Revised July 28, 1999
Please note that a newer analysis Is the Senate Finance Committee Bill a Middle-Class Tax Cut? reflects Senate Finance Committee modifications to the Roth proposal IRA provisions.
Is the Roth Proposal a Middle-Class Tax Cut?
by Iris J. Lav and Robert Greenstein
Table of Contents
II. Increasing the Ceiling for the 14 Percent Bracket
III. IRA Expansions
V. Estate Tax
The tax bill the Senate Finance Committee approved July 21 is sometimes presented as a broad-based middle-class tax-cut proposal. The bill, however, is much less targeted to the middle class than initial reports might suggest. While it does provide some tax reduction for those in the middle of the income spectrum, the bulk of its tax cuts would go to households at higher income levels.
A Treasury Department analysis issued July 27 finds that the ten percent of households with the highest incomes would receive 45 percent of the bill's tax cuts when the tax cuts are in full effect. The top fifth of households would receive 67 percent of the tax cuts two-thirds of them. By contrast, the 20 percent of households in the middle of the income spectrum would receive only nine percent of the tax cuts, less than one seventh what the top fifth would receive. The bottom 60 percent of the population combined would receive just 12 percent of the tax cuts, about the same amount as the richest one percent by itself would get.
Furthermore, the Treasury analysis estimates that the wealthiest one percent of households would receive an average tax cut of $9,569 a year. The bottom 60 percent of the population would receive a $174 average tax cut.
An analysis conducted by Citizens for Tax Justice finds the bill to be even more tilted toward high-income households than the Treasury analysis does. The CTJ analysis estimates that 76 percent of the tax cuts would go to the top fifth of households, while the bottom 60 percent of households would share just 11 percent of the tax cuts. (The CTJ analysis shows a somewhat larger portion of the tax cuts going to high-income households than the Treasury analysis does partly because the CTJ analysis includes the effects of the bill's corporate tax reductions while the Treasury analysis does not.)
COST OF VARIOUS PROVISIONS IN 2009
(in billions of dollars)
Provisions Providing Bulk of Their Benefits to Middle-Class or Lower-Income Filers Reduce 15 percent rate to 14 percent 26.9 EITC marriage penalty relief 1.3 Expand dependent care tax credit 0.7
Provisions Disproportionately Beneficial to Higher-Income Families
Reduce estate and gift taxes 17.2 Raise IRA income and contribution limits 12.8 Raise income limit for 14 percent bracket 20.1 Allow married filers to file as singles 24.5
Source: Joint Committee on Taxation
An examination of the major provisions of the bill shows why it tilts toward those at higher income levels.
- The provision in the package that would do the most for middle-class taxpayers is the proposed reduction of the 15 percent tax rate to 14 percent. Even this proposal, however, would be of greater benefit to those at higher-income levels the full benefit of this tax rate reduction would be available only to individuals and families whose incomes place them above the 15 percent bracket. Middle-class families in the 15 percent bracket would get only a partial benefit from the rate reduction.
- This tax rate reduction appears to represent a little more than a quarter of the tax-cut benefits in the Roth tax package over the next 10 years; it would consume $216 billion of the package's $792 billion cost over this period.
But by 2009, when provisions benefitting higher-income taxpayers such as the IRA expansions and estate tax reductions are phased in more fully, the rate reduction accounts for just 17 percent of the total cost of the package.
- Although there are some other, smaller provisions in the package that would benefit moderate- and middle-income families such as the increase in the dependent care credit and the marriage penalty reduction for working-couple families that receive the EITC much of the remainder of the tax-cut benefits would go for provisions that accord a disproportionate share of their benefits to the 20 percent of taxpayers with the highest incomes. Several of the other principal tax cut proposals in the Roth package including its IRA proposals, marriage penalty relief provisions, and estate tax cuts fall into this category.
Should the Distribution of Tax Cuts Mirror the Distribution of Tax Burdens?
Some proponents of the Senate Finance Committee tax bill dismiss data showing the bulk of the bill's tax cuts would go to more affluent households by observing that these households pay the bulk of the taxes and should therefore get the bulk of the tax cuts. This raises the question of what standard to use in assessing how a tax cut is distributed. Should tax cuts be apportioned in accordance with the share of taxes that various income groups pay?
While such a standard may have a superficial appeal, it is, in fact, highly problematic. Use of such a standard implies that the more income disparities widen in the United States and high-income individuals receive the lion's share of the income gains (and thus pay more of the taxes), the more that tax cuts should be directed to the wealthy, making the disparities even greater.
Use of such a standard also overlooks the fact that the wages and living standards of much of the population, with the notable exception of upper-income households, are not much better than they were a decade or two ago. In fact, the hourly wage of the typical (or median) worker is slightly lower today than it was at the end of the 1970s, after adjusting for inflation. By contrast, both executive compensation and capital gains income have risen smartly for those on the upper rungs of the economic ladder.
These developments have multiple causes, including international competition, technological advances, the decline in unionization, other economic factors, and policy changes. Given these trends toward widening wage and income disparities, tax policy ought to compensate at least modestly. At a minimum, tax policy should not magnify these trends.
This is a matter of some importance, since the trend toward increasing income disparities has been quite marked. Congressional Budget Office data show that from 1977 to 1995 (the first and last years for which such data are now available), the average before-tax income of the top one percent of the population jumped 77 percent after adjustment for inflation. The average income of the top fifth of the population also rose substantially, climbing 29 percent. But the average income of the middle fifth barely changed during this period, rising only two percent, and the average income of the bottom two fifths of the population declined. A policy of distributing the lion's share of tax cuts to those on the top rungs of the economic ladder, on the grounds that tax cuts should be conferred in proportion to taxes paid, would exacerbate rather than ameliorate these trends. It would increase further the growing disparities of income and wealth between the most affluent individuals and the rest of society.
Finally, there is the issue of priorities. There is not an economic need for tax cuts geared to the high end of the income spectrum the economy is running at full tilt with the current tax rates, the stock market is booming at the current capital gains rates, high-income households are already much better off than in the past, and Federal Reserve chairman Alan Greenspan has cautioned that tax cuts in general may be ill-advised at this point. Thus, the question arises as to whether tax cuts of this nature should take precedence over other needs. Should tax cuts that provide the lion's share of their benefits to the most affluent members of society be accorded priority over greater debt reduction, strengthening the long-term financial security of Medicare and Social Security, public investments that hold promise for improving long-term productivity growth (such as investments in education and training, infrastructure, research, and early intervention programs for children), and even tax cuts in which a greater share of the tax reductions go to the middle class and the working poor?
The Income Tax Rate Cut
The press release that Senator Roth issued in unveiling his proposal on July 9 stated that as a result of reducing the 15 percent rate to 14 percent, "[a] middle income family of four would receive a tax cut of $450." This figure has been widely reported. The press release and some of the media coverage of it may leave the impression that this rate reduction would provide the same-size tax cut for all taxpayers.
Neither the statement that the rate reduction would provide a $450 tax cut for a typical middle-income family of four nor the impression that all families would get the same-size tax cut is accurate, however. Most middle-class families of four would receive tax cuts considerably smaller than $450.
- For a family of four with income of $37,000, the tax reduction from the rate cut would be $188. (The median income for all families the income level at which a family is exactly in the middle of the income distribution is $37,000.) To receive a tax cut of $450, such a family's income would have to exceed $61,000.
- The much-touted $450 tax cut applies only to families with income at least as high as the level at which the 15 percent tax bracket ends and the 28 percent tax bracket begins. Families with incomes at or above this level would receive a $450 tax cut. All families below this level would receive a smaller tax cut.
- The income level at which the 15 percent bracket ends has been widely misreported as being $43,050 for married filers. The $43,050 figure, however, is the level of taxable income at which the 15 percent bracket ends for married filers; it is not the level of adjusted gross income at which filers move from the 15 percent to the 28 percent bracket. The lowest level of gross income at which the 15 percent bracket ends for a married family of four is $61,250. (This is the level of adjusted gross income at which the standard deduction and the four personal exemptions the family would claim would reduce the family's taxable income to $43,050, the break point between the 15 percent and 28 percent brackets.) Married families of four that itemize their deductions can have incomes somewhat higher than $61,250 and remain in the 15 percent bracket.
- Three-quarters of filers are in the 15 percent bracket or owe no income tax. Only the top quarter of filers are in higher brackets, and only they would receive the full $450 tax reduction under this proposal.
- Families with gross incomes at more modest levels would get little or no benefit from the rate cut. Consider, for example, a family of four with income of $25,000. While such a family would owe little income tax, it pays sizeable payroll taxes and other federal taxes. This family would receive a tax cut of just $20 from the rate reduction. By contrast, most families of four at high income levels would, as noted, receive the maximum $450 tax cut.
Even so, the rate reduction would provide a substantial share of its tax-cut benefits to those in the middle parts of the income spectrum. That is not true of the other major proposals in the Roth package.
Increasing the Ceiling for the 14 Percent Tax Bracket
In addition to reducing the 15 percent tax rate to 14 percent, the plan would increase the amount of a taxpayer's income that is taxed at the 14 percent rate rather than the 28 percent rate. This would be accomplished by raising the income levels at which the current 15 percent tax bracket ends and the 28 percent bracket begins.
- The three-quarters of taxpayers with the lowest incomes would receive no benefit from lifting the ceiling on the 15 percent tax bracket. This provision thus benefits only the quarter of taxpayers with incomes high enough to be above the cut-off for the 15 percent tax bracket. As noted above, that cut-off is $61,250 for two-parent families with two children if the families take the standard deduction and more than that for families that itemize.
- This provision would not start taking effect until 2005 and would phase in between 2005 and 2007. By 2009, however, its cost would be $20 billion a year, with all $20 billion of these tax cuts accruing to the top one-quarter of taxpayers. Moreover, this provision would cost fully three-fourths as much by 2009 as the reduction in the bottom rate from 15 percent to 14 percent.
The Roth proposal includes three types of IRA expansions. One would remove completely the income limits on the use of Roth IRA tax preferences by individuals with employer-sponsored retirement plans. Another would increase the income limits on the use of conventional, deductible IRAs. These changes would extend the IRA tax breaks to highly paid individuals with incomes above the limits that current tax law sets. A third IRA expansion would more than double the amount that a taxpayer and spouse can contribute each year to either a conventional IRA or a Roth IRA. This, too, would primarily benefit those on the higher rungs of the income scale, since few middle-income families can afford to put this much of their income aside and place it in an IRA each year.
Together, the effect of these three changes would be to give the 20 percent of taxpayers with the highest incomes large new tax breaks. Many of these taxpayers would secure these generous tax breaks by shifting savings from one account to another, rather than by saving more.
- Under current law, deductible deposits to conventional IRAs, as well as deposits to Roth IRAs, may be made by a taxpayer covered by an employer-sponsored pension plan if the taxpayer's income is below a specified level. For married filers, the income limit is $160,000 for Roth IRAs. For conventional IRAs, the income limits for married filers is scheduled to increase under current law to $90,000 by 2007.(1) Taxpayers of any income level who are not covered by an employer-sponsored plan may make tax-advantaged deposits to either Roth IRAs or conventional IRAs.
- The Roth package would repeal the income limits on Roth IRAs and lift the income limit on deductible IRAs for married filers to $137,000 by 2008. This would allow substantial numbers of additional taxpayers with incomes that exceed the current limits to use deductible IRAs or Roth IRAs without regard to whether they also participate in an employer-sponsored plan.
- The current limits exclude only a modest proportion of taxpayers from IRA tax preferences. The Joint Committee on Taxation reports that more than 80 percent of married taxpayers with earnings and more than 85 percent of single taxpayers with earnings are eligible to make deductible contributions to conventional IRAs in 1999. These percentages will rise under current law, as the income limits for conventional IRAs increase in stages through 2007. Furthermore, the income limits for Roth IRAs are much higher than those that apply to conventional IRAs; the proportion of taxpayers eligible to make Roth IRA contributions under current law consequently is considerably higher than 80 percent to 85 percent.
- Since current law limits the ability of only the 20 percent of taxpayers with the highest incomes to use conventional IRAs and the ability of a still-smaller percentage of high-income taxpayers to use Roth IRAs eliminating the income limits for Roth IRAs and lifting the limits for deductible IRAs would almost exclusively benefit upper-income taxpayers.
- The Roth proposal also would increase the amount that can be contributed each year to either conventional or Roth IRAs. Under current law, a taxpayer and spouse may each contribute $2,000; the Roth proposal would raise the maximum contribution to $5,000 each. Thus, the total amount a couple could contribute would rise from $4,000 to $10,000. This, too, would favor higher-income taxpayers. Most of those able to contribute more than $2,000 to an IRA annually would be people who have relatively high incomes or already have substantial assets.
- Many higher-income individuals would be able to shift savings they already possess from taxable investments to tax-advantaged IRAs, thus securing a larger tax break without increasing their savings. On average, people who save through IRAs hold more than three times as much in financial assets as people who do not use IRAs, giving them ample opportunity to transfer assets from other types of savings to IRA accounts.
- While helping high-income households, an increase in the IRA contribution limits to $5,000 could work to the detriment of some low- and middle-income workers. It could lead some small businesses not to offer an employer-sponsored pension plan.
Currently, a small business owner can contribute $2,000 to his or her own IRA and another $2,000 to his or her spouse's IRA, for a total of $4,000. To place more funds in a tax-advantaged retirement account, the business owner would have to establish an employer-sponsored plan that covers the business' employees, as well as the owner.
Under the Roth proposal, however, the small business owner and his or her spouse could deposit a total of $10,000 into their IRAs rather than $4,000. With these higher limits, the small business owner may not see a need to provide a company pension plan and may drop such a plan or fail to institute a plan in the first place. (Donald Lubick, Assistant Secretary of the Treasury for Tax Policy, noted earlier this year in Congressional testimony on this matter, "Currently, a small business owner who wants to save $5,000 or more for retirement on a tax-favored basis generally would choose to adopt an employer plan. However, if the IRA limit were raised to $5,000, the owner could save that amount or jointly with the owner's spouse, $10,000 on a tax-preferred basis without adopting a plan for employees. Therefore, higher IRA limits could reduce interest in employer retirement plans, particularly among owners of small businesses. If this happens, higher IRA limits would work at cross purposes with other proposals that attempt to increase coverage among employees of small businesses."(2))
There is, in addition to these three IRA provisions, one other upper-income IRA tax break in the Roth plan. Under current law, taxpayers with incomes below $100,000 may choose to convert conventional IRAs they hold to Roth IRAs. The Senate Finance package would lift the income limit for such conversions from $100,000 to $1 million. Anyone with gross income of up to $1 million would be able to roll over his or her conventional IRAs into Roth IRAs.
- This provision raises $7.2 billion from 2001 through 2004, because taxpayers making the conversion would have to pay income tax on the funds withdrawn from conventional IRAs and deposited into Roth IRAs. (This is not an increase in the taxes imposed on these individuals; those who convert their funds would pay tax now rather than paying it as they withdraw the funds after they retire.) Once the funds are shifted to Roth IRAs, however, all earnings would be forever free of tax. As a result, the provision begins to lose revenue in 2005. From 2005 through 2009, the revenue loss totals about $11 billion.
- Shifting these funds from conventional IRAs to Roth IRAs could be particularly advantageous to taxpayers with very high incomes who can not make such conversions under current law because of the $100,000 income limit. Beyond the tax-free earnings that the Roth accounts afford, Roth IRAs allow taxpayers to bequeath large amounts of funds to their heirs free of income tax. While conventional IRAs require taxpayers to begin taking distributions of funds from their IRA accounts no later than at age 70½, no such requirements apply to Roth IRAs. Holders of Roth IRAs may leave all of the funds in the accounts, which then can be inherited. Moreover, an heir may be able to keep the bulk of the funds from an inherited Roth IRA on deposit, with earnings continuing to compound free of tax. Heirs generally are required to take distributions from the inherited accounts only gradually, spread over the course of their own life expectancies.
Marriage Penalty Relief
The Roth proposal claims to "eliminate" marriage penalties by allowing taxpayers the option of filing as though they were single taxpayers on a combined form, with income from jointly-owned assets split evenly. Unlike marriage penalty reduction options that target relief on middle-class taxpayers, such as proposals to increase the standard deduction for married couples, allowing married taxpayers the option of filing as though they were single taxpayers provides a disproportionate share of the tax-cut benefits to higher-income couples.
- The Joint Tax Committee estimates show that when fully in effect, this provision would cost more than $20 billion a year. Analysis of similar proposals in the past indicates that more than 80 percent of the tax cut benefits provided would go to couples with incomes in the top third of the income distribution (i.e., to married filers with incomes exceeding $50,000). Allowing married couples to file as single taxpayers is particularly advantageous for higher-income taxpayers in the 28 percent, 31 percent, 36 percent, and 39.6 percent brackets because it can result in more of their income being taxed at lower rates.
- The option to file as single taxpayers does not provide marriage penalty tax relief to the working poor and near-poor married couples that can face large marriage tax penalties as a result of the structure of the Earned Income Tax Credit. A separate provision in the Roth plan does address EITC marriage penalties, although it appears to provide proportionately less marriage penalty relief for EITC families than it does for higher-income families.
The Roth plan also contains a large cut in the estate tax. It would increase the estate tax exemption by 50 percent, raising the amount of an estate that is exempt from tax from the first $1 million to the first $1.5 million. That change would take place in 2007. Several other reductions in the estate tax also are included in the plan.
These changes have a large cost. The Joint Tax Committee estimates they would lose $16.3 billion in 2009.
The large tax reductions that these changes in the estate tax would generate would be concentrated on the estates of the nation's wealthiest decedents. Joint Tax Committee estimates show that under current law, only two percent of all deaths result in estate tax liability. The Committee's estimates show that only 1.96 percent of decedents in 1999 will have estates large enough to require payment of any estate tax.(3)
Moreover, the bulk of the estate tax is paid by rather large estates. An IRS analysis of the 32,000 taxable estates filing in 1995 showed that the one-sixth of taxable estates with gross value exceeding $2.5 million paid nearly 70 percent of total estate taxes.(4)
The estate tax cut in the Roth plan thus would benefit the estates of those on the top rungs of the income scale. Claims that family farms and small businesses would be among the principal beneficiaries of this tax cut are inaccurate. Farms and small, family-owned businesses make up only a very small proportion of taxable estates. The IRS analysis of estates that filed in 1995 found that all farm property, regardless of size, accounted for less than one-half of one percent of all assets included in taxable estates. Family-owned business assets such as closely-held stocks, limited partnerships, and non-corporate businesses, accounted for less than four percent of the value of all taxable estates of less than $5 million.
Health Insurance Deductions
The Roth proposal also includes a new tax deduction for the purchase of health insurance by taxpayers who pay at least 50 percent of the cost of the premium. As first glance, this may sound like an attractive idea. The proposed deduction, however, would provide little help to most of the uninsured and would not reduce the ranks of the uninsured significantly.
At least 93 percent of the uninsured individuals either pay no income tax or are in the 15 percent income tax bracket. For them, the deduction would do little or nothing to make insurance more affordable, because it would reduce the cost of insurance by no more than 15 percent. As a result, those who would benefit most from such a tax deduction are, by and large, individuals in higher tax brackets who already purchase individual insurance.
- Some 18 million uninsured individuals 43 percent of all of the non-elderly uninsured owe no income tax; their earnings are too low for them to incur a tax liability.(5) These uninsured individuals would receive no benefit from a tax deduction. A tax deduction thus would not do anything to make health insurance more affordable for them.
- Another 20 million uninsured individuals 50 percent of the non-elderly people without health insurance pay income tax at a 15 percent marginal tax rate. (A top marginal rate of 15 percent applies to two-parent families of four with gross incomes up to at least $61,250.) A deduction would provide these taxpayers with a subsidy equal to only 15 percent of the cost of insurance not covered by an employer. For low- and moderate-income families and individuals without employer-sponsored coverage, a 15 percent subsidy which leaves them with the other 85 percent of the premium cost is much too small a subsidy to make insurance affordable.
- For example, for a family earning $35,000 whose employer does not offer insurance, the proposed deduction would reduce the out-of-pocket cost of a typical family health insurance policy that carries a $1,000 deductible from $6,700 to $5,860 or from 19 percent of income to 17 percent of income.(6) An Urban Institute study shows that more than three-quarters of low- and moderate-income uninsured individuals will not purchase insurance that consumes more than five percent of their income.(7)
Few families that have forgone health coverage because they cannot afford to spend 19 percent of income on it would be able to afford coverage because a deduction lowered its cost to 17 percent of income. Insurance would generally remain unaffordable for them. (It is worth noting that to address affordability problems, the child health block grant established in 1997 limits premiums and co-payments to five percent of income for families with incomes above 150 percent of the poverty line and to lesser amounts for poorer families.)
- The proposal might be of modest help to some moderate-income families whose employer pays half or nearly half of the premium costs, since the deduction would be in addition to the employer subsidy. Even families whose employers paid 50 percent of the premium, however, would receive only very modest help from the deduction. The deduction would reduce the proportion of the premium these families have to pay only from 50 percent of the premium to 42.5 percent.
That might help some families afford insurance, but the number of such families would likely be small. Moreover, the deduction could induce some employers that currently pay more than 50 percent of premium costs to scale back their contribution to 50 percent (or possibly less).
- The group that would appear to benefit most from this deduction would be higher-income taxpayers. A health insurance deduction is worth more than twice as much to affluent individuals in the 31 percent, 36 percent, and 39.6 percent brackets than to moderate- and middle-income families in the 15 percent bracket. Although few higher-income individuals and families are uninsured, a significant number do buy insurance on the individual market. Under this proposal, these higher-income taxpayers could deduct the cost of the premiums that they pay for health insurance coverage they already have.
1. Under current law, married taxpayers who participate in an employer-sponsored pension plan may deduct contributions to a conventional IRA if they have income below $61,000 in 1999; the income limits rise to $90,000 by 2007. Married taxpayers participating in an employer-sponsored plan may contribute to a Roth IRA if they have income below $160,000. (For single individuals, the income limit for deductible contributions to a conventional IRA is $41,000 in 1999, rising to $60,000 in 2005. The income limit for making a contribution to a Roth IRA is $110,000 for single taxpayers participating in an employer-sponsored plan.)
2. Statement of Donald C. Lubick, Assistant Secretary of the Treasury for Tax Policy, before the Subcommittee on Oversight, House Committee on Ways and Means, March 23, 1999.
3. Joint Committee on Taxation, Present Law and Background on Federal Tax Provisions Relating to Retirement Savings Incentives, Health and Long-Term Care, and Estate and Gift Taxes (JCX-29-99), June 15, 1999.
4. Internal Revenue Service, SOI Bulletin, Winter 1996-97.
5. Government Accounting Office, Letter to The Honorable Daniel Patrick Moynihan, June 10, 1998, GAO/HEHS-98-190R, Enclosure II. The analysis is based on the 1996 Current Population Survey.
6. A Government Accounting Office study found that in 1996 the middle of the range of premium costs was $5,700 for a family-coverage policy that included a $1,000 deductible. The proposed tax deduction would provide a subsidy of $840 (15 percent of $5,700 equals $840). This means the family would have to pay the remaining $4,860, or 14 percent of its income, to purchase the health insurance policy. Since this premium is for a policy with a $1,000 deductible, another three percent of income would have to be expended before any benefits would be available. The family's net expenditure for health coverage the premium plus the deductible would total $5,860, or 17 percent of the family's income. Without the proposed tax deduction, the full cost of the policy plus the $1,000 deductible is equal to 19 percent of the family's income.
7. Leighton Ku, Teresa Coughlin, The Use of Sliding Scale Premiums in Subsidized Insurance Programs, Urban Institute, March 1997.