EITC EXPANSION, NEW MARGINAL RATES IN OBRA 1993 INCREASE MARRIAGE PENALTIES, BONUSES.

MARRIAGE TAX PENALTIES AFTER THE OMNIBUS BUDGET RECONCILIATION ACT OF 1993

Gregg A. Esenwein Specialist in Public Finance Economics Division

SUMMARY

The Omnibus Budget Reconciliation Act of 1993 (OBRA93) reduced the marriage neutrality of the Federal individual income tax system at the lower and upper ends of the income spectrum. This reduction in marriage neutrality occurred because OBRA93 significantly expanded the size and coverage of the earned income tax credit (EITC) and added two new marginal income tax rates, 36 and 39.6 percent, at the upper-end of the income range. Consequently, when compared to prior law, some married couples will pay more in income taxes than they would have as two unmarried single individuals (or as two unmarried heads of household), while other married couples will pay less income taxes than they would have as two unmarried single individuals (or two unmarried heads of household). ¹

BACKGROUND

It is a widely accepted goal that the individual income tax should not influence the choice of individuals with regard to their marital status. Marriage neutrality, however, conflicts with two other widely accepted concepts of equity: progressivity (income tax payments should rise as a percentage of income as income increases) and that couples with the same total income should pay the same tax.

Regardless of how these three concepts of equity are juggled, however, under current definitions an income tax can be designed to achieve only two of the goals. It can not simultaneously achieve all three. The system might be marriage neutral and tax couples with equal incomes equally, but then it would not be progressive. As an alternative, the tax system might be progressive and tax couples with equal incomes equally, but then it would not be marriage neutral.

By increasing the EITC and adding two new marginal tax rate brackets, OBRA93 made the individual income tax structurally more progressive than it had been under prior law. The cost of this increased structural progressivity, however, was a decrease in the system's marriage neutrality at the lower and upper ends of the income scale. There is no unambiguous answer to whether this trade off between increased structural progressivity and decreased marriage neutrality has made the income tax more or less equitable.

CAUSES OF STRUCTURAL PENALTIES AND BONUSES

The most important structural factors affecting the marriage neutrality of the income tax are the earned income tax credit, the standard deduction, and the tax rate schedules. Under the current system, single individuals, heads of household, and married couples are subject to different standard deductions and tax rate schedules. The EITC amount and phaseout range varies based on the number of dependents claimed on each return. These differences give rise to marriage tax penalties and bonuses.

When the income of one spouse is added to the income of the other spouse, a married couple might find themselves paying either more tax (a marriage penalty) or less tax (a marriage bonus) than they would by filing as two singles. Conversely, two singles (or two heads of household) contemplating marriage might find that their income tax liability increases (a marriage tax penalty) or decreases (a marriage tax bonus) by filing a joint return.

In general, the division of income, or income split, of two individuals determines whether they have a marriage tax bonus or penalty. The largest marriage bonuses occur when one spouse earns 100 percent of the total income. In this case, the married couple can take full advantage of the higher standard deduction and the lower marginal tax rate brackets for joint returns. Had they filed as two singles, since only one had income, the entire tax burden would have been borne by the one individual filing a single return.

The more evenly divided the income the more likely a married couple will experience a marriage tax penalty. The largest tax penalties occur where the income is evenly divided between the two spouses, a 50/50 income split. In this instance the stacking of income and the resultant taxation at higher marginal tax rates produces a larger tax liability for a joint return than would have been the case for two single returns. At the lower end of the income scale, the stacking of income may result in reduced EITCs for joint returns compared to what they would have been had the couple filed as two singles (or two heads of household.)

STRUCTURAL CHANGES UNDER OBRA93

OBRA93 made two major structural changes that affected the marriage neutrality of the individual income tax. It increased and expanded the EITC, and it added two new marginal tax rates, 36 and 39.6 percent, at the upper-end of the income scale. The EITC was changed in several ways. OBRA93 repealed the supplemental tax credit for children under one-year of age and the supplemental tax credit for health insurance premiums for children. At the same time, OBRA93 increased the maximum EITC for families with qualifying children; extended the income range over which the EITC is phased out; and extended EITC coverage to childless taxpayers ages 25 to 64 who are not claimed as dependents on another taxpayer's return.

The expansion of the EITC will be phased in over a 3-year period starting January 1, 1994. Table 1 compares the EITC under prior law and the EITC under OBRA93 for tax year 1994. ²

         TABLE 1. EITC in 1994 Under Prior Law and Current Law

              TABLE 2. Statutory Marginal Tax Bates, 1994

Although the changes in OBRA93 increased both marriage tax penalties and marriage tax bonuses from what they had been under prior law, public attention has focused only on the penalty side of the issue. In addition, popular discussions of the subject have failed to make clear that the problem of a non-marriage neutral income tax existed prior to OBRA93 and was not a result of the Act. Since it appears that people are primarily concerned with marriage tax penalties, the following analysis focuses on the change in marriage tax penalties from their levels under prior law. (It should be noted, however, that from an equity standpoint, marriage tax bonuses are just as problematic as marriage tax penalties.)

Table 3 shows the worst case scenario marriage tax penalties in 1994 for single individuals with equal incomes, no dependents, and who qualify for the EITC. For example, table 3 shows that two single individuals with incomes of $5,000 each (total income of $10,000) would pay $612 more in taxes if they got married than they would as two single individuals. This occurs because as single individuals they both qualify for the maximum EITC of $306 where, if they were a married couple, their $10,000 total income would put them over the threshold for the phaseout of the EITC. As indicated in this table, the new EITC increases the marriage penalty from what it had been under prior law for taxpayers with these characteristics and total incomes up to $18,000.

Table 3 also indicates that the two new marginal tax rates adopted under OBRA93 produce increased marriage tax penalties for taxpayers with incomes in excess of $150,000. The maximum dollar marriage tax penalty for two singles in 1994 will be $15,520, a substantial increase over the maximum prior law penalty of $1,912. This increase occurs primarily because the 39.6 percent marginal tax rate applies to taxable incomes in excess of $250,000 for singles, married couples, and heads of household. Hence, two singles (or two heads of household) with taxable incomes of $250,000 each would not see any of their income taxed at 39.6 percent; if they married, however, $250,000 of their total taxable income would fall into the 39.6 percent marginal tax rate bracket.

              Table 3. Worst Case Marriage Tax Penalties

              Table 4. Worst Case Marriage Tax Penalties

Although marriage tax penalties are quite large under current law, it is important to remember that large marriage tax penalties also occurred under prior law. For instance, while two heads of household might face marriage tax penalties of up to $4,615 under current law, they would have incurred a penalty of $3,823 under pre- OBRA93 tax provisions. It should also be realized that the OBRA93 increase in the EITC reduced tax liabilities for taxpayers in the lower income ranges. Hence, although they may appear worse off in a relative sense because marriage tax penalties have increased, in an absolute sense, taxpayers in the lower income ranges are still better off because their taxes are actually lower under OBRA93 than they would have been under prior law.

² For detailed 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 Report No. 93-384 EPW, by James R. Storey. Oct. 20, 1993, 28p.