than $50 million.

                           END OF FOOTNOTE

Authorization

Sections 103, 141, 143, and 146 of the Internal Revenue Code of 1986.

Description

Veterans' housing bonds are used to provide mortgages at below- market interest rates on owner-occupied principal residences of homebuyers who are veterans. These veterans' housing bonds are classified as private-activity bonds rather than governmental bonds, because a substantial portion of their benefits accrues to individuals rather than to the general public.

Each State with an approved program is subject to an annual volume cap related to its average veterans' housing bond volume between 1979 and 1985. For further discussion of the distinction between governmental bonds and private-activity bonds, see the entry under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Impact

Since interest on the bonds is tax exempt, purchasers are willing to accept lower before-tax rates of interest than on taxable securities. These low-interest rates enable issuers to offer mortgages on veterans' owner-occupied housing at reduced mortgage interest rates.

Some of the benefits of the tax exemption also flow to bondholders. For a discussion of the factors that determine the shares of benefits going to bondholders and homeowners, and estimates of the distribution of tax-exempt interest income by income class, see the "Impact" discussion under General Purpose Public Assistance: Exclusion of Interest on Public Purpose State and Local Debt.

Rationale

Veterans' housing bonds were first issued by the States after World War II, when both State and Federal governments enacted programs to provide benefits to veterans as a reward for their service to the Nation.

The Omnibus Budget Reconciliation Act of 1980 required that veterans' housing bonds must be general obligations of the State. The Deficit Reduction Act of 1984 restricted the issuance of these bonds to the five States that had qualified programs in existence prior to June 22, 1984, and limited issuance to each State's average issuance between 1979 and 1984.

Loans were restricted to veterans who served in active duty any time prior to 1977 and whose application for the mortgage financing occurred before the later of 30 years after leaving the service or January 31, 1985, thereby imposing an effective sunset date for the year 2007. Loans were also restricted to principal residences.

Assessment

The need for these bonds has been questioned, because veterans are eligible for numerous other housing subsidies that encourage home ownership and reduce the cost of their housing. As one of many categories of tax-exempt private-activity bonds, veterans' housing bonds have been criticized because they increased the financing costs of bonds issued for public capital stock and increased the supply of assets available to individuals and corporations to shelter their income from taxation.

Selected Bibliography

U.S. Congress, Joint Committee on Taxation. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, Committee Print, 98th Congress, 2nd session. December 31, 1984, pp. 903-958.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

                  General Purpose Fiscal Assistance

                        EXCLUSION OF INTEREST

 

               ON PUBLIC PURPOSE STATE AND LOCAL DEBT

                       Estimated Revenue Loss

                      [In billions of dollars]

 

__________________________________________________________________

 

     Fiscal year      Individuals    Corporations       Total

 

__________________________________________________________________

 

        1995               9.5            3.2            13.1

 

        1996              10.0            3.3            13.3

 

        1997              10.5            3.5            14.0

 

        1998              11.0            3.7            14.7

 

        1999              11.5            3.8            15.3

Authorization

Sections 103 and 141 of the Internal Revenue Code of 1986.

Description

Certain obligations of State and local governments qualify as "governmental" bonds. The interest income earned by individual and corporate purchasers of these bonds is excluded from taxable income.

This interest income is not taxed because the bond proceeds generally are used to build capital facilities that are owned and operated by governmental entities and serve the general public interest, such as highways, schools, and government buildings.

These bonds can be issued in unlimited amounts. The revenue loss estimates in the above table for general fiscal assistance are based on the excluded interest income on these governmental bonds.

Other obligations of State and local governments are classified as "private-activity" bonds. The interest income earned by individual and corporate purchasers of these bonds is included in taxable income.

This interest income is taxed because the bond proceeds are believed to provide substantial benefits to private businesses and individuals (in addition to any benefits that may be provided to the general public). Tax exemption is available for a subset of these otherwise taxable private-activity bonds if the proceeds are used to finance an activity included on a list of activities specified in the Code.

However, unlike governmental bonds, these tax-exempt private- activity bonds may not be issued in unlimited amounts. All governmental entities within the State are subject to a State volume cap on new issues of these tax-exempt private-activity bonds equal to the greater of $50 per State resident or $150 million.

Each activity included in the list of private activities eligible for tax-exempt financing is discussed elsewhere in this document under the private activity's related budget function.

Impact

The distributional impact of this interest exclusion can be viewed from two perspectives: first, the division of tax benefits between State and local governments and bond purchasers; and second, the division of the tax benefits among income classes.

The direct benefits of the exempt interest income from tax- exempt bonds flow to both State and local governments and to the purchasers of the bonds. The exclusion of interest income causes the interest rate on State and local government obligations to be lower than the rate that must be paid on comparable taxable bonds. In effect, the Federal Government pays part of State and local interest costs. For example, if the market rate on tax-exempt bonds is 8 percent when the taxable rate is 10 percent, there is a 2-percentage point interest rate subsidy to State and local governments.

The interest exclusion also raises the after-tax return for some bond purchasers. A taxpayer facing a 20-percent marginal tax rate is equally well off purchasing either the 8-percent tax-exempt bond or the 10-percent taxable bond (both yield an 8-percent after-tax interest rate).

But a taxpayer facing a 30-percent marginal tax rate is better off buying a tax-exempt bond, because the after-tax return on the taxable bond is 7 percent, and on the tax-exempt bond, 8 percent. These "inframarginal" investors receive windfall gains.

The allocation of benefits between the bondholders and State and local governments (and, implicitly, its taxpayer citizens) depends on the spread in interest rates between the tax-exempt and taxable bond market, the share of the tax-exempt bond volume purchased by individuals with marginal tax rates exceeding the market-clearing marginal tax rate, and the range of the marginal tax rate structure.

The reduction of the top income tax rate of bond purchasers from the 70-percent individual rate that prevailed prior to 1981 to the 34-percent corporate rate that prevails in 1992 has increased substantially the share of the tax benefits going to State and local governments.

The table below provides an estimate of the distribution by income class of tax-exempt interest income (including interest income from both governmental and private-activity bonds).

Over 52 percent of individuals' tax-exempt interest income is earned by returns with adjusted gross income in excess of $100,000, although these returns represent only 2.8 percent of all returns.

Returns below $40,000 earn only 19.1 percent of tax-exempt interest income, although they represent more than 77 percent of all returns.

The revenue loss is even more concentrated in the higher income classes than the interest income because the average marginal tax rate (which determines the value of the tax benefit from the nontaxed interest income) is higher for higher-income classes.

                 Distribution of Tax-Exempt Interest

 

                            Income, 1992

 

       _______________________________________________

 

         Adjusted Gross Income          Percentage

 

            Class ($1000)              Distribution

 

       _______________________________________________

 

             Below $10                       4.2

 

             $10-$20                         4.2

 

             $20-$30                         6.0

 

             $30-$40                         6.6

 

             $40-$50                         6.3

 

             $50-$75                        15.2

 

             $75-$100                        9.6

 

             $100-$200                      14.4

 

             $200 and Over                  33.4

Rationale

This exemption has been in the income tax laws since 1913, and was based on the belief that the income had constitutional protection from Federal Government taxation. The claim to this constitutional protection was eliminated by the Supreme Court in 1988, South Carolina v. Baker (485 U.S. 505, [1988]).

In spite of this loss of protection, many believe the exemption for governmental bonds is still justified on economic grounds, principally as a means of encouraging State and local governments to overcome a tendency to underinvest in public capital formation.

Bond issues whose debt service is supported by State and local tax bases have been left untouched by legislation, with a few exceptions such as arbitrage restrictions, denial of Federal guarantee, and registration. The reason for this is that most of these bonds have been issued for the construction of public capital stock, such as schools, highways, sewer systems, and government buildings.

This has not been the case for revenue bonds without tax-base support and whose debt service is paid from revenue generated by the facilities built with the bond proceeds. These bonds have been the subject of almost continual legislative scrutiny in recent years, beginning with the Revenue and Expenditure Control Act of 1968 and peaking with a comprehensive overhaul by the Tax Reform Act of 1986.

This legislation has focused on curbing issuance of the subset of tax-exempt revenue bonds used to finance the quasi-public investment activities of private businesses and individuals that are characterized as "private-activity" bonds. Each private activity eligible for tax exemption is discussed elsewhere in this document under the private activity's related budget function.

Assessment

This tax expenditure subsidizes the provision of State and local public services. It encourages State and local taxpayers to correct their tendency to underprovide public services because of their reluctance to pay for the benefits untaxed nonresidents inevitably receive along with residents.

The form of the subsidy has been questioned because it subsidizes one factor of public sector production, capital, and encourages State and local taxpayers to substitute capital for labor in the public production process. This would make sense if any underconsumption of State and local public services was isolated in capital facilities, but there is no evidence that this is the case. Thus, to the extent a subsidy of State and local public service provision is needed to obtain the amount desired by Federal taxpayers, the subsidy probably should not be restricted to capital.

The efficiency of the subsidy, in the sense of the share of the Federal revenue loss that shows up as reduced State and local interest costs rather than as windfall gains for purchasers of the bonds, has also been the subject of considerable concern.

This State and local share of the benefits depends to a great extent on the number of bond purchasers with marginal tax rates higher than the marginal tax rate of the purchaser who clears the market. The share of the subsidy received by State and local governments was improved considerably during the 1980s as the highest statutory marginal income tax rate on individuals was reduced from 70 percent to 31 percent and on corporations from 46 percent to 34 percent.

The open-ended structure of the subsidy affects Federal control of its budget. The amount of the Federal revenue loss on governmental bonds is entirely dependent upon the decisions of State and local officials. No appropriation is made -- the Federal Government stands ready to forego the collection of income taxes on as many governmental bonds as the State and local sector desires to issue.

Selected Bibliography

Forbes, Ronald W., and John E. Petersen. "Background Paper," Building a Broader Market: Report of the Twentieth Century Fund Task Force on the Municipal Bond Market. New York: McGraw-Hill, 1976, pp. 27-174.

Fortune, Peter. "The Municipal Bond Market, Part II: Problems and Policies," New England Economic Review. May/June, 1992, pp. 47- 64.

Livingston, Michael. "Reform or Revolution? Tax-Exempt Bonds, The Legislative Process, and the Meaning of Tax Reform," U.C. Davis Law Review 22. Summer 1989, pp. 1165-1237.

Mussa, Michael L., and Roger C. Kormendi. The Taxation of Municipal Bonds: An Economic Appraisal. Washington, DC: American Enterprise Institute, 1979.

Ott, David J., and Allan H. Meltzer. Federal Tax Treatment of State and Local Securities. Washington, DC: The Brookings Institution, 1963.

Shaul, Marnie. "The Taxable Bond Option for Municipal Bonds." Columbus, Ohio: Academy for Contemporary Problems, 1977.

Temple, Judy. "Limitations on State and Local Government Borrowing for Private Purposes." National Tax Journal, v. 46, March 1993, pp. 41-53.

Zimmerman, Dennis. The Private Use of Tax-Exempt Bonds: Controlling Public Subsidy of Private Activity. Washington, DC: The Urban Institute Press, 1991.

                  General Purpose Fiscal Assistance

              DEDUCTION OF NONBUSINESS STATE AND LOCAL

 

                          GOVERNMENT INCOME

 

                     AND PERSONAL PROPERTY TAXES

                       Estimated Revenue Loss

                      [In billions of dollars]

 

__________________________________________________________________

 

     Fiscal year      Individuals    Corporations       Total

 

__________________________________________________________________

 

        1995              24.7            --             24.7

 

        1996              26.2            --             26.2

 

        1997              27.7            --             27.7

 

        1998              29.3            --             29.3

 

        1999              31.0            --             31.0

Authorization

Section 164 of the Internal Revenue Code of 1986.

Description

State and local income and personal property taxes paid by individuals are deductible from adjusted gross income. Business income and property taxes are deductible as business expenses, but their deduction is not a tax expenditure because deduction is necessary for the proper measurement of business economic income.

Impact

The deduction of State and local individual income and personal property taxes increases the individual's after-Federal-tax income and reduces the individual's after-Federal-tax price of the State and local public services provided with these tax dollars. The taxpayer probably reacts by using some of his tax benefits to purchase additional State and local public services (thereby generating higher State and local budgets) and using the remaining tax benefit for private consumption and saving.

The distribution of tax expenditures from State and local income and personal property tax deductions is concentrated in the higher income classes. Almost 80 percent of the tax benefits are taken by families with incomes in excess of $75,000. As with any deduction, it is worth more as marginal tax rates increase. Personal property tax deductions are but a small fraction of income tax deductions ($3.3 billion compared to $88 billion in 1991), and are less concentrated in higher income classes.

                   Distribution by Income Class of

 

             Tax Expenditure for State and Local Income

 

            and Personal Property Tax Deductions at 1994

 

                  Tax Rates and 1994 Income Levels

 

     ___________________________________________________

 

             Income Class               Percentage

 

          (in thousands of $)          Distribution

 

     ____________________________________________________

 

             Below $10                       0.0

 

             $10 to $20                      0.1

 

             $20 to $30                      0.5

 

             $30 to $40                      1.8

 

             $40 to $50                      3.4

 

             $50 to $75                     14.7

 

             $75 to $100                    17.3

 

             $100 to $200                   25.1

 

             $200 and over                  37.2

Rationale

Deductibility of State and local taxes was adopted in 1913 in order "not to tax a tax" or, to put it another way, to avoid taxing income that was obligated to expenditures over which the taxpayer was felt to have no discretionary control. However, user charges (such as for sewer and water services) and special assessments (such as for sidewalk repairs) were not deductible. Some general-purpose taxes have lost their deductibility.

The Revenue Act of 1964 eliminated deductibility for motor vehicle operators' licenses, and the Revenue Act of 1978 eliminated deductibility of the excise tax on gasoline. These decisions represent congressional concern that differences among States in the legal specification of taxes allowed differential deductibility treatment for taxes that were essentially the same in terms of their economic incidence.

The Tax Reform Act of 1986 eliminated deductibility of sales taxes, partly due to concern that these taxes were estimated and therefore did not perfectly represent reductions of taxable income, and partly due to concerns that some portion of the tax reflects discretionary decisions of State and local taxpayers to consume services through the public sector that might be consumed through private (nondeductible) purchase.

The Omnibus Budget Reconciliation Act of 1990 curtailed the tax benefit from State and local income and real property tax deductions for higher income taxpayers by requiring that itemized deductions be reduced by a percentage of the amount by which adjusted gross income exceeds some threshold amount. This provision was to expire after 1995; the Omnibus Budget Reconciliation Act of 1993 made the provision permanent.

Assessment

Modern theories of the public sector discount the "don't tax a tax" justification for State and local tax deductibility, emphasizing instead that taxes represent citizens' decisions to consume goods and services collectively. In that sense, State and local taxes are benefit taxes and should be treated the same as expenditures for private consumption -- not deductible against Federal taxable income.

Deductibility can also be seen as an integral part of the Federal system of intergovernmental assistance and policy. Modern theories of the public sector also suggest that

(1) deductibility does provide indirect financial assistance for the State and local sector and should result in increased State and local budgets, and

(2) will influence the choice of State and local tax instruments if deductibility is not provided uniformly.

Deductibility also has the effect of reducing interstate tax competition because it narrows interstate differentials between statutory tax rates.

Selected Bibliography

Brazer, Harvey. "The Deductibility of State and Local Taxes under the Individual Income Tax," U.S. Congress, Committee on Ways and Means, Tax Revision Compendium: Compendium of Papers on Broadening the Tax Base. v. 1. November 16, 1959.

Feldstein, Martin, and Gilbert Metcalf. "The Effect of Federal Tax Deductibility on State and Local Taxes and Spending," Journal of Political Economy. 1987, pp. 710-736.

Gade, Mary and Lee C. Adkins. "Tax Exporting and State Revenue Structures," National Tax Journal. March 1990, pp. 39-52.

Kenyon, Daphne. "Federal Income Tax Deductibility of State and Local Taxes: What Are Its Effects? Should It Be Modified or Eliminated? Strengthening the Federal Revenue System. Advisory Commission on Intergovernmental Relations Report A-97. 1984, pp. 37- 66.

Noto, Nonna A., and Dennis Zimmerman. "Limiting State-Local Tax Deductibility: Effects Among the States," National Tax Journal. December 1984, pp. 539-549.

--. Limiting State-Local Tax Deductibility in Exchange for Increased General Revenue Sharing: An Analysis of the Economic Effects. U.S. Congress, Subcommittee on Intergovernmental Relations, Committee on Governmental Affairs, 98th Congress, 1st session, Committee Print S. Prt 98-77. August 1983.

                  General Purpose Fiscal Assistance

                  TAX CREDIT FOR SECTION 936 INCOME

                       Estimated Revenue Loss

 

                      [In billions of dollars]

          Fiscal year   Individuals  Corporations    Total

 

          ________________________________________________

             1995          -             3.7         3.7

 

             1996          -             3.8         3.8

 

             1997          -             4.0         4.0

 

             1998          -             4.1         4.1

 

             1999          -             4.2         4.2

Authorization

Section 936.

Description

In general, corporations chartered in the United States are subject to U.S. taxes on their worldwide income. However, the possessions tax credit provided by section 936 of the Internal Revenue Code permits qualified U.S. corporations that operate in Puerto Rico, the U.S. Virgin Islands, and other U.S. possessions a tax credit that offset some or all of their U.S. tax liability on income from business operations and certain types of financial investment in the possessions. The credit has the effect of exempting qualified income taxes at the Federal level. The possessions have generally enacted their own complementary set of tax incentives.

To qualify for the credit, a firm must derive 80 percent of its gross from the possessions. Also, 75 percent of a qualified corporation's income must be from the active conduct of a business in a possession rather than from passive (financial) investment. The amount of the tax credit is generally equal to a firm's tax liability on possessions-source income subject to a new cap enacted in 1993. After a transition period ending in 1998, the cap would equal 40 percent of the credit a firm could otherwise claim. Alternatively, a firm can choose a cap equal to a specified portion of its wages and depreciation paid in the possessions. (It is likely that the second cap will be most favorable for most firms.)

To qualify for the credit, passive investment income (known as Qualified Possessions Source Investment Income, or QPSII) must generally be from the possessions and the underlying funds must be derived from business operations in the possessions. Since 1986, QPSII includes investment in active business assets or development projects in qualified Caribbean countries.

Impact

The most direct effect of the possessions tax credit is to reduce the cost of qualified investment in Puerto Rico and the Virgin Islands. In addition, changes introduced by the Omnibus Budget Reconciliation Act of 1993 (OBRA93) reduce the effective cost of qualified wages paid in the possessions.

In 1989, the largest user of the credit was the pharmaceuticals industry, which accounted for 49 percent of all credits claimed under section 936. In the long run, however, the burden of the corporate income tax (and the benefit from reductions in it) probably spreads beyond corporate stockholders to owners of capital in general. Also -- particularly since enactment of OBRA93 -- it is likely that part of the benefit of section 936 is shared by labor in the possessions.

Rationale

A Federal tax exemption for firms earning income in the possessions has been in effect since the Revenue Act of 1921, although its precise nature has undergone several changes. However, the credit was not heavily used in Puerto Rico until the years following World War II, when the Puerto Rican Government integrated the Federal tax exemption into its "Operation Bootstrap" development plan; the plan was designed, in part, to attract investment from the mainland United States.

The Tax Reform Act of 1976 implemented several changes designed to strengthen the provision's incentive effect and to tie it more closely to the possessions. The Act also instituted the credit- cum-exemption mechanism that is currently in place. In keeping the essential elements of the tax exemption intact, Congress indicated that the provision's purpose was to keep Puerto Rico and the possessions competitive with low-wage, low-cost foreign countries as a location for investment.

Changes in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) focused in part on mainland parent firms that used transfers of intangible assets (e.g., patents) to possessions subsidiaries as a means of sheltering mainland-source income from taxes. TEFRA increased the portion of a firm's income that must be from active investment from 50 percent to 65 percent. The Tax Reform Act of 1986 also sought to link the tax credit more tightly to tangible investment in the possessions by increasing the portion of income that must be from active business investment to 75 percent and allowed certain investments in Caribbean countries to qualify as QPSII.

The Omnibus Budget Reconciliation Act of 1993 scaled back the credit by limiting each firm's maximum credit to a specified portion of wage and depreciation costs incurred in the credit. While the Act's change is likely to reduce the tax benefit for some firms, the new cap's link with wages and depreciation probably increased the incentive to employ labor and tangible investment in the possessions.

The possessions tax credit is also intertwined with the issue of Puerto Rico's political status, and whether Puerto Rico should retain its current Commonwealth status, become a U.S. State, or become independent. The link exists because both independence and statehood may ultimately required repeal of section 936.

Assessment

Because it reduces the cost of investment in Puerto Rico and the Virgin Islands, the possessions tax credit encourages firms to divert investment from the mainland and foreign countries to the possessions. The measure probably played an important role in attracting a large flow of investment to Puerto Rico in the years following World War II. The investment, in turn, helped transform Puerto Rico's economy from one based on agriculture to one heavily dependent on manufacturing. The inflow of investment probably also increased the earnings of Puerto Rican labor by increasing the capital/labor ratio in Puerto Rico.

Section 936's supporters maintain that the provision is critical to the well-being of Puerto Rico's economy. However, the credit's critics have pointed out that the current exemption is an incentive to invest rather than a direct incentive to employ labor, and to the extent it increases employment in Puerto Rico, it does so only as a by-product of its increase in investment. In addition, some have questioned the measure's cost-effectiveness, arguing that the measure's cost in terms of foregone tax collections is high compared to the number of jobs the provision creates in Puerto Rico.

Selected Bibliography

Brumbaugh, David L. The Possessions Tax Credit: Economic Analysis of the 1993 Revisions. Library of Congress, Congressional Research Service Report 94-650 E. Washington, DC: 1994.

--. The Possessions Tax Credit (IRC Section 936): Background and Issues. Library of Congress, Congressional Research Service Report 88-200 E. Washington, DC: 1988.

--. Puerto Rico and Federal Taxes under Section 936: History and Proposed Changes. Library of Congress, Congressional Research Service Report 85-196. Washington, DC: 1985.

Martin, Gary D. "Industrial Policy by Accident: the United States in Puerto Rico," Journal of Hispanic Policy, v. 4. 1989-90, pp. 93-115.

Sierra, Ralph J., Jr. "Funding Caribbean Basin Initiative Activities with Section 936 Funds," International Tax Journal, v. 18. Spring, 1992, pp. 27-58.

U.S. Congressional Budget Office. Potential Economic Impacts of Changes in Puerto Rico's Status under S. 712. Washington, DC: 1990.

U.S. Department of the Treasury. The Operation and Effect of the Possessions Corporation System of Taxation, Sixth Report. Washington, DC: 1989.

U.S. General Accounting Office. Pharmaceutical Industry: Tax Benefits of Operating in Puerto Rico, Report GGD-92-72BR. Washington, DC: 1992.

U.S. President (1981-1989: Reagan). The President's Tax Proposals to the Congress for Fairness, Growth, and Simplicity. Washington, DC: U.S. Government Printing Office, 1985, pp. 307-12.

                              Interest

                DEFERRAL OF INTEREST ON SAVINGS BONDS

                       Estimated Revenue Loss

 

                      [In billions of dollars]

          Fiscal year   Individuals  Corporations    Total

 

          _________________________________________________

             1995          1.3           -            1.3

 

             1996          1.4           -            1.4

 

             1997          1.5           -            1.5

 

             1998          1.6           -            1.6

 

             1999          1.7           -            1.7

Authorization

Section 454(c) of the Internal Revenue Code of 1992.

Description

Owners of U.S. Treasury Series E and EE savings bonds have the option of either including interest in taxable income as it accrues or excluding interest from taxable income until the bond is redeemed. Furthermore, EE bonds may be exchanged for current income HH savings bonds with the accrued interest deferred until the HH bonds are redeemed. The revenue loss shown above is the tax that would be due on the deferred interest if it were reported and taxed as it accrued.

Impact

The deferral of tax on interest income resulting from owning savings bonds provides two advantages. First, payment of tax on the interest is deferred, amounting to an interest-free loan. Second, the taxpayer often is in a lower income bracket when the bonds are redeemed. This is particularly common when the bonds are purchased while the owner is working and redeemed after the owner retires.

Savings bonds appeal to small savers because of such financial features as their small denominations, ease of purchase, and safety. Furthermore, there is currently an annual cash purchase limit of $15,000 per person in terms of issue price. Because poor families save little and do not pay Federal income taxes, the tax deferral of interest on savings bonds primarily benefits middle income families.

Rationale

Prior to 1951, a cash-basis taxpayer generally reported interest on U.S. Treasury original issue discount bonds in the year of redemption or maturity, whichever came first. In 1951, when provision was made to extend Series E bonds past their dates of original maturity, a provision was enacted to allow the taxpayer either to report the interest currently, or at the date of redemption, or upon final maturity. The committee reports indicated that the provision was adopted to facilitate the extension of maturity dates.

On January 1, 1960, the Treasury permitted owners of E bonds to exchange these bonds for current income H bonds with the continued deferment of Federal income taxes on accrued interest until the H bonds were redeemed. The purpose was to encourage the holding of U.S. bonds. This tax provision was carried over to EE bonds and HH bonds.

Assessment

The savings bond program was established to provide small savers with a convenient and safe debt instrument and to lower the cost of borrowing to the taxpayer. The option to defer interest from taxable income increases sales of bonds. But there is no empirical study which has determined whether or not the cost savings from increased bond sales more than offset the loss in tax revenue from the accrual.

Selected Bibliography

Bickley, James M. Variable Rate Savings Bonds: Background, Characteristics, and Evaluation. Library of Congress, Congressional Research Service Report 94-632 E. Washington, DC: August 1, 1994.

U.S. Department of the Treasury. A History of the United States Savings Bond Program. Washington, DC: September 1984.

--. Q & A: The Savings Bonds Question and Answer Book. Washington, DC: 1994.

--. The Book on U.S. Savings Bonds. Washington, DC: 1994.

Appendix

FORMS OF TAX EXPENDITURES

EXCLUSIONS, EXEMPTIONS, DEDUCTIONS, CREDITS,

 

PREFERENTIAL RATES, AND DEFERRALS

Tax expenditures may take any of the following forms:

(1) special exclusions, exemptions, and deductions, which reduce taxable income and, thus, result in a lesser amount of tax;

(2) preferential tax rates, which reduce taxes by applying lower rates to part or all of a taxpayer's income;

(3) special credits, which are subtracted from taxes as ordinarily computed; and

(4) deferrals of tax, which result from delayed recognition of income or from allowing in the current year deductions that are properly attributable to a future year.

Computing Tax Liabilities

A brief explanation of how tax liability is computed will help illustrate the relationship between the form of a tax expenditure and the amount of tax relief it provides.

CORPORATE INCOME TAX

Corporations compute taxable income by determining gross income (net of any exclusions) and subtracting any deductions (essentially costs of doing business).

The corporate income tax eventually reaches an average rate of 35 percent in two steps. Below $10,000,000 taxable income is taxed at graduated rates: 15 percent on the first $50,000, 25 percent on the next $25,000, and 34 percent on the next $25,000. The limited graduation provided in this structure was intended to furnish tax relief to smaller corporations. The value of these graduated rates is phased out, via a 5 percent income additional tax, as income rises above $100,000. Thus the marginal tax rate, the rate on the last dollar, is 34 percent on income from $75,000 to $100,000, 39 percent on taxable income from $100,000 to $335,000, and returns to 34 percent on income from $335,000 to $10,000,000. The rate on taxable income in excess of $10,000,000 is 35 percent, and there is a second phase-out, of the benefit of the 34-percent bracket, when taxable income reaches $15,000,000. An extra tax of three percent of the excess above $15,000,000 is imposed (for a total of 38 percent) until the benefit is recovered, which occurs at $18,333,333 taxable income. Above that, income is taxed at a flat 35 percent rate. Most corporate income is taxed at the 35 percent marginal rate.

Any credits are deducted directly from tax liability. The essentially flat statutory rate of the corporation income tax means there is very little difference in marginal tax rates to cause variation in the amount of tax relief provided by a given tax expenditure to different corporate taxpayers. However, corporations without current tax liability will benefit from tax expenditures only if they can carry back or carry forward a net operating loss or credit.

INDIVIDUAL INCOME TAX

Individual taxpayers compute gross income which is the total of all income items except exclusions. They then subtract certain deductions (deductions from gross income or "business" deductions) to arrive at adjusted gross income. The taxpayer then has the option of "itemizing" personal deductions or taking the standard deduction. The taxpayer then deducts personal exemptions to arrive at taxable income. A graduated tax rate structure is applied to this taxable income to yield tax liability, and any credits are subtracted to arrive at the net after-credit tax liability.

The graduated tax structure is applied at rates of 15, 28, 31, 36, and 39.6 percent, with brackets varying across types of tax returns. For joint returns, in 1995, rates on taxable income were 15 percent for the first $39,000, 28 percent for amounts from $39,000 to $94,250, 31 percent for incomes from $94,250 to $143,600, 36 percent for taxable incomes of $143,600 to $256,500, and 39.6 percent for amounts over $256,500. These amounts are indexed for inflation. There are also phase-outs of personal exemptions and excess itemized deductions so that marginal tax rates can be higher at very high income levels.

Exclusions, Deductions, And Exemptions

The amount of tax relief per dollar of each exclusion, exemption, and deduction increases with the taxpayer's marginal tax rate. Thus, the exclusion of interest from State and local bonds saves $39.60 in tax for every $100 of interest for the taxpayer in the 39.6-percent bracket, whereas for the taxpayer in the 15-percent bracket the saving is only $15. Similarly, the increased standard deduction for persons over age 65 or an itemized deduction for charitable contributions are worth twice as much in tax saving to a taxpayer in the 31-percent bracket as to one in the 15 percent bracket.

In general, the following deductions are itemized, i.e., allowed only if the standard deduction is not taken: medical expenses, specified State and local taxes, interest on nonbusiness debt such as home mortgage payments, casualty losses, certain unreimbursed business expenses of employees, charitable contributions, expenses of investment income, union dues, costs of tax return preparation, uniform costs and political contributions. (Certain of these deductions are subject to floors or ceilings).

Whether or not a taxpayer minimizes his tax by itemizing deductions depends on whether the sum of those deductions exceeds the limits on the standard deduction. Higher income individuals are more likely to itemize because they are more likely to have larger amounts of itemized deductions which exceed the standard deduction allowance. Homeowners often itemize because deductibility of mortgage interest and property taxes leads to larger deductions than the standard deduction.

Preferential Rates

The amount of tax reduction that results from a preferential tax rate (such as the reduced rates on the first $75,000 of corporate income) depends on the difference between the preferential rate and the taxpayer's ordinary marginal tax rate. The higher the marginal rate that would otherwise apply, the greater is the tax relief from the preferential rate.

Credits

A tax credit (such as the dependent care credit) is subtracted directly from the tax liability that would accrue otherwise; thus, the amount of tax reduction is the amount of the credit and is not contingent upon the marginal tax rate. A credit can (with one exception) only be used to reduce tax liabilities to the extent a taxpayer has sufficient tax liability to absorb the credit. Most tax credits can be carried backward and/or forward for fixed periods, so that a credit which cannot be used in the year in which it first applies can be used to offset tax liabilities in other prescribed years.

The earned income credit is the only tax credit which is now refundable. That is, a qualifying individual will obtain in cash the entire amount of the refundable credit even if it exceeds tax liability.

Deferrals

Deferral can result either from postponing the time when income is recognized for tax purposes or from accelerating the deduction of expenses. In the year in which a taxpayer does either of these, his taxable income is lower than it otherwise would be, and because of the current reduction in his tax base, his current tax liability is reduced. The reduction in his tax base may be included in taxable income at some later date. However, the taxpayer's marginal tax rate in the later year may differ from the current year rate because either the tax structure or the applicable tax rate has changed.

Furthermore, in some cases the current reduction in the taxpayer's tax base may never be included in his taxable income. Thus, deferral works to reduce current taxes, but there is no assurance that all or even any of the deferred tax will be repaid. On the other hand, the tax repayment may even exceed the amount deferred.

A deferral of taxes has the effect of an interest-free loan for the taxpayer. Apart from any difference between the amount of "principal" repaid and the amount borrowed (that is, the tax deferred), the value of the interest-free loan -- per dollar of tax deferral -- depends on the interest rate at which the taxpayer would borrow and on the length of the period of deferral. If the deferred taxes are never paid, the deferral becomes an exemption. This can occur if, in succeeding years, additional temporary reductions in taxable income are allowed. Thus, in effect, the interest-free loan is refinanced; the amount of refinancing depends on the rate at which the taxpayer's income and deductible expenses grow and can continue in perpetuity.

The tax expenditures for deferrals are estimates of the difference between tax receipts under the current law and tax receipts if the provisions for deferral had never been in effect. Thus, the estimated revenue loss is greater than what would be obtained in the first year of transition from one tax law to another. The amounts are long run estimates at the level of economic activity for the year in question.

DOCUMENT ATTRIBUTES
  • Institutional Authors
    U.S. Senate
    Budget Committee
    Congressional Research Service
  • Cross-Reference
    Text of this 568-page committee print may be ordered from Tax

    Analysts' Access Service as Doc 95-340; call our customer service

    department at (800) 955-2444 for assistance.
  • Index Terms
    tax expenditures
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-340 (568 pages)
  • Tax Analysts Electronic Citation
    95 TNT 8-35
Copy RID