CRS REPORTS ON EFFECT OF INCOME TAX INDEXATION REPEAL.

                       CRS REPORT FOR CONGRESS

The indexation of the Federal individual income tax code represented a dramatic departure from past legislative policy. Due to the structure of the individual income tax (progressive tax rates and nominal dollar amounts), under an unindexed tax system inflation- induced increases in nominal income produce an increase in income tax liabilities that is proportionately greater than the increase in real income. As a result, there is an increase in the real tax burden and an automatic increase in revenues.

Although individual income tax indexation has been in effect since the mid-1980's, it continues to be topic of Congressional debate. Because of concern over projections of continued Federal budget deficits, many see elimination or modification of income tax indexation as a relatively painless means of raising Federal revenue. Estimates indicate that elimination of indexation would increase Federal revenue by $132 billion over a five-year time horizon.

Although elimination of indexation might be a politically viable way of raising additional revenues, from a purely economic perspective, it has several drawbacks. First, economic theory indicates that taxes should be designed to be as neutral as possible so as not to interfere with resource allocation. A neutral income tax would take account of inflation and hence, indexation of the tax structure is one way of achieving this goal.

Second, as opposed to a more explicit form of tax increase, the effectiveness of repealing indexation as a means of raising specific amounts of revenue depends to a great extent on factors over which there is very little legislative control. If inflation is lower than anticipated, then the revenue yield would be less than expected. If inflation accelerates, then the revenue yield is higher, but the tax increase is larger than anticipated.

Finally, elimination of indexation has very uneven distributional effects across the income spectrum. Large families would see their tax burdens increase more than smaller families because of the erosion in the real value of the personal exemption. Lower income taxpayers, especially if indexation of the earned income tax credit (EITC) were repealed, would see proportionally larger tax increases than taxpayers at the upper end of the income scale.

TABLE OF CONTENTS

HOW INFLATION INCREASES REAL INCOME TAX LIABILITIES

LEGISLATIVE HISTORY OF INDEXATION PROVISIONS

THE MECHANICS OF CURRENT LAW INDEXATION

REVENUE CONSEQUENCES OF AMENDING INDEXATION

DISTRIBUTIONAL EFFECTS OF ELIMINATING INDEXATION

CONCLUSIONS

REPEAL OF INDIVIDUAL INCOME TAX INDEXATION: THE REVENUE AND DISTRIBUTIONAL EFFECTS

The indexation of the Federal individual income tax code represented a dramatic departure from past legislative policy. Due to the structure of the individual income tax (progressive tax rates and nominal dollar amounts), under an unindexed tax system inflation- induced increases in nominal income produce an increase in income tax liabilities that is proportionately greater than the increase in real income. As a result, there is an increase in the real tax burden and an automatic increase in revenues.

Prior to 1981, Congress had periodically enacted tax legislation to counteract this inflation-induced increase in the real tax burden. These periodic tax cuts however, produced only a rough offset to the inflation-induced increase in the tax burden. Between 1960 and 1980 there were several major tax reductions enacted, yet Federal individual income tax receipts as a percentage of gross domestic product (GDP) remained relatively unchanged. In fiscal year 1960, Federal income tax receipts represented 8.1 percent of GDP, in fiscal year 1980 they represented 9.2 percent of GDP.

In an effort to avoid a repetition of these policies, Congress enacted income tax indexation as a part of an overall package of statutory marginal tax rate reductions contained in the Economic Recovery Tax Act of 1981. The official reasons cited were:

. . . Congress believed that the automatic tax increases resulting from the effects of inflation were unfair to taxpayers, since their tax burden as a percentage of income could increase during intervals between tax reduction legislation, with an adverse effect on incentives to work and invest. In addition, the Federal Government was provided with an automatic increase in its aggregate revenue, which in turn created pressure for further spending . . . and thus [indexation] will avoid the past pattern of inequitable, unlegislated tax increases and induced spending. ¹

Although individual income tax indexation has been in effect since the mid-1980's, it continues to be topic of Congressional debate. Because of concern over projections of continued Federal budget deficits, many see elimination or modification of income tax indexation as a relatively painless means of raising Federal revenue. This report provides background information on why indexation was adopted, outlines the legislative history of indexation, describes how current law indexation works, provides revenue estimates on the repeal of indexation, and analyzes the tax distributional implications of its elimination.

HOW INFLATION INCREASES REAL INCOME TAX LIABILITIES

In the United States, the Federal individual income tax is progressive. That is, as incomes increase, income tax liabilities, when measured as a percentage of income, also increase. Part of this progressivity is achieved through marginal tax rates that increase as taxable income increases. In addition, the income tax is structured on the basis of nominal dollar amounts. Some examples of nominal dollar amounts in the income tax are the personal exemption, the standard deduction, and the earned income tax credit. During periods of inflation, under an unindexed tax system, the progressive nature of the marginal tax rates combined with the erosion in the real value of fixed nominal dollar amounts produces automatic tax increases and unintentional changes in the distribution of the tax burden.

The effects of inflation on real income tax liabilities can be illustrated in the following manner. Consider the case of a four- person family with a $50,000 income who filed a joint return in 1994. If we assume that the family did not itemize its deductions, but rather used the standard deduction, then its taxable income would have been $33,850 ($50,000 less standard deduction of $6,350 and four personal exemptions at $2,450 apiece). Income tax liability on taxable income of $33,850 would have been $5,078 which translates into an average tax rate of 10.1 percent ($5,078 income tax liability divided by $50,000 income).

Now consider what would happen if inflation averaged 5 percent in 1994. In order to maintain the same real gross income that it had in 1994, the family would have to earn $52,500 in 1995. In other words, income would have to rise by $2,500 for the family to maintain the same real purchasing power that it had in the previous year. Assuming there is no tax indexation, the family's taxable income would be $36,350 ($52,500 less the standard deduction of $6,350 and four personal exemptions at $2,450 apiece). Income tax owed on a taxable income of $36,350 would be $5,453 which translates into an average tax rate of 10.3 percent. As can be seen from this example, under an unindexed tax system, inflation increased this family's real income tax burden by 0.2 of a percentage point between 1994 and 1995.

If the tax system had been indexed for the assumed 5-percent inflation, the family would have experienced no increase in their real tax burden. For instance, under an indexed system the value of the standard deduction for a joint return would have increased from $6,350 in 1994 to $6,668 ($6,350 times 1.05) in 1995. The personal exemption would have increased from $2,450 to $2,573 ($2,450 times 1.05). Under these circumstances the family's 1995 taxable income would have been $35,540 ($52,500 income less standard deduction and personal exemptions). Based on this taxable income, their income tax liability would have been $5,331 which translates into an average tax rate of 10.1 percent. Thus, under an indexed tax system, the family would have experienced no change in their real income tax liability between 1994 and 1995.

LEGISLATIVE HISTORY OF INDEXATION PROVISIONS

The Economic Recovery Tax Act of 1981 (ERTA81, P.L. 97-34) contained provisions which, for the first time, specified that certain components of the Federal individual income tax system would be indexed for inflation. These components included the zero bracket amount, the marginal tax rate brackets, and the personal exemption. Although enacted in August 1981, indexation did not start until tax year 1985, after completion of the phased-in 23 percent across-the- board reductions in individual income tax rates that formed the cornerstone of ERTA81. ²

Although enactment of these indexation provisions constituted a major change in the U.S. tax system, there was very little debate over this aspect of the bill. In fact, almost all of the attention was focused on the size and shape of the individual tax cuts. Hence, one of the most significant and historic changes in the individual income tax was accomplished with very little fanfare.

The Tax Reform Act of 1986 (TRA86, P.L. 99-514) modified the original indexation provisions of the tax code in several ways. While continuing the indexation of the tax rate brackets and personal exemption, it extended indexation to the new standard deductions, the additional standard deductions for the elderly and the blind, and the earned income tax credit (EITC). TRA86 also extended indexation to the income levels where the new tax rate adjustments and the personal exemption phaseout applied. TRA86 changed the rounding procedures for indexed components so that, with the exception of the EITC, indexed components were rounded down to the nearest $50 (as opposed to the nearest $10 as had been the case under the original indexation provisions). Finally, the base period from which inflation adjustments were calculated was also changed. ³

The Omnibus Reconciliation Act of 1990 (OBRA90, P.L. 101-508) extended indexation to the income threshold where the newly enacted limitation on itemized deductions applied. ⁴ The Omnibus Budget Reconciliation Act of 1993, (OBRA93, P.L. 103-66) delayed indexation of the newly created top marginal tax brackets for one year. Hence, the nominal dollar tax brackets for the 36 and 39.6 marginal income tax rates remained the same for both tax years 1993 and 1994. These two top tax brackets will be indexed starting in tax year 1995. ⁵

Given these changes over the past thirteen years, under current income tax law, the following components of the individual income tax structure are indexed for inflation: the standard deductions; the additional standard deductions for the elderly and the blind; the personal exemption; the earned income tax credit; the income breakpoints between the various marginal income tax rates; the income level at which the limitation on itemized deductions becomes effective; and the income level above which the tax benefits of the personal exemption are phased out.

THE MECHANICS OF CURRENT LAW INDEXATION

The inflation adjustment for any given tax year is based on the percentage amount by which the average Consumer Price Index for all urban consumers (CPI-U) for the twelve month period ending on August 31 of the preceding year exceeds the average CPI-U during a specified twelve month base period. The base period varies depending upon the tax component under consideration.

With the exception of the EITC, inflation adjustments are rounded down to the nearest multiple of $50. Although rounding down affects the accuracy of any given year's inflation adjustment, the effect will not be cumulative since each year's adjustment will be calculated to reflect the entire amount of inflation that has occurred between the adjustment year and the base year.

For example, the adjustment factor for the standard deduction in 1994 was calculated as follows. The average CPI-U for the base period, September 1986 through August 1987, was 111.98. The average CPI-U for the period September 1992 through August 1993 was 143.175. Given these amounts, the inflation adjustment factor for 1994 was 1.2785 (143.175/111.98). This inflation adjustment factor was then applied to the base year values of the standard deductions to determine their indexed values for 1994.

Continuing with the example, the standard deduction for joint returns in the base year was $5,000. Multiplying this amount by the inflation adjustment factor produces a 1994 value of $6,392. Rounding down to the nearest $50 multiple results in an indexed 1994 standard deduction for joint returns of $6,350. This same process is applied to all of the other indexed components of the individual tax code to determine their indexed values for the tax year under consideration.

Under current law, the base year values for the standard deductions are: $5,000 for joint returns, $3,000 for single returns, and $4,400 for head of household returns. The base year values for the additional standard deduction for the aged and the blind are $600 for joint returns and $750 for single returns. The base year CPI-U for these components is the period September 1986 through August 1987. ⁶

The base year value for the personal exemption is $2,000 while the base year CPI-U is the period September 1987 and August 1988. The base year values for the personal exemption phaseout thresholds are; $150,000 for joint returns, $100,000 for single returns, and $125,000 for head of household returns. The base year CPI-U for these components is the period between September 1989 and August 1990.

The base year value for the itemized deduction limitation threshold is $100,000. The base year CPI-U for this component is September 1989 through August 1990. The base year value for the earned income tax credit is $6,000 for one qualifying child and $8,425 for two or more qualifying children. The base year CPI-U for the EITC is the period September 1993 through August 1994. ⁷

The base year values for the taxable income levels where the 28, 31, 36, and 39.6 percent marginal tax rates become effective are as follows:

                 TABLE 1. BASE YEAR TAX RATE SCHEDULES

REVENUE CONSEQUENCES OF AMENDING INDEXATION

Based on projections produced by the Joint Committee on Taxation, the Congressional Budget Office (CBO) has published revenue estimates for both the effects of suspending income tax indexation for 1995 and for repealing income tax indexation. ⁸ Under both scenarios, it is assumed that the earned income tax credit would continue to be indexed for inflation. The changes would, however, affect all the other indexed components of the individual income tax. These revenue estimates are reproduced in Table 2.

As Table 2 shows, considerable revenue can be raised by modifying the individual income tax indexation provisions. Even suspending indexation for one year would add $46 billion to Federal revenue over a five-year period. Outright repeal of indexation would increase Federal revenues by $132 billion over the five-year forecast horizon.

    TABLE 2. REVENUE EFFECTS OF SUSPENDING OR REPEALING INCOME TAX

DISTRIBUTIONAL EFFECTS OF ELIMINATING INDEXATION

To determine the distributional effects of eliminating indexation, the average income tax rates (income tax payments as a percentage of income) of taxpayers were calculated under an indexed and unindexed tax system. The calculations assume four-person families filing joint returns. The families include two "qualifying" children for purposes of calculating the EITC. The EITC amounts are based on 1996 credit levels calculated in terms of 1994 dollars. Income was assumed to consist of only wage income and total income was assumed to equal adjusted gross income. Over the period analyzed, it was assumed that nominal annual income increased in tandem with inflation so that real income remained constant.

It was further assumed that returns with 1994 incomes of $100,000 and below took the standard deduction. Returns with 1994 incomes in excess of $100,000 were assumed to have itemized their deductions with itemized deductions equal to 20 percent of income. Finally, to better isolate the effects of inflation on average tax rates over time, the current rounding provisions covering indexed components of the tax system were ignored.

It should be noted that these assumptions are not necessarily representative of taxpayer characteristics. Nor are they intended to provide an accurate picture of the distribution of the income tax burden. Rather, they were chosen to highlight the interaction between inflation and an unindexed tax code.

          TABLE 3. AVERAGE INCOME TAX RATES UNDER AN INDEXED

Column 4 shows average tax rates after three years when the tax structure is not indexed for inflation. Column 5 presents the percentage point differences between average tax rates under the indexed and unindexed tax structures. Figures shown in parenthesis indicate that the taxpayer owes no tax, and as a result of the EITC is actually receiving a tax rebate from the Federal Government.

The data indicate that if indexation were repealed, including indexation of the EITC, then the largest tax increases would occur at the lower end of the income spectrum. For families with incomes of $25,000 and below, average income tax rates would increase by 2.5 to 3.5 percentage points. This increase would result primarily from the reduction in the real value of EITC payments.

If indexation of the EITC was maintained, however, families at the lower end of the income spectrum would be less adversely affected by the repeal of general indexation than families with higher incomes. This would occur because lower income families, who have little or no taxable income, would be able to rely on the maintenance of the real value of EITC payments to offset the erosion in the real value of the other structural components of the tax system.

Over the rest of the income scale, the pattern of tax increases that would result from repeal of indexation can be explained as follows. In general, fixed dollar amounts in the tax code are more important for lower to middle income taxpayers, since they represent a relatively larger fraction of income, than to upper income taxpayers, where fixed dollar amounts represent successively smaller fractions of income. Hence, inflation induced erosion in items such as the standard deduction and personal exemption would have a more pronounced adverse effect on lower to middle income taxpayers than it would for upper income taxpayers. Indeed, at the highest ranges of the income scale, most taxpayers itemize rather than use the standard deduction and receive no benefits from the personal exemptions.

In addition, it should be noted that large families would be more adversely affected by the repeal of income tax indexation than would smaller families. This is simply because large families claim more personal exemptions than smaller families and hence, the erosion in the real value of the personal exemption under an unindexed system would produce a larger tax increases for these families.

Another reason for the pattern of tax increases involves the width of the tax brackets. Taxpayers whose taxable incomes fall into the lower portions of the tax brackets would not experience increases in their marginal tax rate as a result of inflation induced increases in taxable income. Since their marginal tax rate would not be increasing, the change in their average tax rate would be less than it would have been if they had experienced a significant increase in the percentage of their income taxed at their highest marginal tax rate or if they had been pushed into a higher marginal tax rate bracket. This phenomenon, which is commonly referred to as "bracket" creep, produces the pattern of discrete jumps in average tax rates at certain points on the income scale that is shown in table 3.

For example, the family with 1994 income of $75,000 experiences a 1.07 percentage point increase in its average tax rate between 1994 and 1997. This relatively large change occurs primarily because this family experienced a significant growth in the percentage of its income taxed at its highest marginal tax rate of 28 percent. Since taxpayers at the highest income levels essentially face a flat rate tax, they would experience smaller increases in their average tax rates from repeal of tax indexation than would taxpayers with lower incomes.

CONCLUSIONS

Adoption of tax indexation represented a major reform of the Federal individual income tax system. Economic theory is unambiguous in that to minimize distortions in resource allocation, an ideal income tax would assess tax on a real (inflation-adjusted) basis. Indexation of the tax structure is one means of moving closer to this theoretically ideal tax system.

Although elimination of indexation might be a politically viable way of raising additional revenues, from a purely economic perspective, it has several drawbacks. First, it would be a retreat from tax reform. Second, as opposed to a more explicit form of tax increase, the effectiveness of repealing indexation as a means of raising specific amounts of revenue depends to a great extent on factors over which there is very little legislative control. If inflation is lower than anticipated, then the revenue yield would be less than expected. If inflation accelerates, then the revenue yield is higher, but the tax increase is larger than anticipated.

Finally, elimination of indexation has very uneven distributional effects across the income spectrum. Large families would see their tax burdens increase more than smaller families. Lower income taxpayers, especially if indexation of the EITC were repealed, would see larger tax increase than taxpayers at the upper end of the income scale.

² General Explanation of the Economic Recovery Tax Act of 1981.

³ U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. JCS-10-87. May 4, 1987. Washington, D.C.

⁴ U.S. Congress. Conference Committees, 1990. Omnibus Budget Reconciliation Act of 1990. Conference Report to Accompany H.R. 5835. H.Rpt. 101-964. October 1990. Washington, D.C.

⁵ U.S. Congress. Conference Committees, 1993. Conference Report on H.R. 2264, Omnibus Budget Reconciliation Act of 1993. H.Rpt. 103-213. August 1993. Washington, D.C.

⁶ For more information of the current Federal individual income tax rate structure see: U.S. Library of Congress. Congressional Research Service. Individual Income Tax Rates: 1994, by Gregg A Esenwein. CRS Rep. 93-921E. October 1993. 15p.

⁷ For more information on the EITC see: U.S. Library of Congress. Congressional Research Service. The Earned Income Tax Credit: A Growing Form of Aid to Low Income Workers, by James Storey. CRS Rep. 93-384EPW. October 20, 1993. 28 p.

⁸ United States Congress. Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. March 1994. Washington, D.C.