|
CHAPTER |
| 3 |
| Revenue Options |
|
Change in Revenues |
|
||||||||||
|
|
Raise all tax rates on ordinary income by 1 percentage point |
+21.1 |
+30.4 |
+30.3 |
+43.7 |
+50.8 |
|
+176.3 |
|
+445.2 |
|
|
|
Raise all ordinary tax rates and AMT rates by 1 percentage point |
+38.1 |
+56.5 |
+59.9 |
+62.5 |
+66.0 |
|
+283.0 |
|
+667.8 |
|
|
|
Raise all ordinary tax rates, AMT rates, and dividend and capital gains rates by 1 percentage point |
+38.8 |
+59.9 |
+62.6 |
+65.3 |
+67.2 |
|
+293.8 |
|
+685.6 |
|
|
|
Raise the top ordinary tax rate by 1 percentage point |
+3.9 |
+5.5 |
+5.5 |
+6.4 |
+7.3 |
|
+28.6 |
|
+75.5 |
|
|
|
Raise the top two ordinary tax rates by 1 percentage point |
+4.6 |
+6.6 |
+6.6 |
+8.6 |
+10.2 |
|
+36.6 |
|
+100.9 |
|
|
|
Raise the top three ordinary tax rates by 1 percentage point |
+5.2 |
+7.5 |
+7.4 |
+10.6 |
+12.7 |
|
+43.4 |
|
+121.0 |
|
|
|
Raise the top four ordinary tax rates by 1 percentage point |
+7.6 |
+11.0 |
+11.0 |
+18.7 |
+23.0 |
|
+71.3 |
|
+200.5 |
|
|
|
Raise the tax rate on ordinary taxable income over $1 million for joint filers ($500,000 for others) by 5 percentage points |
+12.0 |
+17.0 |
+16.9 |
+19.0 |
+21.3 |
|
+86.2 |
|
+224.3 |
|
Under current law, individuals will face six statutory rates on taxable income earned through tax year 2010: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent. After 2010, those tax rates are scheduled to revert to the five brackets—15 percent, 28 percent, 31 percent, 36 percent, and 39.6 percent—that were in effect before the Economic Growth and Tax Relief Reconciliation Act of 2001 was enacted.
Depending on his or her total taxable income, an individual may face several different rates (see the table below). For example, in 2007, a person filing singly with taxable income of $35,000 would pay a tax rate of 10 percent on the first $7,825 of income, 15 percent on the next $24,025, and 25 percent on the last $3,150. The starting points for those tax brackets are indexed to increase with inflation each year.
|
0
|
|
0
|
|
|
10
|
|
15
|
|
|
7,825
|
|
15,650
|
|
|
15
|
|
15
|
|
|
31,850
|
|
63,700
|
|
|
25
|
|
28
|
|
|
77,100
|
|
128,500
|
|
|
28
|
|
31
|
|
|
160,850
|
|
195,850
|
|
|
33
|
|
36
|
|
|
349,700
|
|
349,700
|
|
|
35
|
|
39.6
|
|
Not all income that goes to individuals is taxed at those rates, however. Income from long-term capital gains (gains on assets that are held for more than one year) is subject to lower rates under a separate schedule. The same is true for income from dividends through 2010. Taxpayers subject to the alternative minimum tax (AMT)—another method of computing federal income tax liability—face statutory rates of 26 percent and 28 percent.
This option would increase statutory rates under the individual income tax in several alternative ways:
Boosting all statutory tax rates on ordinary income by 1 percentage point would increase revenues by a total of $176.3 billion over the five-year period from 2008 to 2012. Under that alternative, for example, the top rate of 35 percent in 2010 would rise to 36 percent, and the top rate of 39.6 percent thereafter would increase to 40.6 percent. Rates for the AMT would remain the same as under current law. Thus, the revenue impact of raising all of the ordinary tax rates would diminish over time as more taxpayers became subject to the AMT and therefore were not affected by the rise in regular rates.
Raising AMT rates as well as allof the regular tax rates by 1 percentage point would increase revenues during the 2008–2012 period by $283.0 billion. That revenue impact would be less affected by the number of taxpayers subject to the AMT because such taxpayers would face higher statutory tax rates, too. If, in addition to raising the ordinary and AMT rates, lawmakers boosted the separate tax rates on capital gains and dividends by 1 percentage point, federal revenues would increase by a total of $293.8 billion over the next five years.
Alternatively, lawmakers could target specific individual income tax rates. For example, boosting only the top statutory rate on ordinary income by 1 percentage point would raise $28.6 billion over the 2008–2012 period. Most people who face the top rate in the ordinary rate schedule are not subject to the alternative minimum tax, so the AMT would not limit the impact of that increase in regular tax rates.
A final alternative would be to create an additional bracket at the top of the regular rate schedule by raising the tax rate on ordinary taxable income in excess of $1 million for joint filers ($500,000 for other taxpayers) by 5 percentage points. Income above those levels would be taxed at a rate of 40 percent through 2010 and 44.6 percent thereafter, which would increase revenues by $86.2 billion over five years.
As a way to raise revenues, a boost in tax rates would have some administrative advantages over other types of tax increases because it would require only relatively minor changes to the current tax-collection system. Rate hikes would also have drawbacks, however. Higher tax rates would reduce people's incentives to work and save. In addition, they would encourage taxpayers to shift income from taxable to nontaxable forms and to increase spending on items that are tax-deductible, such as home mortgage interest and charitable donations. In those ways, higher tax rates would cause economic resources to be allocated less efficiently than they might be otherwise.
The estimates shown here incorporate the assumption that taxpayers would respond to higher rates by shifting income from taxable to nontaxable or tax-deferred forms. (Such a shift might involve substituting tax-exempt bonds for other investments or opting for more tax-free fringe benefits instead of cash compensation.) However, the estimates do not incorporate potential changes in how much people would work or save in response to higher statutory tax rates. Such changes are uncertain and would depend in part on whether the federal government used the added tax revenues to pay down debt or to finance tax cuts or additional spending.
|
Change in Revenuesa
|
-0.5
|
-2.3
|
-2.4
|
-97.8
|
-174.7
|
|
-277.7
|
|
-1,221.9
|
|
In the past six years, the Congress and the President have enacted several tax laws that substantially alter the individual income tax system: the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the Working Families Tax Relief Act of 2004 (WFTRA), and the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). EGTRRA reduced tax rates, created a 10 percent tax bracket, increased the value of the child tax credit, provided relief from the marriage penalty and the alternative minimum tax (AMT), and made many smaller changes to the tax code. The main provisions of EGTRRA were originally scheduled to phase in gradually between 2001 and 2010; the entire law was slated to expire in 2011. JGTRRA accelerated the phasing in of some of those provisions. It also further lessened the burden of the AMT and reduced the tax rate on income from capital gains and certain dividends. WFTRA extended several of the provisions that had been accelerated under JGTRRA—the larger child tax credit, marriage-penalty and AMT relief, and the 10 percent tax bracket—for various lengths of time. TIPRA extended the reduced rates on capital gains and dividend income through 2010 and provided relief from the AMT in 2006. Finally, the Pension Protection Act of 2006 permanently extended the provisions of EGTRRA that deal with retirement savings.
This option would make permanent nearly all of those changes to the individual income tax, including AMT relief. (The exception would be the reduced tax rates on capital gains and dividends, which are discussed in the next option.) Provisions of EGTRRA that are set to expire in 2011 would instead continue at the levels specified for 2010; provisions that are due to expire earlier would remain at the level specified for the final year before they would otherwise have reverted to the 2001 level. Provisions that were accelerated or expanded by JGTRRA, WFTRA, or TIPRA would continue at the fully phased-in level. Together, those changes would reduce revenues and increase outlays by a total of $277.7 billion over the 2008–2012 period.
Extending those provisions would have various effects on how efficiently the economy functions, with the effects depending in part on how the extensions were financed. One important channel for those economic effects is through the lower marginal tax rates (the rate that applies to a taxpayer's last dollar of income) that would be associated with extending the provisions. Higher marginal tax rates distort various decisions—for example, by encouraging people to shift income from taxable to nontaxable forms (which could be accomplished by substituting tax-exempt bonds for other investments or tax-free fringe benefits for cash compensation). Higher rates also motivate people to spend more on tax-deductible items, such as home mortgage interest and charitable donations. Lower tax rates can reduce those distortions and allow investment to be allocated to whatever use has the highest economic return, thus leaving people better off. Lower marginal tax rates can also encourage people to work and save more (unlike lower average tax rates, which can encourage people to work and save less).
The broader economic impact of lower tax rates, however, depends on how the rate reductions are financed. Financing tax cuts through higher budget deficits would reduce national saving, which would impair long-term economic growth and could offset any positive economic effects of the lower tax rates.
Permanently extending EGTRRA's individual income tax provisions would have mixed effects on the complexity of the tax system, which some people advocate simplifying. Certain provisions, such as relief from the AMT, simplify the tax code for some taxpayers. Other provisions, such as the expansion of tax-favored accounts for education savings, complicate the tax code.
Besides effects on economic efficiency and the complexity of the tax code, equity (fairness) is another key consideration in assessing tax policy. EGTRRA's individual income tax provisions reduce income taxes by a larger share of previous after-tax income for higher-income households than for lower-income households. However, although the reductions relative to income would be greater for higher-income households, extending EGTRRA's provisions would not significantly alter the shares of income taxes paid by different households across the income distribution.
|
Change in Revenues
|
+0.4
|
+1.4
|
-1.6
|
-13.9
|
-17.7
|
|
-31.4
|
|
-208.5
|
|
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) reduced the special tax rates that apply to most long-term capital gains (gains on assets that are held for more than a year). The rate at which those gains are taxed depends on the income of the individual who realizes them. Gains realized by people whose income puts them in the top four tax brackets for ordinary income (25 percent, 28 percent, 33 percent, or 35 percent) are now taxed at a 15 percent rate, compared with 20 percent before JGTRRA. Gains realized by people whose income puts them in the two lowest brackets (10 percent or 15 percent) are taxed at a 5 percent rate, down from the pre-JGTRRA rate of 8 percent or 10 percent. In a major change, JGTRRA also extended the new 5 percent and 15 percent tax rates on capital gains to dividends from U.S. and some foreign corporations. (Dividends had previously been taxed at the higher rates on ordinary income.)
JGTRRA's rates on capital gains and dividends had been scheduled to last through 2008, with the 5 percent rate falling to zero that year. However, the Tax Increase Prevention and Reconciliation Act of 2005 extended the zero and 15 percent rates through 2010. Starting in 2011, rates on capital gains are scheduled to revert to 10 percent or 20 percent for gains held up to five years and to 8 percent or 18 percent for many gains held longer than five years. Tax rates on dividends are scheduled to return to the rates on ordinary income, which would range from 15 percent to 39.6 percent at that point.
This option would permanently extend the zero and 15 percent tax rates on capital gains and dividends. Such a change would reduce revenues by $31.4 billion over the 2008–2012 period and by $208.5 billion over the 2008–2017 period. The reduction in revenues over 10 years would be much greater than the drop during the first five years because the option would not affect current-law tax rates until January 1, 2011.
The main rationale for lower tax rates on capital gains and dividends is that they reduce the extra tax burden that the law previously placed on equity invested in C corporations (companies subject to the corporate income tax). Most large businesses and some small ones are organized as C corporations. The return on the equity invested in such companies is corporate profits. Once a firm has paid corporate income tax (typically 35 percent) on those profits, it can either distribute the remaining profits to shareholders as dividends, which are then taxed at the individual level, or it can retain and reinvest them. Reinvested earnings presumably increase a corporation's value (by roughly the amount invested), so they also raise the value of the firm's stock. When individuals sell that stock, they pay capital gains taxes on the reinvested earnings. Thus, the return on equity invested in C corporations is often taxed twice: once as corporate profits and a second time as dividends or capital gains. By reducing tax rates on the latter types of income, current law lessens—but does not eliminate—the extra tax burden.
Those extra taxes on corporate profits distort investment to some degree. They prompt some investment to be shifted from C corporations to other types of businesses—such as S corporations, partnerships, sole proprietorships, or limited liability companies—and to owner-occupied housing. The additional taxes also encourage C corporations to finance more of their investments by selling bonds rather than stock (because corporations can deduct interest payments on bonds) and by retaining earnings rather than paying dividends (because individuals normally pay lower tax rates on capital gains and can defer realizing the gains). Those distortions interfere with the allocation of investment to whatever use has the highest economic return. Consequently, they reduce economic efficiency and leave most people less well off.
Current law mitigates those distortions by lessening the extra tax burden—but only for a short period. Because the lower rates on dividends and capital gains expire at the end of 2010, investments made after that time will not benefit from them. In addition, many investments made between 2003 and 2010 will benefit only partially from the lower tax rates because some of the returns will not be earned until after 2010. Hence, many of the gains in economic efficiency that could result from the lower rates will not be realized unless current law is perceived to be permanent.
Other options for reducing the extra tax burden on corporate equity have been widely discussed. Under one alternative, dividends and capital gains paid from profits that had been fully taxed at the corporate level would themselves be exempt from taxation at the individual level (see Revenue Option 25). Another approach would end the practice of allowing firms to deduct interest costs from their taxable income and would tax other types of businesses at the same rate as C corporations.
Compared with those other options, the lower rates provided under current law are less complete and less targeted, though simpler. They remove less of the extra burden from the return on corporate equity than those alternatives would. They also apply more broadly because they are not limited to dividends and gains from fully taxed corporate profits. Corporations (like individuals) receive extra tax deductions and credits for certain investments; thus, the return on those investments is less burdened under current law than is the return on fully taxed profits. Furthermore, people realize capital gains from investments in unincorporated businesses and individually owned property, and neither type of investment is subject to the tax on corporate profits. Such imprecise targeting reduces the effectiveness of current tax rates on capital gains and dividends because it fails to lessen the burden on fully taxed corporate earnings relative to all other returns on investments. Complete and targeted leveling of the tax burden would be more complicated to administer, and policymakers in the United States have never tried it. Targeting could be improved, however, with little additional complication by limiting the lower capital gains tax rates to gains on shares of C corporations.
The main argument against extending the lower tax rates on dividends is that the previous rates that applied to dividends may not have distorted the allocation of investment. Some analysts believe that the tax on dividends affects returns to stock owners but not corporations' decisions to invest. In that view, reducing the tax rate on dividends to no more than 15 percent provided a windfall to shareholders. Economists are currently investigating the degree to which the tax on dividends distorts investment. (Most analysts agree, however, that the tax on capital gains distorts investment decisions by C corporations, so the rationale for taxing capital gains on corporate stocks at a lower rate is not subject to the same question.)
The taxation of capital gains is one of the more complex parts of the individual income tax. Permanently extending the zero and 15 percent tax rates would reduce some of the complexity present under current law. It would preserve other sources of complexity, however, such as the rules that are needed to limit taxpayers' ability to convert ordinary income into capital gains and the different tax rates that apply to gains from the sale of specific types of assets. (Greater simplicity is discussed in the next option.)
|
Change in Revenues
|
+1.1
|
+5.1
|
+4.6
|
+3.9
|
+1.2
|
|
+13.5
|
|
+8.4
|
|
When a taxpayer sells an asset whose value has increased since it was purchased, the taxpayer realizes a capital gain, which is generally subject to taxation. Gains realized on assets that are held for more than a year (long-term capital gains) are taxed at various rates, many of which are lower than the rates that apply to ordinary income. Which tax rate a capital gain is subject to depends on the year in which the gain is realized, the type of asset sold, how long it was held, and the taxpayer's other income—a level of complexity that requires people to make numerous calculations to determine their tax liability.
This option would simplify that process by allowing taxpayers to deduct from their taxable income 45 percent of their net realizations of long-term capital gains—whether or not they itemize their other deductions. The remaining 55 percent of their gains would be taxed as ordinary income. With the deduction, a taxpayer's actual rate on capital gains would be 55 percent of his or her marginal rate on ordinary income (the rate on the last dollar of income). In 2008, for example, someone in the 25 percent tax bracket for ordinary income would face a rate of 13.75 percent on capital gains; someone in the 35 percent bracket would face a rate of 19.25 percent. (Taxpayers subject to the alternative minimum tax would adjust for its lower rate structure by treating 31 percent of the deduction as income taxable under the alternative tax.) This option is a variant of the exclusion that applied to capital gains before 1987.
Those changes are designed to be roughly revenue neutral over the 2008–2017 period, under the assumption that they would be enacted at the end of 2007 and take effect on January 1, 2008. Under current law, tax rates on capital gains are scheduled to rise abruptly at the beginning of 2011; relative to current law, this option would increase revenues by a total of $13.5 billion over the next five years (in an irregular pattern) but would reduce revenues by a total of $5.1 billion over the following five years.
The tax rates that apply to capital gains under current law are highly varied and complex. For example, through 2010, taxpayers who are in individual income tax brackets of 25 percent or above and who sell corporate stock owned for more than a year will pay 15 percent in taxes on their realized gains. Starting in 2011, however, they will pay 20 percent—unless the stock was purchased in 2001 or later and held for at least five years. In that case, the applicable rate will be 18 percent. Taxpayers in the 10 percent or 15 percent bracket of the individual income tax face a 5 percent rate on gains through 2007 and then no tax on capital gains through 2010. Beginning in 2011, those taxpayers will face rates of 10 percent on gains from assets held for up to five years and 8 percent on gains from assets held for more than five years. An exception to all of those rates exists for original stock from certain start-up businesses that is held for more than five years. Gains from such stock are generally taxed at an effective rate that is half of the taxpayer's rate on ordinary income, up to a maximum of 14 percent. Through 2010, that maximum alternative rate turns out to be similar to the top rate of 15 percent on gains from other types of stock.
Gains on many other assets face the same rates as gains on corporate stock, but there are exceptions. Some unrecaptured depreciation on real estate is classified as a capital gain and taxed at ordinary income tax rates, up to a maximum of 25 percent. Gains from the sale of gold, art, or other collectibles are also taxed at ordinary rates, but up to a maximum of 28 percent. Taxpayers who are subject to the alternative minimum tax face different rates on gains from selling collectibles or original stock issues of certain start-up companies.
The variety of rates forces taxpayers with long-term gains to make many calculations to determine their tax. On their 2006 returns, for example, taxpayers with gains from most sales of assets or with qualifying dividends must figure their tax by completing a worksheet with 19 lines. If a taxpayer has a gain on a qualifying start-up business or a collectible, he or she must instead complete a worksheet with 7 lines and then another with 37 lines. For a gain on depreciated real estate, worksheets with 18 and then 37 lines are required. Beginning in 2011, the forms will become even more complicated because different rates will be applied to most gains on assets held for at least five years.
The main advantage of this option is that it would substantially lessen the burden of complying with the capital gains tax by replacing the current worksheets with just three or four lines on the schedule for reporting capital gains. The new calculation would be similar to the calculations required between 1942 and 1986, when the tax code excluded a portion of capital gains from taxpayers' adjusted gross income. Unlike that exclusion, however, this approach would not understate the income of taxpayers with gains when determining eligibility for tax credits and other advantages intended for lower-income people.
The main disadvantage of this option is that it would overturn several provisions of the tax code that policymakers, for various reasons, have decided are desirable. In particular, the option would eliminate separate capital gains rates for assets that are classified as collectibles or held for more than five years (whether issued by a start-up business or not). Furthermore, all deductions for depreciation would be recaptured at ordinary tax rates instead of some depreciation benefiting from rates that are capped at 25 percent. Care is warranted, therefore, in weighing the reasons for those provisions against the benefits of simplification.
In 2003, tax rates on dividends were reduced to equal the rates on capital gains in order to offset some of the extra burden that dividends and capital gains on corporate stock bear because of the corporate income tax (see the previous option). Under current law, that parallel treatment will continue through 2010. Parallel treatment could be retained in this option by extending the same 45 percent deduction to qualifying dividends. A further step to reflect the unique tax burden on corporate stock would be to allow the deduction only for dividends and gains on corporate stock and to tax gains on other assets as ordinary income. (Revenue Option 25 addresses the integration of corporate and individual income taxes more completely.)
|
Change in Revenues |
|
|
|
|
|
|
|
|
|
|
|
|
|
Make the current exemption amounts permanent and index the AMT for inflation |
-21.3 |
-57.3 |
-67.3 |
-56.7 |
-34.0 |
|
-236.6 |
|
-522.5 |
|
|
|
Apply some regular deductions and exemptions to the AMT |
-29.6 |
-78.7 |
-91.5 |
-74.9 |
-39.1 |
|
-313.8 |
|
-627.2 |
|
|
|
Eliminate the AMT |
-34.1 |
-88.6 |
-100.1 |
-81.1 |
-40.6 |
|
-344.5 |
|
-668.1 |
|
As its name implies, the individual alternative minimum tax (AMT) is an alternate method of computing federal income tax liability. A minimum tax was initially enacted in 1969 amid concerns that taxpayers with substantial income were aggressively using tax preferences to reduce their tax liability to very low levels—in some cases, to zero. The Tax Reform Act of 1986 largely established the present form of the AMT; policymakers have modified the tax several times since that law was enacted.
In recent years, the AMT has begun to affect growing numbers of taxpayers. As a result, lawmakers have enacted a series of temporary measures to reduce the number of people subject to the tax. This option would either make some of those measures permanent, make further changes to limit the scope of the AMT, or do away with the minimum tax entirely. Those alternatives would reduce federal revenues by as much as $34.1 billion in 2008 and $344.5 billion over five years.
To compute liability under the AMT, taxpayers must include several additional items in their taxable income that are excluded under the regular income tax, such as the deduction for state and local taxes, personal exemptions, and the standard deduction. The additional items also include tax preferences that only taxpayers with complex financial circumstances generally use: for example, the deduction for some intangible costs associated with drilling for oil and gas. Under the AMT, the total of those adjustments is replaced with an exemption—in tax year 2006, $42,500 for single filers and $62,550 for married couples filing a joint return—that phases out at higher income levels. Taxpayers subtract the exemption from their income to determine their alternative minimum taxable income, which is taxed at two rates: 26 percent on the first $175,000 and 28 percent on the remainder. Taxpayers must pay the higher of their liability under the AMT or under the individual income tax.
The size of the AMT exemptions was temporarily increased by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the Working Families Tax Relief Act of 2004 (WFTRA), and the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Before 2001, the exemptions were $33,750 for single filers and $45,000 for joint filers. EGTRRA raised those amounts to $35,750 for single filers and $49,000 for joint filers for tax years 2001 and 2002. JGTRRA increased the exemptions further—to $40,250 and $58,000 for both 2003 and 2004—and WFTRA extended those amounts through 2005. TIPRA raised the exemptions to $42,500 and $62,550 for 2006. Under current law, the exemptions revert to their pre-EGTRRA levels beginning in 2007.
Unlike the tax brackets and exemptions for the individual income tax, the brackets and exemptions for the AMT are not indexed to increase with inflation each year. At any given level of nominal income, taxpayers will see their liability under the individual income tax decline over time as the value of the standard deduction and personal exemptions rises with inflation. Moreover, as the size of the lower tax brackets grows, more income is taxed at lower rates. With the AMT, by contrast, the lack of indexation means that liability at a given level of nominal income remains the same. Therefore, as nominal income grows with inflation over time, AMT liability will exceed liability under the individual income tax over a larger and larger portion of the income distribution, shifting increasing numbers of taxpayers to the AMT from the individual income tax.
Policymakers could reduce the number of taxpayers subject to the AMT in several alternative ways. One approach would be to make the exemption amounts enacted in TIPRA permanent and to index both them and the AMT brackets for inflation after 2007. Under that approach, 6.2 million taxpayers would be affected by the AMT in 2010 (the peak year)—rather than 30 million under current law—and revenues would be $236.6 billion lower over the 2008–2012 period than they would be otherwise.1 A second alternative would be to allow taxpayers to take the standard deduction, personal exemptions, and deduction for state and local taxes when computing their tax liability under the AMT. That change would reduce the number of people affected by the AMT to 2.8 million in 2010 and cut revenues by $313.8 billion over the 2008–2012 period. A third alternative, which was included in the 2005 report of the President's Advisory Panel on Federal Tax Reform, would be to eliminate the AMT altogether. That alternative would move the estimated 30 million taxpayers who would have been subject to the AMT in 2010 back to the individual income tax, at a revenue cost of $344.5 billion over five years.
A major benefit of all three of those approaches would be simplification. Taxpayers who are now affected by the AMT or who are close to being affected by it must calculate their tax liability twice. As the number of such taxpayers rises sharply, the complexity of many tax returns will increase. Many taxpayers will join the AMT's ranks not because they are sheltering a large amount of income but because they have many dependents or high state and local taxes. This option would simplify the tax system by making fewer taxpayers subject to the alternative tax.
Another rationale for providing relief from the AMT would be to mitigate the perhaps unintended consequences that an unindexed AMT would have on certain features of the tax system. For example, if the AMT is not modified, it will begin to limit the value of the standard deduction and personal exemption under the regular income tax. That process alone will make some taxpayers subject to the AMT, beyond those whom the tax was originally intended to target, and will increase their tax liability over time.
Potential disadvantages of providing relief from the AMT, besides the large reduction in revenues, involve issues of fairness and economic effects. First, the approaches in this option would primarily benefit higher-income taxpayers. Second, the changes would affect people's incentives to work and save. Relief from the AMT would alter the marginal tax rate (the rate that applies to the last dollar of income) faced by taxpayers who are currently subject to the alternative tax. Some taxpayers would see their marginal rates increase under these alternatives, although more would see their marginal rates decline. AMT relief might reduce some people's tax liability, which would allow them to achieve the same level of after-tax income with less income before taxes and thus, to some extent, affect their work behavior. On balance, how the changes in this option would affect incentives to work and save is not clear; the overall impact would depend on taxpayers' relative responsiveness to those incentives.
|
Change in Revenuesa
|
+0.4
|
+2.1
|
+2.5
|
+5.5
|
+7.9
|
|
+18.4
|
|
+81.8
|
|
Various parameters of the tax code are indexed to increase at the rate of inflation each year, as measured by the consumer price index for all urban consumers (CPI-U). Those parameters include the amounts of personal and dependent exemptions, the size of the standard deductions, the income thresholds that divide the different rate brackets in the individual income tax, the amount of annual gifts exempt from the gift tax, and the thresholds and phaseout boundaries for the earned income tax credit, the child tax credit, and several other, minor credits. Indexing allows those tax parameters to grow over time in nominal terms but keeps them relatively stable in real (inflation-adjusted) terms.
This option would use the chained CPI-U, an alternative measure of inflation, rather than the standard CPI-U to index parameters of the tax code. Both measures are calculated by the Bureau of Labor Statistics; however, the Congressional Budget Office estimates that the chained CPI-U is likely to grow 0.3 percentage points more slowly than the standard CPI-U. Indexing with that lower measure would increase the amount of income subject to taxation over time and thus result in higher tax revenues. The net revenue increase would be relatively small in 2008 (about $400 million) but would grow in subsequent years, reaching $7.9 billion in 2012 and totaling $18.4 billion over that five-year period. (Using the same alternative measure for all federal benefit programs that are indexed for inflation would reduce spending by $34.5 billion over the five-year period and by nearly $140 billion through 2017.)
A rationale for indexing tax parameters by less than the full increase in the CPI-U is that many analysts believe the CPI-U overestimates changes in the cost of living. The CPI-U measures inflation on the basis of price changes for a fixed basket of goods. According to many analysts, that method fails to fully account for increases in the quality of existing products, the value of newly introduced products, and the extent to which households can maintain their standard of living by substituting one product for another when the price of a good changes relative to the prices of all other goods. To explicitly address the substitution bias inherent in the CPI-U, the Bureau of Labor Statistics created the chained CPI-U.
Using the chained CPI-U to index tax parameters would be difficult to implement, however, because that measure is subject to revisions. In addition, because indexing with that lower measure would raise the amount of taxable income and thus tax revenues over time, it would result in an increased burden on taxpayers.
|
Change in Revenues |
|
||||||||||
|
|
Reduce the maximum mortgage on which interest can be deducted from $1 million to $400,000 |
+4.2 |
+4.9 |
+5.7 |
+7.2 |
+8.3 |
|
+30.3 |
|
+88.1 |
|
|
|
Convert the mortgage interest deduction into a credit |
+21.7 |
+31.2 |
+34.2 |
+37.8 |
+41.0 |
|
+165.9 |
|
+418.5 |
|
The tax code treats investments in owner-occupied housing more favorably than other investments. For example, if a person owns a house and rents it out, he or she pays taxes on the rental income (net of expenses such as mortgage interest, property taxes, depreciation, and maintenance). The owner also pays a tax on any capital gain when the house is sold. If, instead, the owner lives in the house, no rent changes hands, so the tax code does not require the owner to report the rental value of the home as gross income. Yet the owner can deduct mortgage interest and property taxes from his or her other income in computing income tax liability. The owner can also exclude from taxation as much as $250,000 of any capital gain (or $500,000 if filing a joint return) when the home is sold.
In part, the rental value of housing services is excluded from income because it is difficult to determine that value when no rent changes hands. It is simple, however, to exclude expenses in calculating taxable income. In fact, housing-related expenses other than mortgage interest and property taxes cannot be deducted from a homeowner's income. Moreover, current law limits the amount of mortgage interest that can be deducted to the interest on up to $1 million of debt that a homeowner has incurred to buy, build, or improve a first or second home, as well as interest on as much as $100,000 in other loans (such as home-equity loans) that the owner has secured with the home, regardless of the loans' purposes.
This option would further restrict the mortgage interest deduction in one of two ways. The first alternative would lower the maximum mortgage amount eligible for the interest deduction from $1 million to $400,000. That change would raise taxes for 1.2 million people with large mortgages in 2008, increasing revenues by $4.2 billion in that year and by $30.3 billion over the 2008–2012 period. The lower cap would affect more homeowners over time as incomes and housing prices rose.
The second alternative would replace the current deduction with a 15 percent tax credit for interest on mortgages of $400,000 or less on a primary residence only. (In 2005, the President's Advisory Panel on Federal Tax Reform proposed a more complex variant of that approach.) That alternative would increase taxes for an estimated 28.6 million people in 2008 but lower them for some other taxpayers. In all, the change would increase revenues by $21.7 billion in 2008 and by $165.9 billion over five years because the reduced benefits to taxpayers in higher rate brackets would exceed the increased benefits to taxpayers in lower brackets.
The main rationale for curtailing the mortgage interest deduction is to improve the efficiency of the economy. The deduction encourages people to invest more in owner-occupied housing than they would if all investments were taxed equally. As a result, the owner's return on additional investment in housing, aside from the tax advantages, is likely to be lower than returns on additional investment in businesses. Reducing the maximum mortgage on which interest could be deducted should make affected homeowners less willing to invest in homes relative to stocks, bonds, savings accounts, and their own businesses. Between 1981 and 2005, 37 percent of net private investment in the United States went into owner-occupied housing. That share is large enough that less investment in owner-occupied housing—even for larger homes alone—could eventually boost capital in other sectors of the economy and increase total economic output.
Another advantage of limiting the mortgage interest deduction is that it would discourage taxpayers from borrowing against their homes to fund tax-favored retirement savings accounts, such as 401(k) plans and individual retirement accounts. That practice takes advantage of tax savings on both transactions and thus provides an incentive for people to pay down their mortgage debt more slowly and contribute more to retirement accounts than they would if mortgage interest were not deductible. Such transactions reduce revenue without increasing net saving, because the higher retirement contributions are offset by larger amounts of outstanding mortgage debt.
A drawback of limiting the deductibility of mortgage interest suddenly and deeply is that home values, home construction, and mortgage lending would most likely fall abruptly, particularly for larger houses. Those rapid declines would create hardships for owners of such homes, for builders, and for lenders. Lowering the cap gradually, or with substantial advance warning, would greatly reduce the hardships of adjusting to the change. Nonetheless, over the long run, the shift of investment from housing to other activities would mean less home construction and less increase in the value of homes than would occur under current law.
Another drawback is that this option might reduce home ownership. Greater home ownership contributes to social and political stability, according to its advocates, by strengthening people's stake in their communities and governments. In addition, home ownership motivates people to maintain their homes and may bolster neighborhoods by reducing mobility. Individuals typically do not consider those benefits to the community when deciding whether to rent or own, so a subsidy to promote home ownership may tilt their decisions in the direction of the community's interest.
The mortgage interest deduction, however, may be an ineffective means of inducing renters to become homeowners. Despite that tax treatment, the United States has about the same rate of home ownership as Canada, the United Kingdom, and Australia, which do not allow mortgage interest to be deducted. The deduction's effect on home buying may be small because lower-income households—which face greater barriers to home ownership—benefit less from it than higher-income households do. One reason is that the deduction has value only for owners whose total deductions exceed the standard deduction, so they have a reason to itemize. Lower-income homeowners are less likely to have deductions that large. Another reason is that the entire amount of the mortgage interest deduction can be used to reduce taxes only by people whose other deductions exceed the standard deduction. Lower-income people are less likely to have that many other deductions. Finally, for homeowners who itemize, the tax savings increase with their income tax rate and mortgage size. For example, an owner in the 15 percent tax bracket saves 15 cents per dollar of mortgage interest deducted, whereas an owner in the 35 percent bracket saves 35 cents. That larger saving per dollar deducted is magnified for higher-income households because they tend to buy larger homes with bigger mortgages.
The second approach in this option—replacing the mortgage interest deduction with a tax credit—would redirect the tax advantages of home ownership to lower-income taxpayers. Currently, many homeowners find themselves unable to take advantage of the deduction for mortgage interest. According to the President's Advisory Panel on Federal Tax Reform, only 54 percent of taxpayers who pay mortgage interest receive a tax benefit. Converting the mortgage interest deduction to a 15 percent credit would equalize the interest rate subsidy to borrowers regardless of their tax bracket and whether they itemized deductions.
The potential effectiveness of a 15 percent credit in getting more people to become homeowners is uncertain, however. That rate may be too low to encourage enough additional home ownership to improve neighborhoods and community participation. Alternatively, encouraging some people to own homes could reduce their flexibility with regard to job locations.
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Change in Revenues |
|
||||||||||
|
|
End the current deduction |
+10.5 |
+42.1 |
+41.9 |
+53.3 |
+88.3 |
|
+236.1 |
|
+694.4 |
|
|
|
Cap the deduction at 2 percent
of adjusted gross income |
+6.7 |
+26.6 |
+26.3 |
+34.7 |
+62.2 |
|
+156.5 |
|
+471.5 |
|
In determining their taxable income, taxpayers may either claim a standard deduction or itemize certain expenses to deduct from their adjusted gross income (AGI). Such expenses have long included state and local taxes on income, real estate, and personal property. Under the American Jobs Creation Act of 2004, taxpayers who itemized deductions in 2004 and 2005 had the choice of deducting their state and local sales taxes, which previously had not been deductible, instead of their state and local income taxes. That provision was extended for 2006 and 2007 by the Tax Relief and Health Care Act of 2006.
This option would curtail the deductibility of state and local tax payments, either by eliminating the deduction or by allowing taxpayers to deduct such taxes only up to an amount equal to 2 percent of their AGI. Eliminating deductibility completely would increase federal revenues by a total of $236.1 billion between 2008 and 2012. Setting a ceiling for the deduction at 2 percent of AGI would raise revenues to a lesser degree: by $156.5 billion over that five-year period.
The federal income tax deduction for state and local taxes is effectively a federal subsidy to state and local governments. As such, it indirectly finances spending by those governments at the expense of other uses of federal revenues. Both variations of this option would substantially reduce the incentive that the current subsidy provides for state and local government spending. However, research indicates that total state and local spending is not very sensitive to that incentive.
Some proponents of curtailing the deduction argue that the federal government should not subsidize state and local governments in this manner; others argue that the deduction largely benefits wealthier localities, where many taxpayers itemize, are in the upper tax brackets, and enjoy more-abundant state and local government services. Because the value of an additional dollar of itemized deductions increases with the marginal tax rate (the rate on the last dollar of income), the deductions are worth more to taxpayers in higher income tax brackets than to those in lower brackets. Additionally, the deductibility of taxes may deter states and localities from financing services with nondeductible fees, which may be more efficient.
One argument against eliminating or restricting the current deduction involves the equity of the tax system. A person who must pay relatively high state and local taxes is less able to pay federal taxes than is someone with the same total income and a smaller state and local tax bill. The validity of that argument depends at least in part on whether people who pay higher state and local taxes also benefit from more publicly provided goods and services.