Include Disability Payments From the Department of Veterans Affairs in Taxable Income

The goal of the Department of Veterans Affairs' (VA) disability system is to compensate veterans for earnings lost as a result of their service-connected disabilities. According to statute, the amount of lost earnings is meant to be equal to the average reduction of earnings capacity experienced by civilian workers with similar medical conditions or injuries.

Compensable service-connected disabilities are medical problems incurred or aggravated during active duty, although not necessarily during the performance of military duties. Conditions range widely in severity and type, including scars, hypertension, and the loss of one or more limbs. The amount of a veteran's base payment is linked to his or her composite disability rating, which is expressed from zero to 100 percent in increments of 10 percentage points. Lower VA ratings generally reflect that a disability is less severe; in 2015 about one in three recipients of disability compensation had a rating of 20 percent or less. Veterans do not have to demonstrate that their condition has reduced their earnings or interferes with daily functioning. Disability compensation is not means-tested, and payments are exempt from federal and state income taxes. Veterans who have a job are eligible for benefits, and most working-age veterans who receive disability benefits are employed. Payments are in the form of monthly annuities and typically continue until death. Because disability benefits are based on VA's calculation of average earnings lost as a result of specific conditions, payments do not reflect disparities in earnings that are attributable to differences in veterans' education, training, occupation, or motivation to work.

This option considers two alternative approaches to taxing VA disability benefits under the individual income tax. The first alternative would include all such disability payments in taxable income. The staff of the Joint Committee on Taxation (JCT) estimates that, if implemented, this alternative would increase federal revenues by $94 billion from 2017 through 2026. The second alternative would include disability payments in taxable income only for veterans with a disability rating of 20 percent or less. That alternative would raise federal revenues by a smaller amount—$38 billion over the 2017–2026 period—according to JCT's estimates.

An argument in favor of the option is that including disability payments in taxable income would increase the equity of the tax system. Taxing disability payments would lead to taxpayers with comparable combined income—that is, from disability payments, earnings, and other sources—incurring similar tax liabilities. Eliminating income exclusions in the tax system moves the system toward one in which people in similar financial and family circumstances face similar tax rates. Furthermore, because higher-income taxpayers face higher tax rates than lower-income taxpayers, this option would result in taxpayers with higher combined income paying a larger share of their income in taxes than taxpayers with less income.

An argument against this option is that VA disability payments are connected to military service, which is not like civilian employment; instead, it confers unique benefits to society and imposes extraordinary risks on service members. By that logic, the pay and benefits that service members receive—such as the current exclusion of disability compensation from taxation—should reflect the hardships of military life. Veterans, however, are entitled to disability payments even for non-work-related medical conditions, as long as those conditions were incurred during the period when the individuals were serving on active duty. In contrast, disability benefits received by civilian workers for non-work-related injuries are taxable if the employer paid the premiums.