The Final Tax
Assessing the Long-Term Costs And the Distribution of Tax Benefits
by Iris J. Lav
The tax bill that Congress approved on July 31 appears in its early years to be a tax plan dominated by benefits for middle-income taxpayers. As in the tax bills the House and Senate passed earlier, however, the legislation includes an array of tax cuts primarily for higher-income taxpayers for which costs are kept artificially low in the initial years by a series of design gimmicks, but that swell in cost over time. When fully effective, the new legislation will provide nearly as great a proportion of its tax cut benefits to the highest-income Americans as the House and Senate tax bills would have done.
Estimates by Citizens for Tax Justice show that when fully in effect, the new legislation will channel 32 percent of its tax cut benefits to the one percent of the population with the highest incomes. The top 20 percent of the population will garner 78 percent of the benefits. By comparison, the Senate tax bill would have given 34 percent of the benefits to the top one percent of the population and 84 percent of benefits to the top fifth. (Note that the proportion of benefits going to various income groups under the CTJ methodology is not directly comparable to the proportions contained in Treasury analyses that earlier Center reports have discussed. Treasury estimates of the distribution of the benefits of the final tax bill are not available at this time.)
Like the House and Senate bills, the final tax legislation will grow substantially in cost over time. According to the Joint Committee on Taxation, the legislation will cost $95 billion from 1997 through 2002, but grow in cost to $180 billion in the subsequent five years from 2003 through 2007. By 2007, the annual cost will be $39 billion, which is double the average annual cost in the first five years.
Over the second 10 years, from 2008 through 2017, the legislation appears to be somewhat less costly than the House and Senate tax bills. Despite the inclusion of most of the features that cause the tax cuts for higher-income taxpayers to swell in cost over time, at first blush the cost of this tax agreement in the second ten years appears to be closer to $500 billion than to the $650 billion to $700 billion estimates for the Senate and House bills respectively.(1)
The differences in the long-term estimates, however, may soon disappear. Virtually all of the difference in the long-term cost between the final tax package and the Senate bill is attributable to one provision affecting the individual alternative minimum tax.(2) The House and Senate bills each included a provision intended to reduce the impact of the individual alternative minimum tax on middle- and upper-middle-income taxpayers. The budget agreement makes no change in the individual AMT.
Over the next few years, however, Congress and the Administration are extremely likely to return to this issue and change the AMT in a way that loses substantial revenue. In part because of the new college tuition tax credit and the child tax credit, several million middle-income taxpayers will become subject to the alternative minimum tax in the years ahead. As a result, significant numbers of middle-income families will face considerable tax complexity and also will lose some or all of their new tax credit benefits. This is a situation Congress almost certainly will seek to remedy, most likely through an expensive change in the alternative minimum tax that grows substantially in cost over time to match the expected growth in the number of families who otherwise will be subject to the AMT. Although the AMT changes in the Senate bill did not represent the optimal or most efficient way to address the problems raised by the interaction of the AMT with the new tax credits, it is instructive to consider what the cost of the final tax bill would be if an AMT change similar to the one in the Senate bill were added to it. If the Senate AMT changes had been incorporated into the final bill, the cost of the tax legislation over the 10 years after 2007 would be similar to the cost of the Senate tax bill $650 billion during this period.
Upper-income Provisions Include More Generous Features from both House and Senate Versions
The tax cuts in the final legislation that primarily benefit high-income individuals bear strong similarity to the upper-income tax cut provisions in the House and Senate tax bills. In fact, in a number of cases, the final bill combines upper-income tax cut provisions present in the House but not the Senate bill with upper-income tax cuts included in the Senate but not the House bill. For example, the final bill contains a reduction in the alternative minimum tax for corporations only modestly less generous than the reduction in the corporate AMT included in the House tax bill; the Senate bill did not include any corporate AMT reduction. Similarly, the estate tax breaks are slightly smaller than those the Senate proposed but far deeper than the estate tax provisions in the House bill. And while the House bill's capital gains indexing provision is not included in the final bill, the capital gains rate cuts in the final bill are more generous than those in the Senate bill. In addition, while the IRA tax breaks in the final legislation are less costly than either the House or Senate IRA provisions because the new, backloaded IRAs will be subject to income limits the final bill includes an increase in income limits for deductible IRAs that was part of the Senate bill but was not in the House version.
The Child Tax Credit Helps More Families than House or Senate Versions
The child tax credit provisions in the final bill generally reflect the provisions in President Clinton's June 30 tax proposal and extend more assistance to moderate-income families than the provisions in the House and Senate tax bills would have done. The main difference between the final bill and the House and Senate bills relates to whether the Earned Income Tax Credit benefits a family receives affect the amount of the family's child tax credit.
Under the House tax bill, the child tax credit would have been determined after EITC benefits are calculated. If a family's EITC eliminated its income tax liability, the family would not qualify for the child tax credit. The Senate bill would have provided the credit to children whose families owe income tax after half of their EITC is subtracted.
The President's proposal and the final legislation provide the credit to families that owe income tax before the EITC is computed. This approach is the same as that taken by the child tax credit that Congress passed in 1995 as part of the tax package President Clinton vetoed that year. This approach reflects the fact that the primary taxes paid by moderate-income families are payroll and excise taxes, not income taxes.
For families with three or more children, the final tax bill also includes a second step in determining child tax credit benefits. If the employee share of a family's payroll tax exceeds the family's EITC, the family's child credit is increased to cover the difference. In no event can the credit exceed $500 per child in the family.
The Administration estimates that the child tax credit in the final legislation would provide assistance to 7.5 million more children than would have been helped by the House bill and 5.9 million more children than the Senate bill would have aided.
Costs of High-income Provisions Are Backloaded
As a result of the phase-ins, delayed effective dates, and revenue acceleration gimmicks in the legislation, the cost of the provisions that primarily benefit higher-income taxpayers increases substantially over time. The Joint Tax Committee revenue tables on the legislation show that:
Since 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 or edges down, the benefits of the tax package as a whole become increasingly skewed toward upper-income taxpayers as the years pass.
Beyond 2007, the cost of most of the provisions primarily benefiting higher-income taxpayers particularly the 18 percent capital gains tax rate on assets held more than five years and the backloaded IRAs will continue to grow rapidly. By contrast, the cost of the child tax credit will continue declining because neither the amount of the credit nor the eligibility thresholds for it are indexed for inflation, and because an increasing number of families will lose portions of their credit to the alternative minimum tax. Ultimately, the higher-income provisions will account for the majority of the cost of the tax package.
Who Benefits from Specific Tax Cuts?
The four tax cuts in the tax bill that provide the majority of their benefits to higher-income taxpayers are the capital gains tax cut, the estate tax cut, the reductions in the corporate alternative minimum tax, and the Individual Retirement Account expansions.
CBO analysts have found that the five percent of individuals with incomes exceeding $100,000 receive 75 percent of capital gains income in any year.* These individuals would secure the lion's share of the legislation's capital gains tax cut.
Economists generally assume that the benefits of reducing the corporate alternative minimum tax would be distributed among individual taxpayers in proportion to their ownership of corporations or their ownership of capital. In either case, the proposal to reduce this tax would principally benefit those with high incomes, among whom the ownership of capital and corporate stock is concentrated.
In the estate tax area, the provisions that raise the amount of an estate exempt from tax will benefit heirs of the top two percent of estates. Other estates already are exempt from this tax.
The benefits of the new, backloaded IRAs will largely be garnered by taxpayers who have incomes between $50,000 and $160,000 and are covered under an employer-sponsored retirement plan. (Married taxpayers with incomes below $50,000 are eligible for IRA tax deductions under current law. So are taxpayers at higher income levels who are not covered by an employer-sponsored retirement plan.) Most of the taxpayers who will benefit from the IRA provisions of the legislation have incomes well above the national average; approximately 70 percent of taxpayers already are eligible to make deductible deposits to IRAs under current law.
Design Features Increase Backloading of Provisions
The capital gains, estate tax, and IRA provisions of the legislation use timing shifts in revenue collections, delayed effective dates, and slow phase-ins, which minimize their cost in the first several years these provisions will be in effect. Eventually, however, these upper-income tax cut provisions become quite costly.
The legislation establishes a new type of IRA that 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) will be collected between fiscal years 1999 and 2002 instead.
These backloaded IRA gimmicks are used to mask the cost of other IRA tax breaks in the bill, especially during the first five years. In addition to establishing the new, backloaded IRAs, the legislation also increases the income limits below which taxpayers covered by employer-sponsored retirement plans may make deductible deposits to IRAs.
Although the cost of the IRA provisions in the tax bill is $1.8 billion over the first five years, according to the Joint Tax Committee, the cost increases ten-fold to $18.4 billion in the second five-year period from 2003 to 2007. In 2007, the cost equals $5 billion in a single year and is growing at a rate of approximately $600 million a year.
The estate tax cuts in the legislation are phased in slowly by raising the estate tax exemption from $600,000 to $1 million over nine years, reaching $1 million in 2006. 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 full effects of the $1 million exemption level will not begin to be felt until after 2007. Thus, the full cost of the estate tax cut will not appear until after the end of the initial 10-year period.
The estate tax provisions will lose $6.4 billion in the first five years but $34.5 billion, or more than five times as much, in the second five years. In 2007, the loss will equal $8.9 billion in a single year. At that point, the revenue loss from this provision will be rising sharply and will continue to do so for at least a few additional years. The estate tax provisions of the legislation will eliminate one-quarter of the revenue expected from estate taxes in 2007 and will likely reduce estate tax revenues by an even larger proportion in years after that.
While the tax bill does not include the costly, backloaded capital gains indexing provision the House Ways and Means Committee passed, its capital gains rate cuts remain expensive and grow in cost over time. In the initial years after enactment, the reduction in the capital gains tax rate is assumed to bring in a boomlet of additional revenues, as some taxpayers who would have held their assets for a longer period if the current capital gains tax rate had remained in place choose to sell some assets at the new, lower capital gains tax rate.
As a result, the capital gains rate cut is assumed to raise $7.8 billion in revenues in the first three years after the legislation's enactment. The Joint Tax Committee estimates that over the 1998-2002 period, the revenue loss from the capital gains cut will total only $123 million. But the revenue loss rises to $21.2 billion in the second five years. By 2007, the annual cost is $5 billion.
An additional capital gains rate reduction will take effect in 2001, with the first revenue losses that it causes delayed until 2006. Under this provision, gains on assets purchased in or after 2001 and held for at least five years will be taxed at a maximum rate of 18 percent, rather than at a 20 percent maximum rate. In addition, taxpayers who own assets purchased before 2001 will be able to elect to pay capital gains taxes, for tax year 2001, on the increase in the value of these assets between the date the assets were purchased and 2001. Assets purchased before 2001 for which these "mark-to-market" taxes are paid in 2001 will then qualify for the 18 percent capital gains rate if the assets are sold in or after 2006.
The additional lower tax rate for assets held for more than five years increases the extent to which the capital gains tax cut is backloaded and will grow in cost after 2007. According to the Joint Committee on Taxation's revenue tables, the "mark-to-market" procedure has the effect of accelerating approximately $1.5 billion in taxes into fiscal year 2002 that otherwise would be paid in later years when the assets are actually sold. (Capital gains taxes for tax year 2001 are largely paid in fiscal year 2002.) This deepens the revenue hole in subsequent years. In addition, only the vanguard of the cost of the 18 percent capital gains tax rate is visible in the next 10 years. In 2007, capital gains taxes will be paid at the 18 percent rate only on assets purchased (or marked to market) in 2001 and sold in 2006. By 2008, assets purchased in 2002 or 2003 also will qualify for this low 18 percent rate, along with assets purchased or marked to market in 2001. By 2012, any asset purchased between 2001 and 2007 or marked to market in 2001 will qualify. In short, the pool of assets eligible for the 18 percent rate will expand in years after 2007. As a result, only a fraction of the cost of this provision is perceptible in 2007.
Cuts in Individual Alternative Minimum Tax Likely Required in Future
The tax bill makes no changes in the Alternative Minimum Tax as it applies to individual taxpayers (as distinguished from the AMT for corporations). Omitting any change in the individual AMT makes the tax bill seem less backloaded and less costly in the second decade after enactment than the House and Senate tax bills would have been. But the omission of the individual AMT provisions creates something of a "time bomb" that will almost surely be addressed in the next several years. If the changes in the AMT changes that were deferred are added to the cost of the new tax bill, the total cost in the period from 2008 through 2017 looks similar to the cost of the Senate tax bill.
The AMT was never intended to affect moderate-income taxpayers; its purpose has been to prevent high-income taxpayers from using a combination of tax breaks that together eliminate most or all of an individual's tax liability. The AMT requires taxpayers to pay the larger of either their normal income tax or an income tax computed without most exemptions, deductions, and credits that a taxpayer otherwise would take. Under the alternative income tax computation, a single deduction of $45,000 (for married couples) is allowed in lieu of the normal exemptions, deductions, and credits. The rate applied to the taxable income computed in this alternative manner is either 26 percent or 28 percent, depending on income. For taxpayers in the 28 percent tax bracket or a higher tax bracket, the alternative minimum tax generally is higher than the regular tax computation only if a taxpayer is using a very large amount of deductions and credits disallowed under the AMT.
In the future, however, a growing number of middle-income taxpayers in the 15 percent tax bracket will begin to fall under the AMT. The AMT has a structure that is not indexed for inflation. By contrast, the income tax brackets and the personal exemption are adjusted for inflation each year. As a result, some taxpayers who are at or near the top of the 15 percent tax bracket which in today's dollars includes two-parent families of four with gross incomes close to $60,000 and single-parent families with incomes close to $50,000 will become subject to the AMT in future years and will consequently have to pay more taxes than they would pay under a normal tax calculation.
The new tax bill aggravates this problem, since it creates two large, new credits that families can use to reduce their regular tax liability. This creates an odd effect while the child tax credit and the new credit for college tuition are supposed to help middle-income families, they will cause more of these families to be subject to the complexities of the AMT. In addition, some of the benefits these families might derive from the new tax credits will be taxed back by the AMT.
This situation is virtually certain to cause an outcry as more middle-income families become subject to the AMT. It is a near certainty this problem will be addressed some time in the next several years through a new and costly change in the individual AMT.
Both the House and Senate tax bills included provisions which, while not well-targeted or efficient, would have eased the degree to which middle- and upper-middle-income taxpayers would be forced into the AMT. These provisions were dropped from the final tax bill.
When this problem ultimately is addressed, the tax changes made will necessarily be costly and will increase substantially the extent to which the tax cuts swell in cost over time. Since the AMT will catch increasing numbers of middle-income families with each passing year, addressing this matter entails losing an increasing amount of revenue with each passing year.
This is the one area where a backloaded tax change might have been justified. Since a change in the individual AMT was not included in the new tax bill, it surely will be added to the tax code in the not-too-distant future. In this sense, the changes that will be made in the future in the individual AMT are the unseen part of the current tax legislation; they ultimately will add to its long-term cost.
1. For estimates of the cost in the 2008-2017 period of House and Senate bills, see Robert Greenstein and Iris J. Lav, The Clinton Tax Plan, July 3, 1997.
2. If the reduction in the individual AMT is removed from the estimate of the costs of the House and Senate tax bills, the estimated cost of the House bill from 2008 through 2017 drops from $700 billion to $550 billion. The estimated cost of the Senate bill drops from $650 billion to approximately $500 billion.
3. In one respect, the final tax bill cuts the capital gains tax less than the Senate bill would have done. The bill requires assets to be held for at least 18 months to qualify for the capital gains tax rate of 20 percent. Profits on assets held between one year and 18 months would be taxed at 28 percent, while profits on assets held less than a year will continue to be taxed as ordinary income. The Senate bill lowered the top capital gains tax rate to 20 percent on assets held for at least 12 months, rather than for at least 18 months. The additional revenue lost as a result of reducing the top rate to 18 percent for assets held for more than five years, however, ultimately outweighs the gain in revenue, relative to the Senate bill, that results from applying a 28 percent tax rate to assets held between 12 and 18 months.