Senate Finance Committee Tax Plan: An Analysis

Senate Finance Committee Tax Plan:
Backloading Holds Down Near-Term Costs;
Provisions Benefiting Higher-income Taxpayers Explode in Future Years

The tax cut plan the Finance Committee approved June 20 is designed in a fashion that keeps its costs artificially low in the initial years so that the plan fits within the cost limits the budget agreement sets. The Finance Committee proposal, however, includes an array of costly tax cuts — primarily for higher-income taxpayers — that swell in cost over time.

While the Finance Committee plan lacks the capital gains indexing provision in the tax plan that the Ways and Means Committee has approved and some of the Ways and Means Committee's corporate tax cuts, its estate tax and Individual Retirement Account expansions are larger than those in the House package. The Finance Committee plan ultimately becomes a package that is both very expensive and heavily tilted in favor of upper-income taxpayers. The Joint Tax Committee revenue tables on the Finance Committee package show that:

The costs of key elements of the Senate Finance Committee tax cut, especially those benefiting higher-income taxpayers, would continue to grow substantially in the years beyond 2007. Based on the Joint Tax Committee's estimate of the year-by-year costs of the tax cut in the first 10 years and the design of these proposals, we estimate the Finance Committee tax proposals would lose between $600 billion and $700 billion in the second 10-year period, from 2008 through 2017. (See second text box for a discussion of these estimates and the methodology underlying them.) This is the period when the baby boom generation begins to retire and deficits are forecast to rise to alarming levels that will damage the economy unless unprecedented austerity measures are instituted.

The heavy backloading of provisions that provide most of their tax cut benefits to high-income individuals allows the Committee to fit an extensive array of tax cuts within the cost constraints that the budget agreement establishes for the initial five-year and ten-year periods. The backloading devices also serve to mask the fact that when fully in effect, the Finance Committee tax plan is heavily tilted toward those on the upper rungs of the economic ladder.

The IRA, estate tax, and capital gains provisions of the Finance Committee plan make heavy use of gimmicks — including timing shifts in revenue collections and slow phase-ins — to minimize the revenue losses that these tax cuts would cause during the first five years, as well as for several years thereafter. Ultimately, however, these upper-income tax cut provisions become very costly.

The Finance Committee approved two types of IRA expansions. One type, like the Ways and Means Committee version, is designed to defer most of the revenue loss it causes until after the end of the initial 10-year period. These "backloaded" IRAs, known as "IRA Plus" accounts, also are engineered so that billions of dollars in taxes the federal government normally would collect after 2002 (and largely after 2007) would be collected between fiscal years 1999 and 2002 instead.

These backloaded IRA gimmicks are used to mask the cost of other IRA tax breaks, especially during the first five years. In addition to establishing the new backloaded IRAs, the Finance Committee plan also increases the income limits below which taxpayers covered by employer-sponsored retirement plans may make deductible deposits to IRAs.⁽³⁾ While the cost of these IRA provisions in the Finance Committee plan is $3.3 billion over the first five years, according to the Joint Tax Committee, the cost increases six-fold to $20.5 billion in the second five-year period from 2003 to 2007. In 2007, the cost equals $5.5 billion in a single year and is growing at a rate of more than $500 million a year. Ultimately, the annual revenue loss from the IRAs expansions would reach $10 billion to $11 billion.

Features of Finance Committee Child Tax Credit Increase Plan's Regressivity

The Finance Committee plan denies the child credit to four million children in near- poor and lower-middle income families that would have received the credit under earlier versions of the child credit. The Finance Committee plan denies the credit to these children by limiting the credit to families that have an income tax liability after half the value of the earned income tax credit is computed. The version of the child credit passed by Congress in 1995 as well as the version introduced by Senator Lott earlier this year would have provided it to families that had an income tax liability before the EITC is computed.

This change would deny or reduce the size of the credit for several millions of families in the $15,000 to $30,000 range and would raise to 38 percent the proportion of children that would fail to qualify for the credit because their families' incomes are not high enough. While reducing the number of lower-middle-income children qualifying for the credit, the Finance Committee plan does not scale back the number of children at higher income levels who qualify for it. While nearly two of every five children would not qualify for the credit because their families' incomes are not high enough, fewer than three percent would fail to qualify because their families' incomes are too high.

The Senate Finance Committee plan would create still another IRA tax break in the form of an education IRA, which would work much like the backloaded IRA Plus accounts. Taxpayers at all income levels would be eligible to deposit up to $2,000 each year for each child, plus the amount of any child tax credit received; interest earned on the accounts would be forever free of tax if the funds were ultimately withdrawn for higher education expenses. Funds not used for education expenses could be withdrawn for other purposes or rolled over, free of tax, to a regular IRA account. By 2007, the education IRAs would add another $3.7 billion a year to the annual revenue loss, with the cost of these IRAs continuing to rise in cost at double-digit rates growth.

The estate tax cuts in the Finance Committee plan are phased in slowly by raising the estate tax exemption from $600,000 to $1 million over nine years. The exemption reaches the $1 million level in 2006, one year earlier than under the Ways and Means Committee plan. This slow phase-in results in an even greater degree of backloading than may initially be apparent. Probate and settlement of an estate generally must precede tax filing, and most estate tax returns for people who die in a given year are filed one to three years later. Due to the time needed for legal proceedings regarding estates, the effects of the $1 million exemption level would not begin to be felt until after 2007. Thus, the full cost of the estate tax cut would not be felt until after the end of the initial 10-year period. In addition, the exemption amount would be indexed annually for inflation in years subsequent to 2006, in effect creating a continuous phase-in of higher exemption levels. As a result, the cost of this provision would continue to rise after the phase-in is complete.

The Finance Committee estate tax cut goes beyond the Ways and Means Committee proposal by allowing an additional $1 million of of the value of a "qualified family-owned business or farm" in an estate to be sheltered from estate taxes. This provision applies without regard to the size of the family-owned business. While the term "family-owned business" conjures up a neighborhood grocery store, businesses such as a local grocery store would be unlikely to have sufficient net value to derive a benefit from this provision. On the other hand, some of the largest businesses in the country — businesses with annual sales and profits in the billions of dollars such as Mars candy, Cargill agribusiness, Continental Grain, and Koch Oil — are family owned and controlled. Owners of very large and mid-sized businesses, as constrasted with small businesses, would be major beneficiaries of this proposal.

The estate tax provisions would lose $6.5 billion in the first five years but $30.8 billion, or more than four times as much, in the second five years. In 2007, the loss would equal $9.8 billion in a single year. At that point, the revenue loss from this provision is rising sharply.

While the Finance Committee plan does not include the costly, backloaded capital gains indexing provision adopted by the Ways and Means Committee, it does contain an expensive capital gains rate cut that grows in cost over time. In the initial years after enactment, the reduced rate is assumed to bring in a boomlet of additional revenues, because some taxpayers who would hold their assets at the higher tax rate would presumably be willing to sell them at a lower tax rate. Thus, the finance capital gains rate cut is assumed to raise $8.3 billion in revenues in the first two years after enactment. Over the 1998-2002 period, the revenue losses from the capital gains cut average only $660 billion a year. But the cost rises in subsequent years, reaching an annual cost of $4.7 billion by 2007.

Cost in Second Ten Years Likely to Be $600 Billion to $700 Billion

The cost of a number of the provisions in the Finance Committee tax package grow substantially in cost over time. The cost in 2007 of the tax cuts primarily benefiting higher-income taxpayers — the capital gains, estate tax, and IRA provisions — is six times greater than the average annual cost of these provisions from 1998 through 2002, and costs are continuing to grow at the end of the 10-year period. The tax cut is likely to lose between $600 billion and $700 billion in the second 10-year period, from 2008 through 2017. Several methods of estimating the cost of the Finance Committee tax cuts during the second 10-year period produce similar results.

One conservative method of estimation is to assume that the cost of the tax cuts will grow by the same dollar amount in each year from 2008 through 2017 as the average amount the Joint Tax Committee revenue tables show the cost will grow from 2004 through 2007. Using that assumption, the annual cost of the tax cut would rise from $41 billion in 2007 to $81 billion in 2017. Estimated in this manner, the total cost of the tax cut in the 10-year period from 2008 through 2017 would be $633 billion.¹

Using the average annual increment in cost between 2004 and 2007 as the basis for projection, however, does not fully capture the rate at which the tax cut is growing in cost at the end of the first 10 years. For a number of reasons, the backloaded IRAs, the estate tax provisions, and changes in the individual alternative minimum tax are likely to continue for a number of years to rise in cost at rates similar to or only slightly below the rates at which these provisions are growing at the end of the initial 10-year period. Backloaded IRAs generally are estimated not to reach a stable cost until withdrawals balance new deposits, probably sometime in the latter part of the second decade after enactment. In addition, the rate of growth of the estate tax provisions would remain high for a few years into the second decade; the increase in the amount of an estate excluded from taxation would be fully phased in by 2006, but the extended time it normally takes to settle estates — and thus to pay the taxes on them — would postpone the full revenue loss from being felt for an additional three or four years. After that time, indexing of the estate tax exemption would keep growth high.

Thus, an alternative, still-conservative estimate would assume that the average rate at which the tax cut would grow between 2004 and 2007 would continue through 2010; for the remaining seven years through 2017, the growth in cost is assumed to fall back to the rate of GDP growth.² Under these assumptions, the cost in the 10-year period from 2008 through 2017 would be $646 billion.

It is likely, however, that tax cut would continue to grow at rates that exceed GDP growth for more than three years beyond the initial ten. A third potential method of estimation would assume that the average rate at which the tax cut would grow between 2004 and 2007 would continue through 2010, as in the previous estimate, and that the rate of growth then would decline gradually, falling back to the rate of GDP growth by 2014. This method is still conservative, because the cost of IRAs (as well as some other tax breaks) is likely to continue to grow at rates exceeding GDP throughout the second decade after enactment. Under this set of assumptions, the cost of the tax cut would rise from $41 billion in 2007 to $86 billion in 2017, and the cost in the 10-year period from 2008 through 2017 would be $684 billion.
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¹ The increases in cost of the Finance Committee tax cuts are $2.9 billion from 2004 to 2005, $4.1 billion from 2005 to 2006, and $5.0 billion from 2006 to 2007. The average increase of $4.0 billion substantially understates the extent to which the tax package is growing at the end of the initial 10-year period.
² GDP growth is assumed to be 4.6 percent each year. This is the growth rate for the years 2006 and 2007 in the Congressional Budget Office's March 1997 baseline.

By contrast, the major tax cut provisions that largely benefit middle-income taxpayers do not mushroom in cost over time; that is a characteristic primarily of the upper-income tax cuts in the Finance Committee plan. The two principal provisions largely targeted to middle- and upper-middle-income families — the child tax credit and the HOPE scholarships — have costs that remain steady over the 10-year period. The $22.7 billion cost of these two provisions together in 2007 is slightly less than their $23.3 billion cost in 1999.

Fitting the Budget Agreement without Capital Gains Indexing

The cost of the Finance Committee tax cut does not increase smoothly over the 10-year period; like the cost path set forth in the budget agreement and the Ways and Means Committee tax bill, the cost dips in 2002 and then increases substantially in subsequent years. The Ways and Means Committee version achieves the 2002 cost dip by instituting capital gains indexing in 2001 and using a gimmick that causes the collection in 2002 of capital gains revenues that would otherwise have been collected in future years.

In the Finance Committee plan, which does not include capital gains indexing, the dip is cost in 2002 results from a gimmick involving the airline ticket tax. The provision of the Finance Committee plan involving the airline ticket tax is designed to shift some airline ticket tax revenues that would have been collected at the end of fiscal year 2001 into the beginning of fiscal year 2002. This shift does not change the total amount of revenue the airline ticket tax raises, but simply results in lowering fiscal revenue collections in fiscal year 2001 and increasing collections for fiscal year 2002.

As the cost of provisions benefiting higher-income taxpayers increases over time while the cost of the child tax credit and the HOPE scholarships remains constant, the benefits of the tax package as a whole become increasing skewed toward upper-income taxpayers.

The Joint Tax Committee tables show that taken together, the capital gains, estate tax, and IRA provisions (including the education IRA) would lose a total of $15.1 billion during the years through 2002. In the second five years, from 2003 through 2007, the revenue loss from these provisions jumps to $89.5 billion nearly six times as much as the loss in the initial five-year period.

Furthermore, these figures do not reflect other major tax cuts in the package that would confer sizable shares of their tax cut benefits on high-income taxpayers. For example, while the increase in the exemption from the individual alternative minimum tax will prevent middle-income taxpayers from becoming subject to a provision that never was intended to affect them, it also will lower the taxes of many higher-income taxpayers.

The alternative minimum tax provision also grows in cost substantially over time. Eventually, the Senate Finance Committee plan becomes a piece of legislation whose predominant effect is to provide upper-income tax relief and enlarge the after-tax incomes of those in the most affluent strata of society.

Tables from the Treasury Department, which measured the effect of the Roth tax proposal (prior to mark-up) when fully implemented, find that more than 65 percent of the revenue loss resulting from the tax cuts would benefit the top 20 percent of taxpayers. The benefit going to the highest-income one percent of taxpayers would be greater than the benefit shared by the bottom 60 percent of all taxpayers.

These tax cuts for upper-income taxpayers would mushroom in cost just as the baby boom generation begins to retire. Both CBO and GAO long-term forecasts indicate that deficits will shoot up in the baby boom generation's retirement years, as Medicaid, Medicare and Social Security costs rise substantially while the ratio of workers to retirees falls. These long-term forecasts show that deficits are expected to reach levels in these years that would cause serious damage to the economy over time.

1. Congressional Budget Office, Perspectives on the Ownership of Capital Assets and the Realization of Capital Gains, May 1997.

3. It also proposes to eliminate income limits on deductible deposits to IRAs for taxpayers whose spouses are covered by employer-sponsored retirement plans.