August 20, 1999
Tax Bill Contains Only Modest Benefits For Middle Class
Despite Its High Cost
by Iris J. Lav and Robert Greenstein
Table of Contents
The tax bill Congress approved in early August is decidedly not a broad-based middle-class tax cut plan; it is only modestly less favorable to high-income taxpayers than the earlier version of the tax bill the House of Representatives passed. Although the tax plan does provide some tax reduction for those in the middle of the income spectrum, an overwhelming and disproportionate share of the tax cuts in the bill would go to those at higher income levels.
A Treasury Department analysis issued August 5 finds that the 10 percent of households with the highest incomes would receive 59 percent of the bill's tax cuts when the tax cuts are in full effect. The top fifth of households would receive 78.5 percent of the tax cuts more than three-quarters of the total. By contrast, the bottom 60 percent of the population combined would receive just 7.5 percent of the tax cuts, only about one-third as much as the top one percent would get by itself.
The Treasury analysis estimates that the wealthiest one percent of households would each receive an average tax cut of nearly $32,000 a year. The bottom 60 percent of the population would receive a $166 average tax cut.
An analysis conducted by Citizens for Tax Justice similarly finds the bill to be heavily skewed toward high-income households. The CTJ analysis estimates that 81 percent of the tax cuts would go to the top fifth of households, while the bottom 60 percent of households would share just 9 percent of the tax cuts.
The provisions in the package that would do the most for middle-class taxpayers are the proposed increase in the standard deduction for married couples and the proposed reduction of the 15 percent tax rate to 14 percent.
COST OF VARIOUS PROVISIONS IN 2008
(in billions of dollars)
Provisions Providing Bulk of Their Benefits to Middle-class or Lower-income Filers Reduce 15 percent rate to 14 percent
Increase standard deduction for couples
EITC marriage penalty relief
Expand dependent care tax credit
Provisions Disproportionately Beneficial to Higher-income Families Cut 28, 31, 36, and 39.6 percent rates
Repeal individual AMT
Raise income limit for 14 percent bracket
Cut capital gains taxes
Repeal estate and gift taxes
Raise IRA and pension income and contribution limits
Corporate and business tax breaks
Total cost in 2008
Source: Joint Committee on Taxation
- The increase in the standard deduction for married couples and the reduction in the 15 percent tax rate account for less than one-fifth of the annual tax-cut benefits the bill provides. In 2008, when most provisions are largely phased in and before the artificial "sunset" of a number of provisions in the bill, these two provisions would account for only $32 billion of the $168 billion that the Joint Committee on Taxation estimates the package as a whole will cost. (Note that even this reduction in the 15 percent rate would provide a larger dollar tax cut to those at higher-income levels than to much of the middle class. 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.)
- 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 and adoption credits and marriage penalty reduction for married-couple families that receive the Earned Income Tax Credit. But in total, the provisions that grant a substantial share of their benefits to middle- or low-income taxpayers account for less than one-quarter of the bill's cost when the provisions are fully in effect.
- Most of the remaining tax cuts in the bill would accord a disproportionate share of their benefits to the 20 percent of taxpayers with the highest incomes. These provisions include the elimination of the estate tax, the capital gains tax cuts, the elimination of the alternative income tax, provisions raising income and contribution limits for Individual Retirement Accounts and employer-sponsored pension plans, the reduction in the tax rates above the 15 percent rate, and the increase in the income level at which the 15 percent tax rate ends for married filers and the 28 percent rate starts.
Should the Distribution of Tax Cuts Mirror the Distribution of Tax Burdens?
Some proponents of the tax bill dismiss data showing that the bulk of the bills 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 cut benefits. The tax cuts in the bill are, however, disproportionate to taxes paid. The highest-income 20 percent of the population pays about 59 percent of federal taxes but would get 79 percent of the tax cuts in the legislation.
Moreover, the notion that tax cuts should be apportioned in accordance with the share of taxes that various income groups pay is itself highly problematic. Use of such a standard implies that the more that income disparities widen in the United States and high-income individuals receive the lions 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 still 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 lions 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 lions 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), measures to lower the child poverty rate (which remains well above the child poverty rate in Canada and most of western Europe), and tax cuts in which a greater share of the tax reductions go to the middle class and the working poor?
The income tax rate reductions in the bill might seem as though they would provide significant benefits to middle-income taxpayers. In fact, the rate reductions provide only a modest benefit to most moderate- and middle-income families. The bulk of the benefits of the rate cut would go to those at much higher income levels.
The bill gradually reduces each tax rate by one percentage point. Like the Senate bill, the conference agreement gradually lowers the 15 percent rate to 14 percent. But it also lowers each of the other, higher marginal income tax rates, bringing down the 28 percent rate to 27 percent, the 31 percent rate to 30 percent, and so on. Bringing down all of the rates skews the benefits much more in favor of high-income taxpayers than the Senate proposal did.
Even under the Senate bill, the full benefit of reducing the lowest rate from 15 percent to 14 percent would have been secured only by families with income at least as high as the level at which the 15 percent bracket ends and the 28 percent bracket begins. For a family of four, income would have to exceed $61,000 to receive the full benefit equal to about $450 from reducing the 15 percent rate to 14 percent. (See box) Families below this level would receive a smaller tax cut from this provision.
Three-quarters of taxpayers either are in the 15-percent bracket or owe no income tax. Only the top quarter of taxpayers are in the higher brackets, and only they would receive the full benefit of reducing the 15 percent rate. No one outside the top quarter of taxpayers would benefit even to a small degree from reducing the rates in the higher brackets.
Families with gross incomes at more modest levels would gain little from the rate-cut provisions. Consider a family of four with income of $25,000. Although such a family owes 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. For a family of four with income of $35,000, the tax from the rate reduction would be $168. By contrast, a family with gross income of $200,000 could receive a $1,500 break from the rate reduction.
The cost of lowering the 15 percent rate to 14 percent while leaving the higher rates unchanged, as the Senate bill would have done, would have been $26 billion in 2008. Adding in the reductions in the higher tax rates more than doubles the cost; the cost of the rate reduction in the conference agreement is $57 billion in 2008. The additional $31 billion in tax cuts would accrue solely to the 25 percent of taxpayers with the highest incomes.
Marriage Penalty Relief
The conference agreement provides three types of marriage penalty relief: an increase in the standard deduction for married couples, a modification of the earned income credit for married couples, and an increase in the income level at which the 15 percent tax rate ends for married couples and the 28 percent rate begins.
The increase in the standard deduction is well-targeted on middle-income families; most higher-income families have sufficient expenses to itemize their deductions and do not use the standard deduction. The bill would set the standard deduction for married couples at a level twice the deduction for single taxpayers. If this provision were effective in 1999, the standard deduction would increase by $1,400 this year. This would generate a tax cut of $210 for most couples in the 15 percent tax bracket. (Applying a 15 percent tax rate to $1,400 less in income yields a tax cut of $210.)
The second type of marriage penalty relief in the tax bill a modest increase in the amount of earned income credit received by married couples with incomes between $12,000 and $32,000 also is well-targeted. The standard deduction increase and other marriage penalty relief provisions in the conference agreement will not help most of these low- and moderate-income working families because they have no income tax liability and hence cannot make use of larger income tax deductions. Yet many of these families do face marriage penalties that arise from the structure of the Earned Income Tax Credit. EITC marriage penalties occur when two people with earnings marry and their combined, higher income places them at a point in the EITC "phase-out range" at which they receive either a smaller EITC than one or both of them would have received if still single or no EITC at all.(1)
Who Is in the 15 Percent Tax Bracket?
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 familys 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 all individuals and families are in the 15 percent bracket or owe no income tax. Only the top quarter are in higher brackets.
The tax bill would reduce EITC marriage penalties. (The bill would do so by raising by $2,000 both the income level at which the EITC for married families begins to phase down and the income level at which married families cease to qualify for any EITC benefits.) For a husband and wife that each work full time at the minimum wage, this provision would alleviate about one-third of their marriage tax penalty.
In contrast to the standard deduction increase and the EITC provision, the provision in the bill that would raise the income level at which the 15 percent bracket ends and the 28 percent bracket starts for married couples would benefit only those couples with incomes exceeding the level at which the 15 percent bracket currently ends. A couple with two children would need to have income surpassing $61,250 to benefit from this provision. (Couples without children would need to have income exceeding $55,750 to benefit.)
The cost of increasing the standard deduction for married couples to an amount that equals twice the standard deduction for single taxpayers would be $6 billion in 2008, while the cost of the EITC marriage penalty relief would be $1.3 billion. By contrast, the provision raising the income level at which the 15 percent bracket ends would cost $22 billion in 2008, three times as much as the other two provisions combined. All of the $22 billion in cost resulting from increasing the income level at which the 15 percent bracket ends for married couples reflects tax cuts that would be limited to taxpayers in the top quarter of the income distribution.
Alternative Minimum Tax for Individuals
The bill would scale back the individual Alternative Minimum Tax beginning in 2005 and repeal it fully in 2008. This would allow some very high-income taxpayers to pay taxes at rates well below those that middle-income families pay or to avoid paying personal income taxes altogether.
The individual AMT was enacted in its current form in the Tax Reform Act of 1986 as a way to prevent high-income taxpayers from using a combination of tax exemptions, deductions, and credits in such a way that they largely or entirely eliminate their income tax liability. The Joint Committee on Taxation projects that 937,000 taxpayers will pay the AMT in tax year 2000 and that approximately three-quarters of these taxpayers will have incomes exceeding $100,000.
In its current form, the AMT is projected to begin imposing additional taxes on some middle-income families in future years, a development that policymakers never intended.(2) The Joint Committee on Taxation projects that by 2008, some 6.9 million taxpayers will pay the AMT under current law, and 44 percent of them would have incomes below $100,000. By that time, a sizeable number of middle-income taxpayers would have various tax credits such as the child credit, dependent care credit, or education credits effectively reduced or eliminated as a result of the AMT. It is widely acknowledged that some modification to the AMT must be made to prevent this from occurring.
There are a number of ways the AMT could be modified to exempt most middle-income taxpayers from it while assuring that its original purpose to prevent tax avoidance by high-income taxpayers continues in effect. The tax bill that emerged from conference, however, repeals the AMT entirely, which would result in windfalls for some very high-income taxpayers. If the AMT is repealed, some high-income individuals would again be able to escape all federal income tax or to reduce their tax payments very substantially.
The Treasury Department estimates that repeal of the AMT in 2008 would result in 25,000 taxpayers with incomes surpassing $200,000 escaping federal income tax in 2009. The Treasury also estimates that several hundred taxpayers with incomes of more than $1 million would avoid paying any income tax.
Estate Tax Repeal
The tax bill would gradually reduce the estate tax and fully repeal it beginning in 2009. The benefits of estate tax repeal would accrue solely to 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. Specifically, 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)
Estate tax repeal thus would benefit only the estates of those high on the wealth 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 tiny 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.
Cost of Tax Bill Would Reach $2.6 Trillion in Second Ten Years
The tax bill has an official cost of $792 billion over the 10-year period from 2000 through 2009. But its actual cost would likely exceed $792 billion in the first 10 years and reach approximately $2.6 trillion in the second 10 years, from 2010 through 2019.
The bills official cost is held to $792 billion in the first 10 years through use of a gimmick. The bill "sunsets" many of its principal provisions after 2008 including the reductions in tax rates, the marriage penalty relief, the capital gains rate cut and capital gains indexing, the increase in IRA contribution limits, and the repeal of the alternative minimum tax. The official cost estimate assumes these provisions will not be in effect in 2009. All remaining provisions of the bill then sunset after 2009.
In fact, canceling some of these provisions would be virtually impossible as a practical matter, while sunsetting others while technically possible would be extremely difficult politically. If these provisions really ceased to be effective after 2008, the result would be a $54 billion income tax increase in 2009 larger than the tax increase that occurred in 1991 following the 1990 deficit reduction deal that President George Bush negotiated with Congress. (These comparisons adjust costs from different years for inflation.)
Furthermore, full sunset of the bill after 2009 would result in an unprecedented and politically unthinkable single-year tax income of $180 billion, which would be nearly three times larger than the tax increase that took effect in 1994 following enactment of the 1993 deficit-reduction legislation.
Without the highly unrealistic sunset provisions, the bills cost which mushrooms from $62 billion in 2004 to $117 billion by 2006 to $168 billion by 2008 would rise to $180 billion in 2009. The official estimate, by contrast, shows the cost plummeting from $168 billion in 2008 to $126 billion in 2009.
After the initial 10-year period, the cost of the tax cuts in the bill would explode. Using conservative estimates likely to understate the bills long-term cost, we find that if the tax bill became law and was in effect after 2009, it would cost approximately $2.6 trillion in the second 10 years, from 2010 through 2019. This is more than triple the $792 billion cost officially shown for the first 10 years. These massive costs in the second 10 years would occur during the same period in which the baby boom generation begins to retire, Social Security and Medicare costs mount, and surpluses both in the Social Security budget and the non-Social Security budget are expected to stop growing each year and begin shrinking.
Additional information concerning the devices the bill uses to mask its long-term costs and the likely cost of the bill in the second 10 years may be found in the Center analysis, Conference Agreement Tax Cut Would Cost $2.6 Trillion in Second 10 Years, by Iris J. Lav and Robert Greenstein.
The legislation contains substantial reductions in capital gains taxes, which are paid on profits from the sale of stocks, bonds, and similar assets. The preferential tax treatment of capital gains income that current law provides would be expanded in two ways through a rate reduction and an indexing provision.
Under current law, most assets held for more than one year are taxed at a maximum rate of 20 percent. Consider an asset that is purchased for $100,000, grows in value at 7.5 percent per year, and is sold after four years for $133,550. Under current law, the tax would be 20 percent of $33,550, or $6,709.
Current law already provides a major tax break on capital gains income. The affluent individuals who receive the vast bulk of the capital gains income have incomes sufficiently high as to pay income taxes at rates above the 28 percent rate. If capital gains were taxed at the same rate as other types of income, such as salaries, interest, dividends, and self-employment income as they largely were for a number of years following passage of the 1986 Tax Reform Act a taxpayer in the 31 percent bracket who secured the $33,550 profit in the example cited above would owe $10,400 in tax on the profit. Instead, because capital gains income is taxed at a preferential rate of 20 percent, this taxpayer owes $6,709, about one-third less.
Preferential capital gains tax rates are worth the most to the wealthiest individuals. The capital gains tax that a very high-income individual in the 39.6 percent tax bracket pays is only half what this individual would pay if capital gains income were taxed like other income.
The tax bill that Congress passed in early August would substantially enlarge the already-generous capital gains tax breaks in current law. First, the rate at which most capital gains income is taxed would be lowered from 20 percent to 18 percent.
Capital Gains Tax Cut Example
Value after four years* 133,547 Profit 33,547 Tax on profit under current law 6,709 Tax at 18 percent with indexing 4,170 Total tax cut -2,540 Percentage tax cut -38% Effective tax rate on profit 12.4% *Assumes 7.5 percent annual growth in the value of the asset (2.5 percent for inflation and five percent real growth).
Under the 1997 tax law, the tax rate on profits from the sale of assets held more than five years is already scheduled to decrease to 18 percent in 2006. The new tax bill would accelerate the effective date of this rate reduction to January 1999, making it retroactive. More important, the bill would eliminate the requirement that assets be held five years to qualify for the lower rate. The 18 percent rate would apply to gains on all assets held more than one year. In the example discussed above, this rate cut would reduce the tax on the $33,550 profit from $6,709 to $6,038, a further reduction of 10 percent in capital gains taxes.
The bill also adds a major additional capital gains tax break not included in either the House or Senate bill a provision allowing investors to index profits for inflation when figuring their capital gains tax. Under current law, when the capital gains tax is applied to the profit from the sale of an asset, the profit is calculated as the difference between the price for which the asset was sold and the price at which the asset originally was purchased.
Under indexing, a calculation is made that can substantially reduce the amount of profit subject to tax. Assume in the example above that inflation averaged 2.5 percent per year during the four the years investor held the asset. Under the bill, a taxpayer figuring his or her capital gains tax would adjust the $100,000 he or she paid to purchase the asset upward to approximately $110,400 to account for four years of inflation; the capital gain to which the capital gains tax would apply would be considered to be $23,150 rather than $33,550 $133,550 minus $110,400, rather than $133,550 minus $100,000. With an 18 percent capital gains rate, the tax due on the gain would be reduced to $4,170 as a result of indexing, an additional capital gains tax cut of 28 percent.
When the rate cut and indexing are considered together, the total capital gains tax cut in this example would be $2,540 a 38 percent reduction in the capital gains tax. Moreover, this tax cut would come on top of the large reduction in capital gains taxes included in Taxpayer Relief Act of 1997. If those tax cuts are enacted, taxes on capital gains would be slashed more than 50 percent as a result of the two tax bills.
In the example used here of an asset purchased for $100,000 and sold four years later for $133,550, the effective tax rate on the profit would be reduced to 12.4 percent (that is, the capital gains tax paid would equal 12.4 percent of the profit the investor secured). This illustrates the fact that under the bill, many wealthy investors would pay a lower effective rate of tax on profits from the sale of stocks than moderate- and middle-income families would pay on their wages and on interest they receive on modest savings accounts.
The principal beneficiaries of both of the types of capital gains tax breaks the legislation contains would be wealthy investors. Two-thirds of all capital gains are received by the one percent of taxpayers with incomes exceeding $260,000. These high-income individuals thus would receive approximately two-thirds of the benefits from the bill's capital gains tax reductions.
Capital Gains Tax Cuts Would Foster Economic Inefficiency and Tax Sheltering
One effect of the combination of the bills capital gains rate cut and its indexing provision would be to increase substantially the difference between the top income tax rate on most forms of income and the effective tax rate on capital gains income. The current top rate on ordinary income including salaries and interest and dividend income is 39.6 percent. The combination of the proposed 18 percent maximum tax rate on capital gains income and the indexing provision would reduce the effective tax rate on capital gains in many circumstances to approximately 13 percent, or about one-third the rate that very high-income individuals pay on ordinary income.
This differential would create a huge incentive to "convert" ordinary income into capital gains. The large differential could lead investors to avoid investments that yield interest income, forcing some businesses to create equity instruments rather than to borrow needed capital even when borrowing makes more business sense. It also could lead executives to demand compensation in the form of stocks or stock options rather than salary.
More important, it could give new life to the tax shelter industry, which specializes in creating complex, multi-layered transactions that change the character of income for tax purposes. These types of income shifts and tax sheltering are the antithesis of economic efficiency; they skew investment decisions by causing many such decisions to be made on the basis of where the tax advantages are greatest rather than where the economic gain itself is the greatest in the absence of the distorting effect of the tax preferences. It was for precisely this reason to enhance economic efficiency that the Tax Reform Act of 1986 equalized the tax rates on ordinary income and capital gains income.
Moreover, fully one-third of all capital gains income goes to taxpayers whose annual capital gains income exceeds $1 million. These extremely high-income investors would gain the most from these capital gains tax cuts. Most of them would receive average annual capital gains tax cuts greater than the entire income of the typical American family.
Individual Retirement Accounts
The bill includes several types of Individual Retirement Account expansions. It would increase the income limits on the use of Roth IRA tax preferences by individuals with employer-sponsored retirement plans; this would benefit only highly paid individuals with incomes above the limits that current tax law sets. The bill also would more than double the amount a taxpayer and spouse can contribute annually to either a conventional IRA or a Roth IRA.(5) This, too, would primarily benefit those on the higher rungs of the income scale, since few middle-income families could afford to put this much of their income aside and place it in an IRA each year.
The primary effect of these changes would be to give the 20 percent of taxpayers with the highest incomes substantial 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, a taxpayer covered by an employer-sponsored pension plan may make deposits in a Roth IRA or a conventional IRA if the taxpayer's income is below specified levels. For married filers, the income limit is $160,000 for Roth IRAs. For conventional IRAs, the income limit for married filers will increase under current law to $100,000 by 2007.(6) 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 bill would raise the income limit on Roth IRAs for married filers to $210,000. This would allow substantial numbers of additional taxpayers with incomes that exceed the current limits to use Roth IRAs regardless of whether they also participate in a tax-favored 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 lifting the income limits for Roth IRAs would almost exclusively benefit upper-income taxpayers.
- The bill 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 bill 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 benefiting 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 bill, 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. As 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."(7)
The bill also includes one other upper-income IRA tax break. Under current law, all taxpayers with incomes below $100,000 may choose to convert conventional IRAs they hold to Roth IRAs. The bill would allow joint filers with incomes up to $200,000 to make such conversions. Couples with gross incomes between $100,000 and $200,000 would be able to convert conventional IRAs into Roth IRAs.
Shifting funds from conventional IRAs to Roth IRAs could be highly advantageous to many affluent individuals in this income range. Once they have shifted funds from a conventional IRA to a Roth IRA, all amounts earned on the funds would be forever free of income tax. In addition, Roth IRAs can allow wealthy individuals to bequeath large amounts of funds to their heirs free of any income tax. Conventional IRAs require taxpayers to begin taking distributions of funds from their IRA accounts no later than at age 70½, but no such requirements apply to Roth IRAs. Well-to-do holders of Roth IRAs can leave all of the funds in the accounts, which then can be bequeathed. Furthermore, an heir may be able to keep the bulk of the funds from an inherited Roth IRA on deposit, with the 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.)
Health Insurance Deductions
Finally, the tax bill 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 seem an attractive idea. Closer examination indicates, however, that the proposed deduction would provide little help to most of those lacking insurance and would not significantly reduce the ranks of the uninsured.
At least 93 percent of uninsured individuals either pay no income tax or are in the 15 percent income tax bracket. For them, this 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 an income tax liability.(8) These uninsured individuals would receive no benefit from a tax deduction; a deduction would do nothing 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 deduction would provide these taxpayers with a subsidy equal to 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 that leaves them with the other 85 percent of the premium cost is much too small a subsidy to make insurance affordable.
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.(9) 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.(10) Few families that have forgone health coverage because they cannot afford to spend 19 percent of income on it would find coverage affordable because a deduction had lowered its cost to 17 percent of income. (By contrast, the child health block grant established in 1997 set a limit on the premiums and co-payments that can be charged under programs that receive block grant funds, with the limit being five percent of income for families above 150 percent of the poverty line and lesser amounts for poorer families.)
- This provision 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. But even families whose employers pay 50 percent of the premium would receive only very modest help from the deduction. The deduction would reduce the proportion of the premium that these families have to pay only from 50 percent of the premium to 42.5 percent.
While that might help some families afford insurance, the number of such families likely would be small. Moreover, the deduction could induce some employers currently paying 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 provision, these higher-income taxpayers could deduct the cost of the premiums they pay for health insurance coverage they already have.
1. Consider a man and woman that each work full time at the minimum wage. If unmarried, the man would file as a single taxpayer, while the woman would file as a head of household and claim an EITC for her two children. Before they are married, the man pays $550 in income tax while the woman qualifies for a $3,816 refund, the maximum EITC for a family with two children in 1999. Their combined refund thus is $3,270. If they marry, the couple's combined income puts them in the phase-out range of the EITC and reduces their EITC substantially. Their combined refund is reduced to $1,930, yielding a marriage penalty of $1,340.
2. This will occur because the AMT utilizes a single deduction of $45,000 (for married couples) in lieu of the exemptions, deductions, and credits allowed for the normal tax calculation. 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 tax owed under the regular tax computation only if a taxpayer is using a very large amount of deductions and credits disallowed under the AMT. Unlike the personal exemptions and standard deductions used for the normal tax calculation, however, the single $45,000 deduction allowed under the AMT is not indexed for inflation. As a result, a growing number of middle-income taxpayers in the 15 percent tax bracket will begin to be subject to the AMT unless changes in the AMT are made. But there is no need to repeal the AMT to prevent it from affecting the tax burdens of the middle class.
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. Under conventional IRAs, qualified taxpayers and spouses may deduct from their taxable income each year up to $2,000 apiece in contributions to their accounts. Once the contributions are made, earnings of the deposits accumulate free of tax. Income taxes on the principal and interest are deferred until the funds are withdrawn. In contrast, contributions made to Roth IRAs are not deductible from taxable income. But all earnings on Roth IRA deposits are forever free of tax. All qualified withdrawals from Roth IRAs are free of tax because the principal already has been taxed and the earnings are not taxable.
6. 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 $100,000 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 participating in an employer-sponsored plan, 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.)
7. 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.
8. General 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.
9. A General 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 for the purchase of a policy with a $5,700 premium ($840 equals 15 percent of $5,700). 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.
10. Leighton Ku, Teresa Coughlin, The Use of Sliding Scale Premiums in Subsidized Insurance Programs, Urban Institute, March 1997.