CRS Analyzes Tax Rebate in Economic Growth and Tax Relief Reconciliation Act

                       CRS REPORT FOR CONGRESS

[1] The recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) contained a rate reduction tax credit (RRTC) for tax year 2001 in lieu of a 10% marginal income tax bracket. Because some taxpayers will receive an advance check from the IRS for this new tax credit, it has been erroneously referred to as a tax rebate. However, it is not a tax rebate; it is an advance check representing the estimated taxrate reduction credit taxpayers will receive for their 2001 income tax liability. While the majority of taxpayers will receive the maximum advance check, over a quarter of all taxpayers will receive no check at all. To receive an advance check, taxpayers had to have a positive income tax liability after credits on their 2000 tax returns. Using the rate reduction tax credit in lieu of a 10% marginal income tax bracket has significant implications for two types of taxpayers, low-income families and dependents who have taxable incomes. Low-income families who would have experienced a tax reduction under a 10% marginal income tax rate will experience less tax reduction with the new credit. It is not clear whether this effect was intended. On the other hand, high- income taxpayers subject to the alternative minimum tax will see the full benefit of the RRTC since it can be used to offset alternative minimum tax liability. Dependents with taxable income will not receive any tax benefits from this new tax credit. There are no plans to update this report.

INTRODUCTION

[2] The recently enacted Economic Growth and Tax Relief Reconciliation Act of 200l (P.L. 107-16) has generated considerable interest in the popular press. One provision receiving prominent coverage is the so called "tax rebate." This "tax rebate" has created considerable confusion as to how it will work and who will actually get it. In fact, the new tax law does not provide for a tax rebate, rather it creates a "rate reduction tax credit" (RRTC) ¹ in lieu of a 10% tax bracket for tax year 2001. Some taxpayers will receive this new RRTC in the form of an advance check mailed to them by the IRS.

[3] Generally, taxpayers must have income tax liability to receive the RRTC. The Ways and Means Committee reported that of the 130 million tax returns to be filed in 2001, 96 million (or about 74%) reported federal income tax liability. Of the 96 million with tax liability, it is estimated that about 79 million (61%) will receive the maximum credit. About 26% of taxpayers will receive no RRTC. The remaining 13% of taxpayers will receive less than the maximum credit. The advance checks representing the credit for tax year 2001 are scheduled to be sent to taxpayers before October 1, 2001.

[4] The complexity of the RRTC and the advance check for the RRTC has led to much of the apparent confusion. This report describes the RRTC and the advance check, shows why some taxpayers may receive less than the maximum amount; explains why the RRTC was implemented instead of a retroactive 10% rate bracket for 2001; and compares the RRTC to a 10% rate bracket.

BACKGROUND

     o The Economic Growth and Tax Relief Reconciliation Act of 200l

[5] It has been widely reported that taxpayers filing joint returns who have $12,000 of income will receive an advance check of $600 (5% of $12,000), heads of households with $10,000 of income will receive an advance check of $500 (5% of $10,000), and single individuals with $6,000 of income will receive an advance check of $300 (5% of $6,000). However, these income amounts of $12,000, $10,000, $6,000 refer to taxable income levels and not a taxpayer's total income. While most taxpayers may know their total income, fewer actually know their taxable income on which the advance check will be based. The following example exhibits the procedure for moving from taxable income back to the more familiar total income.

[6] Generally, taxable income is total income less exemptions and deductions. Thus, to move up from taxable income to total income requires adding back all deductions and exemptions. For example, in tax year 2000, a married couple with four children that filed a joint return and claimed the standard deduction reduced their total income by $24,150 to arrive at their taxable income (six personal exemptions at $2,800 for each family member plus the standard deduction of $7,350). Hence, even if this family reported a taxable income of zero, they may have actually had total income of $24,150.

[7] To receive an advance check a family would also have to have a tax liability AFTER all credits except for the earned income credit. For example, if the family described above claims the child tax credit for all four children, then the family would have $2,000 in tax credits to reduce their tax liability. Since this family is in the 15% marginal income tax bracket, $2,000 of tax credits cancels out the tax liability on $13,333 of income ($2,000 divided by their 15% marginal income tax rate). Hence, in tax year 2000, this family would not have a positive tax liability until their total income exceeded $37,483 ($24,150 in deductions and exemptions plus $13,333 worth of income covered by the child tax credit). As a result, a family with four children and $37,483 of income will not receive an advance check because they did not have a positive income tax liability.

[8] To receive the maximum possible advance check of $600, a family with four children would have to have additional income of at least $4,000 to produce a $600 income tax liability (15% marginal income tax rate multiplied by $4,000 of taxable income produces a tax liability of $600). This means that to receive the fill $600 advance check, families with four children will have to have total income of at least $41,483 ($37,483 of income before they have a positive income tax plus $4,000 of income to generate additional tax of $600).

[9] Column (b) of Table 1 shows the minimum income needed to receive an advance check and column (c) shows the minimum income needed to receive the maximum advance check. The calculations are for joint returns filed in 2000. For instance, to receive an advance check at all, a married couple filing jointly with two children would have to have at least $25,217 of income. To receive the maximum advance check of $600, families with two children would have to have income of at least $30,350.

    TABLE 1. INCOME THRESHOLDS FOR ADVANCE CHECKS FOR JOINT RETURNS

[10] Table 2 presents the same information for single and head of household returns.

 TABLE 2. INCOME THRESHOLDS FOR ADVANCE CHECKS FOR SINGLE AND HEAD OF

WHY A RATE REDUCTION TAX CREDIT INSTEAD OF A RETROACTIVE 10% TAX BRACKET

[11] Both the original House and Senate versions of the tax cut legislation contained a new 10% tax bracket. The House version established the 10% in 2006 and the Senate version established the 10% bracket retroactive to the 2001 tax year. The conference agreement established a 10% tax bracket effective for tax years beginning after 2000. However, the conference agreement also substituted the RRTC for the 10% bracket in 2001.

[12] Proponents of the RRTC cited the need for immediate tax relief to stimulate the economy. They argued that the retroactive 10% rate bracket may not have been able to deliver immediate tax relief as cleanly as the RRTC because of potential problems implementing changes in the withholding schedules. First, to provide all of the tax relief in 2001, the new withholding schedules would have to "under" withhold the second half of the year at double the amount to compensate for the "over" withholding the first half of the year. As a result, take-home pay would appear significantly larger in the second half of 2001. Then, in 2002, the withholding schedules would revert to the correct rate which would be less than the rate in the last half of 2001. The smaller withholding in 2002 would appear as a tax increase relative to the accelerated rate of the last half of 2001 because take-home pay would decline.

[13] A second option, implementing changes in withholding schedules without compensating for the over withholding the first half of 2001, would only deliver approximately half of the tax relief in 2001. Because lawmakers emphasized the need for immediate relief, this second option would not satisfy the immediate tax relief objective.

[14] Even though the RRTC is in lieu of a new 10% tax bracket, the RRTC is not exactly the same. The following sections explain the differences between the enacted RRTC and an actual 10% marginal tax rate bracket.

THE RRTC VERSUS AN [sic] 10% TAX BRACKET

[15] Using the rate reduction tax credit (RRTC) in lieu of a 10% marginal income tax bracket has significant implications for low- income families, taxpayers subject to the AMT, and dependents who have taxable incomes.

[16] Low-income families who would have benefitted from a 10% tax bracket will see smaller tax relief from the RRTC. This occurs because the RRTC cannot exceed a taxpayer's income tax liability after credits. Consider the case of a married couple with $25,000 of income and two children under 17 years of age. Under current law, in tax year 2001, they would have taxable income of $5,800 and, at a 15% marginal tax rate, income taxes of $870. Because they have two children, they would also receive child tax credits totaling $1,200. Since the child tax credits are refundable, reducing their income tax liability by the child tax credits would produce a negative income tax liability of $330. Since they had no income tax liability, they would not be entitled to an RRTC, even though they had taxable income of $5,800.

[17] If, instead of the RRTC, a 10% tax bracket had been adopted this family would have had an income tax liability of $580(10% marginal income tax rate times $5,800 of taxable income). Subtracting out the $1,200 of child tax credits would have left the family with a negative income tax liability of $620. Hence, using the actual 10% tax rate bracket instead of the RRTC would have reduced this family's income taxes by $290. (While this analysis reflects the legislative language of the 2001 Tax Act, it is not clear that this differential was intended.) The following table compares the effects of the RRTC with an actual 10% income tax rate bracket for four- person low-income families in 2001.

 TABLE 3. RATE REDUCTION TAX CREDIT (RRTC) COMPARED TO A 10% TAX RATE

[18] On the other hand, high-income taxpayers under the AMT would have seen no benefit from a 10% tax rate bracket. However, these taxpayers get the full benefit of the RRTC since the RRTC can be used to reduce alternative minimum tax liability.

[19] Another category of taxpayers who would benefit from a 10% tax bracket but get no tax relief from the RRTC are taxpayers who have taxable income, but are claimed as dependents on someone else's tax return. For example, part time students who work and have taxable incomes would not be eligible for the RRTC if they were claimed as dependents on their parent's tax return.