CRS REPORTS ON TAX CHANGES UNDER OBRA.

                          Gregg A. Esenwein

The Omnibus Budget Reconciliation Act of 1990 (OBRA90) changed the marginal income tax rate structure for individuals. Prior to OBRA90, provisions in the Tax Reform Act of 1986 (TRA86) had created an individual marginal income tax rate structure that consisted of two statutory tax rates, 15 and 28 percent. However, TRA86 also legislated a 5 percent surcharge on the taxable income of certain upper-income households which effectively created a third marginal tax rate of 33 percent. Because the surcharge was phased out as income increased, marginal tax rates rose to 33 percent but then fell back to 28 percent creating an anomaly which came to be known as the tax rate "bubble."

OBRA90 eliminated the 5 percent surcharge and created a marginal tax rate structure consisting of three statutory marginal tax rates of 15, 28, and 31 percent. However, OBRA90 also contained a provision which would limit the amount of itemized deductions that upper-income households could claim and a provision which modified the phaseout of the tax benefits of personal exemptions for upper-income households.

Although OBRA changed the tax rate structure, it maintained, in a slightly modified form, the policy of tax indexation introduced in 1981. Under the Act, the personal exemptions, standard deductions, earned income tax credit, and the tax rate brackets are indexed for inflation. Tax indexation helps prevent inflation from producing automatic tax increases and unintentional changes in the distribution of the tax burden.

TABLE OF CONTENTS

TAX RATES AFTER THE TAX REFORM ACT OF 1986

TAX RATES AFTER THE OMNIBUS BUDGET RECONCILIATION ACT

EFFECTS OF INFLATION ON REAL INCOME TAX LIABILITIES

THE MECHANICS OF INDEXATION

MARGINAL TAX RATE SCHEDULES FOR 1989, 1990, AND 1991

INDIVIDUAL INCOME TAX RATES: 1991

The Omnibus Budget Reconciliation Act of 1990 (OBRA90) changed the marginal income tax rate structure for individuals. Prior to OBRA90, provisions in the Tax Reform Act of 1986 (TRA86) had created an individual marginal income tax rate structure that consisted of two statutory tax rates, 15 and 28 percent. However, TRA86 also legislated a 5 percent surcharge on the taxable income of certain upper-income households which effectively created a third marginal tax rate of 33 percent. Because the surcharge was phased out as income increased, marginal tax rates rose to 33 percent but then fell back to 28 percent creating an anomaly which came to be known as the tax rate "bubble."

OBRA90 eliminated the 5 percent surcharge and created a marginal tax rate structure consisting of three statutory marginal tax rates of 15, 28, and 31 percent. However, OBRA90 also contained a provision which would limit the amount of itemized deductions that upper-income households could claim and a provision which modified the phaseout of the tax benefits of personal exemptions for upper-income households. Both of these provisions have implications for marginal income tax rates.

The following sections of this report describe the marginal tax rate structures under the Tax Reform Act of 1986 and the Omnibus Budget Reconciliation Act of 1990. In addition, the reasons for tax indexation and the mechanics of tax indexation are briefly explained. The final section contains the tax rate schedules, exemption amounts, and standard deductions for joint, single, and head of household returns for tax years 1989, 1990, and 1991.

TAX RATES AFTER THE TAX REFORM ACT OF 1986

Prior to 1986 there were approximately 14 marginal income tax rates ranging from 11 to 50 percent. For tax years after 1987, the Tax Reform Act reduced the marginal tax rate structure to two statutory tax rates of 15 and 28 percent.

Although the Tax Reform Act specified that there were only two statutory individual marginal income tax rates, it also adopted a 5 percent surcharge on the taxable income of certain upper-income households. This surcharge effectively created a third marginal tax rate of 33 percent (28 percent statutory marginal tax rate plus 5 percent surcharge) and produced an anomaly in the tax code that came to be known as the tax rate "bubble."

Because the surcharge was phased out as incomes increased, marginal tax rates rose to 33 percent but then fell back to 28 percent. Hence, the tax rate "bubble." The surcharge was adopted so that the 1986 Act would not change the distribution of the income tax burden relative to its distribution under pre-1986 tax law, would meet the needed revenue targets, and yet allow the 1986 Act to be characterized as having only two statutory marginal tax rates.

The surcharge was designed to phaseout the tax benefits of the 15 percent tax bracket and the tax benefits of the personal exemptions for upper-income households. For joint returns in 1990, the phaseout of the tax benefits of the 15 percent tax bracket starts when taxable income exceeds $78,400 and ends when taxable income reaches $162,770. For single returns, the phaseout of the 15 percent tax bracket occurs over the taxable income range of $47,050 to $97,620. For heads of households, the phaseout occurs over the taxable income range of $67,200 to $134,930.

To demonstrate how the 5 percent surcharge works to "phaseout" the tax benefits of the 15 percent tax bracket consider the following example based on joint returns for 1990. Five percent of the difference between the upper and lower phaseout limits is $4,218.50 ($162,770 less $78,400 multiplied by 5 percent). The difference between taxing the first $32,450 of taxable income at 28 percent instead of 15 percent is also $4,218.50. Hence, assessing the 5 percent surcharge on taxable income between $78,400 and $162,770 is equivalent to having taxed the first $32,450 of taxable income at 28 rather than 15 percent. The 5 percent surcharge produces identical results for both single and head of household returns. This surcharge effectively raises the marginal tax rate on taxable income within these ranges from 28 to 33 percent (28 percent statutory marginal tax rate plus 5 percent surcharge).

A 5 percent surcharge is also used to phaseout the tax benefits of the personal exemption for upper-income households. In 1990, each personal exemption is worth $2,050 and produces a tax savings for a household in the 28 percent marginal tax rate bracket of $574 ($2,050 times 28 percent). To recapture this tax savings a 5 percent surcharge is assessed against $11,480 of taxable income for each personal exemption claimed. A 5 percent surcharge against this amount of taxable income increases tax liability by $574 ($11,480 times 5 percent), which exactly offsets the tax savings from the personal exemption.

The phaseout of personal exemptions starts immediately after the phaseout of the 15 percent tax bracket and the phaseout of each exemption occurs sequentially. This means that the taxable income range over which the 5 percent surcharge applies depends on the number of personal exemptions claimed on the tax return. For example, on a joint return claiming twopersonal exemptions the 5 percent surcharge would apply to taxable income between $162,770 and $185,730 ($162,770 plus two times $11,480). On a joint return with four personal exemptions, the 5 percent surcharge would apply to taxable income between $162,770 and $208,690 ($162,770 plus four times $11,480).

As was also the case with the phaseout of the tax benefits from the 15 percent tax bracket, the phaseout of the personal exemption effectively raises the statutory marginal tax rate from 28 to 33 percent (28 percent regular tax rate plus 5 percent surcharge). As noted, the income range over which the effective marginal tax rate is 33 percent depends on the number of personal exemptions claimed.

TAX RATES AFTER THE OMNIBUS BUDGET RECONCILIATION ACT

The Omnibus Budget Reconciliation Act of 1990 created a three- tiered statutory marginal income tax rate structure with rates of 15, 28, and 31 percent effective in tax years beginning in 1991. (Table 3 shows the marginal tax rate schedules for joint, single, and head of household returns in 1991). OBRA90 also eliminated the tax bubble by repealing the 5 percent surcharge that was instituted under TRA86. Although the 5 percent surcharge was repealed, it was replaced with a limitation on itemized deductions and a new approach to phasing out the tax benefits of the personal exemption for upper-income households.

OBRA90 also reintroduced a tax rate differential on capital gains income. Provisions in the 1986 Act had eliminated the preferential tax treatment of capital gains income and hence, capital gains income was treated as ordinary income and taxed at regular rates of up to 33 percent. OBRA90 contains a provision which would limit the tax on capital gains income to a maximum of 28 percent. This provision would be effective starting in tax year 1991.

The new limitation on itemized deductions works as follows. For tax years starting in 1991, otherwise allowable deductions are reduced by 3 percent of the amount by which a taxpayer's adjusted gross income (AGI) exceeds $100,000 (except in the case of married couples filing separate returns where the AGI limit is $50,000). For example, if a taxpayer's AGI were $110,000 then his otherwise allowable itemized deductions would be reduced by $300 ($110,000 less $100,000 times 3 percent). This provision effectively raises the marginal income tax rate of those taxpayers affected by approximately 1 percentage point. (A dollar of income in excess of $100,000 is taxed as if it were $1.03 since in addition to the extra dollar of income the taxpayer loses .03 of itemized deductions.)

Allowable deductions for medical expenses, casualty and theft losses, and investment interest are not subject to this limitation. For tax years after 1991, the $100,000 threshold will be indexed for inflation. This provision is scheduled to expire after tax year 1995.

The modified phaseout of the tax benefits of the personal exemption works as follows. Each personal exemption is phased out by a factor of 2 percent for each $2,500 (or fraction of $2,500) by which a taxpayer's AGI exceeds a given threshold amount. In 1991, the threshold amount for a joint return is $150,000, for a single return the threshold is $100,000, and for heads of households the threshold is $125,000.

For example, a joint household whose AGI was $183,000 would lose 28 percent of their total personal exemptions claimed. The AGI amount in excess of the threshold in this instance would be $33,000, $183,000 AGI less $150,000 threshold limit. The $33,000 excess divided by $2,500 would produce a factor of 13.2 which when rounded up would equal 14. This figure is multiplied by 2 percent to arrive at the final disallowance amount of 28 percent. Hence, if the family had claimed two personal exemptions, which at $2,150 each would total $4,300, they would only be allowed to deduct $3,096 ($4,300 total personal exemptions less the $1,204 disallowance, which is 28 percent of the total).

For tax years after 1991, these threshold amounts will be indexed for inflation. This provision is also scheduled to expire after tax year 1995.

EFFECTS OF INFLATION ON 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 (the exception to this statement, the tax bubble, is explained later). 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 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 $30,000 income who filed a joint return in 1989. If we assume that the family did not itemize its deductions, but rather used the standard deduction, then its taxable income would have been $16,800 ($30,000 less standard deduction of $5,200 and four personal exemptions at $2,000 apiece). Income tax liability on taxable income of $16,800 would have been $2,250 which translates into an average tax rate of 8.4 percent ($2,250 income tax liability divided by $30,000 income). (See Table 1 for 1989 tax rates.)

Now consider what would happen if inflation averaged 5 percent in 1990. In order to maintain the same real gross income that it had in 1989, the family would have to earn $31,500 in 1990. Assuming there is no indexation, the family's taxable income would be $18,300 ($31,500 less the standard deduction of $5,200 and four personal exemptions at $2,000 apiece). Income tax owed on a taxable income of $18,300 would be $2,745 which translates into an average tax rate of 8.7 percent. As can be seen from this example, under an unindexed tax system, inflation increased this family's real income tax burden by 0.3 of a percentage point between 1989 and 1990.

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 $5,200 in 1989 to $5,460 in 1990. The personal exemption would have increased from $2,000 to $2,100. Under these circumstances the family's 1990 taxable income would have been $17,640 ($31,500 income less standard deduction and personal exemptions). Based on this taxable income their income tax liability would have been $2,646 which translates into an average tax rate of 8.4 percent. Thus, under an indexed tax system the family would have experienced no change in their real income tax liability between 1989 and 1990.

THE MECHANICS OF INDEXATION

Provisions originally contained in the Economic Recovery Tax act of 1981 and later amended by both the Tax Reform Act of 1986 and the Omnibus Budget Reconciliation Act of 1990, specify that certain components of the individual income tax system will be indexed for inflation. These components include the standard deductions, the additional standard deductions for the elderly and the blind, the personal exemption, the earned income tax credit (EITC), the income breakpoints between the various tax rate brackets, the income level at which the limitation on itemized deductions becomes effective, and the income level above which the tax benefits of the personal exemptions are phased out.

The adjustment for any given tax year is to be 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 will be rounded down to the nearest multiple of $50. Although rounding down will affect 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 period.

For example, the adjustment factor for 1991 is calculated as follows. The average CPI-U for the base period, September 1988 through August 1989, was 122.15. The average CPI-U for the period September 1989 through August 1990 was 128.06. Given these amounts, the inflation adjustment factor for 1991 is 1.0484 (128.06/122.15). This inflation adjustment factor is then applied to the 1990 nominal dollar values of the affected tax components to determine their values for 1991.

For instance, the standard deduction for joint returns in 1990 was $5,450. Multiplying this amount by the inflation adjustment factor produces a 1991 value of $5,714. Rounding down to the nearest $50 multiple results in a 1991 standard deduction for joint returns of $5,700. This same process is applied to all of the other indexed components of the tax code to determine their values in terms of 1991 dollars.

MARGINAL TAX RATE SCHEDULES FOR 1989, 1990, AND 1991

The following three tables present the marginal tax rates schedules, personal exemption amounts, and standard deductions for tax years 1989, 1990 and 1991.

 TABLE 1. Statutory Marginal Tax Rates, Personal Exemptions, And