June 26, 1998 IRS Reform Bill Includes New Salvo
of Tax Cuts for Wealthy
by Iris J. Lav
The conference agreement on the Internal Revenue Service Restructuring and Reform Act of 1998, H.R. 2676, includes two new tax breaks: an expansion of the Roth IRA provisions that were enacted in 1997, and a reduction in the capital gains tax rate that is applied to certain types of asset sales. Most of the benefits of the two tax breaks included in the conference agreement will accrue to the wealthiest five percent of taxpayers.
- The sole beneficiaries of the new IRA tax break will be the most affluent five to seven percent of the elderly and their heirs.
- It is likely that more than three-quarters of the benefits of the new capital gains tax break will go to the highest-income five percent of taxpayers. More than three-fifths of the benefits will go to the highest-income one percent of taxpayers, those with incomes exceeding $200,000.
In a dubious and somewhat cynical manipulation of Congressional budget rules, the conference agreement uses the IRA tax break to "pay" for the capital gains tax break. As the provisions are officially scored, one tax break for the wealthy appears to pay for the other upper-income tax break. There are limits, however, to the length of time this type of sleight-of-hand can be sustained. So while the agreement is revenue neutral over the 10-year period that the budget rules specify must be considered, the tax cut reverts to form and the legislation begins to lose billions shortly after the 10-year period ends.
In the second 10-year period from 2008 through 2017, this legislation will lose approximately $30 billion. This substantial revenue loss will occur in the same period the baby boomers begin to retire in large numbers, Medicare is projected to become insolvent, and the Congressional Budget Office and General Accounting Office project that budget deficits will return and start a climb toward record levels.
Lower Capital Gains Rate for Assets Held Short Periods
The Taxpayer Relief Act of 1997 reduced the maximum tax rate on capital gains income from 28 percent to 20 percent. The reduction applied to profits derived from the sale of assets held more than 18 months. As the conference on the IRS reform legislation was nearing completion, a last-minute provision was added to reduce the period an asset must be held to qualify for the preferential 20 percent tax rate from 18 month to 12 months.
Like most capital gains tax breaks, this provision is said to gain revenue in the first few years it is in effect. It generally is assumed that some people will sell assets sooner than they otherwise might have if the tax rate on the profits from the sales is lower. But the additional asset sales are largely an acceleration of sales that otherwise would have occurred in future years, so the revenue-enhancing effect disappears over time. This effect is reflected in the Joint Committee on Taxation estimate of the cost of the provision.
- The Joint Committee on Taxation estimates the shortening of the holding period required to take advantage of the 20 percent capital gains tax rate costs $2.1 billion over the 10-year period from 1998 through 2007.
- In the first five years the provision would be in effect, the Joint Committee finds the cost to be just $338 million. In the second five-year period from 2003 to 2007, the Joint Committee shows the cost rising to $1.7 billion. This means the cost over the second 10 years the provision would be in effect would exceed $3.4 billion.
More than three-quarters of the benefits of this new capital gains tax break are likely to go to the highest-income five percent of taxpayers. While many middle-income households own some stock and other capital assets and have some capital gains income nearly two-thirds of tax returns reporting capital gains are filed by people whose incomes are under $50,000 the amounts of capital gains income received by middle-class families tend to be small. As a result, analysis by the Congressional Budget Office finds that capital gains income and the taxes paid on that income is highly concentrated among upper income households.
The CBO analysis finds that about three-quarters of all capital gains taxes are paid by taxpayers with income that exceed $100,000, roughly the highest-income five percent of all families. More than 60 percent of all capital gains taxes are paid by the highest-income one percent of families, those with incomes exceeding $200,000.(1)
It is likely that the benefits from the capital gains tax break in the IRS reform bill the provision allowing assets held for 12 months rather than 18 months to be taxed at the lower, preferential rate will be at least as skewed in favor of high-income taxpayers as are capital gains profits as a whole. If anything, taxpayers who frequently buy and sell stocks, or who trade "put and call" options, commodity futures, and similar instruments that are held for shorter periods of time are more likely to be upper-income than the average taxpayer who realizes some capital gains income from other types of investments.
Expanded IRA Tax Break
The IRS reforms and the capital gains tax break are financed in large measure by an expansion of the Roth IRA tax break enacted in last year's tax bill. This tax break is cleverly designed so it temporarily raises approximately $8 billion in revenue over the 10-year period over which the budget consequences of the legislation are measured. Once the 10-year period ends, however, the provision loses billions.
The IRA provision would allow some elderly taxpayers (age 70½ and above) with annual incomes in excess of $100,000 to convert their existing, conventional Individual Retirement Accounts into so-called Roth IRAs. Last year's tax legislation recognized how lucrative the opportunity to make this conversion could be for high-income elderly and so allows conversion only by taxpayers with income below $100,000. Lifting this ceiling will provide substantial advantages for many wealthy elderly and their heirs.
First, the wealthy elderly would gain tax-free earnings. Converting funds from conventional IRAs to Roth IRAs is accomplished by paying income tax on the balances in the conventional IRAs. (These taxes otherwise would be due as account-holders gradually withdraw their funds.) Once a conversion is made, all future earnings on funds held in Roth IRAs are tax-free.
Second, converting funds to Roth IRAs would enable wealthy elderly individuals to make large bequests on a tax-free basis. Affluent holders of Roth IRAs need not take any distributions from the accounts. This is in contrast with the rules governing conventional IRAs, which require distributions beginning at age 70½. When the holders of the Roth IRA accounts die, their heirs can inherit the Roth accounts free of income tax. The heirs also generally can continue to escape income tax on the amounts these accounts earn for many years thereafter.
Finally, converting conventional IRAs to Roth IRAs can help wealthy people reduce their estate taxes. For elderly individuals whose wealth exceeds the estate tax exemption, which rises to $1 million by 2006, the payment of income taxes at the time conventional IRAs are converted to Roth IRAs can reduce the liability of their heirs to pay estate tax. The income tax payments at the time of conversion reduce the size of the estate that is inherited, so in a sense the income tax payments are substituted for later estate tax payments. This is of particular benefit because the tax rate paid on the taxable portions of large estates, up to 55 percent, substantially exceeds the income tax rates that apply to the payments made at the time the accounts are converted from conventional to Roth IRAs.
This new tax break is expected to result in a flood of well-to-do elderly people seeking to capture the new tax benefits. It is the taxes these wealthy elderly will pay to convert their accounts to Roth IRAs that are used in the conference agreement to finance most of the cost of the IRS reforms and the capital gains tax cut. According to the Joint Committee on Taxation, the conversion payments result in revenue increases for three years after enactment, with annual losses thereafter. In the IRS legislation, the starting date of this new tax break is delayed to 2005. As a result, only the revenue gain from the conversions and none of the revenue loss that begins once the rush of conversions is finished falls inside the 10-year budget window.
- The Joint Committee on Taxation has estimated that federal revenues would increase $8 billion in the first three years the provision was in effect from 2005 to 2007, as affluent elderly individuals rushed to convert conventional IRAs to Roth IRAs and paid income tax on the converted amounts.
- But the Joint Committee also estimates that starting in the fourth year and forever thereafter the provision would lose an average of more than $1 billion a year in revenue as the income and estate taxes of wealthy elderly individuals and their heirs were reduced.
The sole beneficiaries of this proposal would be the approximately five percent of older taxpayers with incomes exceeding $100,000 and their heirs. All taxpayers with incomes under $100,000 already are eligible under current law to convert their conventional IRA holdings to a Roth IRA.
Designed Deception: Out of Balance in Year 11 and Thereafter
The Senate budget rules require this type of legislation to be revenue neutral over a 10-year period. The IRS reform bill distorts the intent of that rule in a particularly cynical way. As noted, the new IRA tax break raises revenues as taxes are paid to make the conversion from conventional IRAs to the new Roth accounts, but after the initial three-year period the rush of conversions is finished and the provision begins to lose substantial amounts of revenue. By beginning the IRA provision in the eighth year of the 10-year period, all of the revenue gain and none of the revenue loss falls in the budget window. But by the eleventh year, the IRA provision, and the bill as a whole, is far from revenue neutral.
The Joint Committee on Taxation estimate of the conference report shows that the IRS reforms will cost approximately $1.6 billion in 2007, and the capital gains tax break and another small tax cut bring the 2007 cost to $2 billion. This cost is financed by the IRA provision, which raises $2.8 billion in 2007, and three other small revenue measures that together raise about $300 million. (The $1.1 billion difference between the $3.1 billion revenue gain and the $2.0 billion cost in 2007 is said to be "reserved for future tax reductions.")
Moving to 2008, outside the 10-year budget window, the cost of the legislation is likely to remain approximately $2 billion. But by 2008, the IRA provision no longer raises revenue and according to an earlier Joint Committee on Taxation estimate loses nearly $1 billion. So the bill as a whole will cost about $3 billion, with only the $300 million from the smaller revenue-raisers to support that cost. There is an unfunded annual cost of approximately $2.7 billion that appears just one year after the close of the 10-year budget estimating period.
As a result, this legislation will lose approximately $30 billion in the second 10 years, the period from 2008 through 2017. This is the same period the baby boomers begin to retire in large numbers, Medicare is projected to become insolvent, and the Congressional Budget Office and General Accounting Office project that budget deficits will return and start a climb toward record levels. Clever tricks such as beginning tax breaks in the eighth year of the budget period or paying for one tax cut with another do not constitute responsible budgeting.
1. The CBO analysis looked both at a single year, 1993, and at two different multiple-year periods. The CBO multi-year panel data analyses, in which the same taxpayers are considered over seven-year and 10-year periods, eliminate the criticism that sometimes is made regarding single-year snapshots. In single year data, a taxpayer with modest income who sells a business or home may be classified as a high-income taxpayer, while a high-income taxpayer who uses tax-minimizing strategies may appear to have a low income. The CBO study shows that these criticisms have little merit because the multi-year data, which classified families by their average income over the period, gave substantially similar results as the single-year findings. For example, both the seven-year and 10-year panel data found that more than half of all capital gains income (excluding, in this case, gains from sales of primary residences) was realized by the highest-income one percent of taxpayers. Congressional Budget Office, Perspectives on the Ownership of Capital Assets and the Realization of Capital Gains, May 1997.
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