SECTION 13. TAX PROVISIONS RELATED TO RETIREMENT, HEALTH, POVERTY, EMPLOYMENT, DISABILITY AND OTHER SOCIAL ISSUES CONTENTS Introduction Tax Provisions Use of Distributional Analysis Tax Provision Estimates Net Exclusion of Pension Contributions and Earnings Individual Retirement Plans Exclusion of Social Security and Railroad Retirement Benefits Exclusion of Employer Contribution for Medical Insurance Premiums and Medical Care Medical Savings Accounts Cafeteria Plans Health Care Continuation Rules Group Health Plan Requirements Tax Benefits for Accelerated Death Benefits and Long-Term Care Insurance Deduction for Health Insurance Expenses of Self-Employed Individuals Exclusion of Medicare Benefits Deductibility of Medical Expenses Earned Income Credit Exclusion of Public Assistance and SSI Benefits Dependent Care Tax Credit HOPE Credit and Lifetime Learning Credit Qualified State Tuition Programs and Education IRAs Student Loan Interest Deduction Exclusion for Employer-Provided Dependent Care Work Opportunity Tax Credit Welfare-to-Work Tax Credit Exclusion of Workers' Compensation and Special Benefits for Disabled Coal Miners Additional Standard Deduction for the Elderly and Blind Tax Credit for the Elderly and Certain Disabled Individuals Tax Provisions Related to Housing Owner-Occupied Housing Low-Income Housing Credit Tax Credit and Exclusion for Adoption Expenses Child Tax Credit Effect of Tax Provisions on the Income and Taxes of the Elderly and the Poor Hypothetical Tax Calculations for Selected Families Tax Treatment of the Elderly Distribution of Family Income and Taxes Federal Tax Treatment of Families in Poverty References INTRODUCTION The preceding sections of this publication discuss direct payments to individuals for retirement, health, public assistance, employment, and disability benefits provided through entitlement programs within the jurisdiction of the Committee on Ways and Means. The Federal Government also provides benefits to individuals through elements of the income tax set forth in the Internal Revenue Code of 1986 (the Code). The Code is entirely within the jurisdiction of the Committee on Ways and Means. Tax Provisions Several different types of income tax provisions are available to provide economic incentives. Examples include: exclusions, exemptions, deductions, preferential rates, deferrals and credits. Measuring the amount of benefit afforded by a tax provision is difficult. However, one way to measure the benefit is to review the total estimated amounts excluded, exempted, or otherwise afforded special treatment under various provisions of the income tax. Use of Distributional Analysis Analyzing the effectiveness of tax provisions at achieving their policy goals often involves examining the distribution of benefits from the provisions allocated by the income class of those who take advantage of the provisions. The income concept used to show the distribution of tax expenditures by income class is adjusted gross income (AGI) plus: (1) tax-exempt interest; (2) employer contributions for health plans and life insurance; (3) employer share of FICA taxes; (4) workers' compensation; (5) nontaxable Social Security benefits; (6) insurance value of Medicare benefits; (7) minimum tax preferences; and (8) excluded income of U.S. citizens living abroad. This definition of income includes items that clearly increase the ability to pay taxes, but that are not included in the definition of AGI. However, it omits certain items that clearly affect ability to consume goods and services either now or in the future, including accrual of pension benefits, other fringe benefits (such as military benefits, veterans benefits, and parsonage allowances), and means-tested transfer payments (such as Aid to Families with Dependent Children (AFDC), Supplemental Security Income, food stamps, housing subsidies, and general assistance). The tax return is the unit of analysis. Table 13-1 shows the distribution of all tax returns for 1999 by income class. Unless specifically indicated, all distributional tables exclude returns filed by dependents. All projections of income and deduction items and tax parameters are based on economic assumptions consistent with the December 1999 forecast of the Congressional Budget Office. TABLE 13-1.--DISTRIBUTION BY INCOME CLASS OF ALL RETURNS, TAXABLE RETURNS, ITEMIZED RETURNS, AND TAX LIABILITY AT 1999 RATES AND 1999 LAW AND 1999 INCOME LEVELS \1\ ---------------------------------------------------------------------------------------------------------------- All returns Taxable Itemized Tax Income class (thousands) \2\ \3\ returns returns liability ---------------------------------------------------------------------------------------------------------------- Below $10................................................... 22,371 1,463 460 -$8,300 $10-$20..................................................... 26,314 8,634 1,236 -8,519 $20-$30..................................................... 20,301 13,052 2,356 18,989 $30-$40..................................................... 15,902 13,532 3,710 34,291 $40-$50..................................................... 13,082 12,232 4,342 46,655 $50-$75..................................................... 19,829 19,533 10,219 116,354 $75-$100.................................................... 10,042 9,993 7,268 102,779 $100-$200................................................... 8,461 8,449 7,222 173,919 $200 and over............................................... 2,527 2,524 2,309 319,360 --------------------------------------------------- Total................................................... 138,829 89,410 39,121 795,530 ---------------------------------------------------------------------------------------------------------------- \1\ Tax law as in effect on January 1, 1999, is applied to the 1999 level and sources of income and their distribution among taxpayers. \2\ The income concept used to place tax returns into classes is adjusted gross income plus: (1) tax-exempt interest; (2) employer contributions for health plans and life insurance; (3) employer share of FICA tax, (4) workers' compensation; (5) nontaxable Social Security benefits; (6) insurance value of Medicare benefits; (7) alternative minimum tax preference items; and (8) excluded income of U.S. citizens living abroad. \3\ Includes filing and nonfiling units. Filing units include all taxable and nontaxable returns. Nonfiling units include individuals with income that is exempt from Federal income taxation (e.g., transfer payments, interest from tax-exempt bonds, etc.). Excludes individuals who are dependents of other taxpayers and taxpayers with negative income. Note.--Money amounts in millions of dollars, returns in thousands. Detail may not add to total due to rounding. Source: Joint Committee on Taxation. Tax Provision Estimates Table 13-2 provides various estimates for 36 tax provisions related to retirement, health, poverty, employment, disability, and housing. These provisions are examined in detail in this chapter including their legislative history, an explanation of current law, and a brief assessment of their effects. NET EXCLUSION OF PENSION CONTRIBUTIONS AND EARNINGS Legislative History Prior to 1921, no special tax treatment applied to employee retirement trusts. Retirement payments to employees and contributions to pension trusts were deductible by the employer as an ordinary and necessary business expense. Employees were taxed on amounts actually received as well as on employer contributions to a trust if there was a reasonable expectation of benefits accruing from the trust. The 1921 Code provided an exemption for a trust forming part of a qualified profit sharing or stock bonus plan. TABLE 13-2.--ESTIMATED TAX BASE EXCEPTIONS AND CREDITS UNDER THE PRESENT INCOME TAX FOR VARIOUS ITEMS,\1\ CALENDAR YEARS 2001-5 [In billions of dollars] ---------------------------------------------------------------------------------------------------------------- Year Item ------------------------------------------------------------ Total 2001 2002 2003 2004 2005 2001-5 ---------------------------------------------------------------------------------------------------------------- I. Tax base exceptions related to: Retirement: Net exclusion of pension $372.9 $361.5 $344.9 $341.3 $344.3 $1,764.8 contributions and earnings......... Keogh plans......................... 20.1 20.4 20.6 21.9 23.7 106.8 Individual retirement plans......... 55.5 62.9 67.6 73.3 76.7 336.1 Exclusion of Social Security and 269.7 279.3 288.4 298.8 307.1 1,443.3 railroad retirement benefits in excess of employee share of payroll tax \2\............................ Health: Exclusions of employer contributions 359.5 384.5 407.1 431.9 458.9 2,042.0 for medical care, health insurance premiums and long-term care insurance premiums \3\............. Exclusion of Medicare benefits: Medicare part A................. 131.7 138.3 145.4 153.8 164.8 734.0 Medicare part B................. 81.7 88.0 96.3 103.2 111.9 481.1 Deductibility of medical expenses 29.5 32.3 33.9 35.5 36.5 167.7 \4\................................ Deductibility of health insurance 7.2 9.0 14.1 14.9 15.8 60.9 expenses of the self-employed \5\.. Exclusion of accelerated death 2.1 2.5 2.9 3.5 3.9 14.8 benefits........................... Poverty: Exclusion of public assistance and 54.7 57.4 60.4 63.4 69.8 305.8 SSI cash benefits.................. Employment: Exclusion of employer-provided 0.7 0.7 0.7 0.8 0.8 3.6 dependent care \6\................. Employee stock ownership plans...... 13.5 14.0 14.6 15.2 15.8 73.1 Exclusion for benefits provided 45.7 48.9 51.8 55.0 58.5 259.9 under cafeteria plans \7\.......... Elderly and disabled: Exclusion of workers' compensation and special benefits for disabled coal miners: Workers' compensation........... 32.1 33.7 34.6 35.3 37.2 172.8 Special benefits for disabled 0.3 0.3 0.3 0.3 0.3 1.6 coal miners.................... Additional standard deduction for 12.1 12.5 13.0 13.5 14.4 65.5 elderly and blind.................. Housing: Deductibility of mortgage interest.. 239.4 250.9 261.7 273.4 285.8 1,311.2 Deductibility of property tax on 85.4 89.5 93.8 98.2 102.6 469.5 owner-occupied housing............. Exclusion of interest on State and 3.3 3.3 3.3 3.4 3.4 16.8 local government bonds for owner- occupied housing................... Depreciation of rental housing in 6.7 7.6 8.2 9.3 10.6 42.4 excess of alternative depreciation system............................. Exclusion of interest on State and 0.7 0.7 0.7 0.8 0.8 3.6 local government bonds for rental housing............................ Families: Qualified State tuition programs and 0.1 0.2 0.2 0.2 0.2 0.9 education IRAs..................... Student loan interest deduction..... 0.4 0.4 0.4 0.5 0.5 2.2 Employer-provided adoption expenses (\8\) (\8\) (\8\) (\8\) (\8\) (\8\) II. Tax credits related to: Poverty: Earned income credit: Nonrefundable portion........... 4.3 4.3 4.4 4.5 4.6 22.0 Refundable portion \9\.......... 26.4 26.7 27.2 27.8 28.4 136.5 Employment: Dependent care credit............... 2.4 2.3 2.3 2.3 2.1 11.5 Work opportunity tax credit......... 0.3 0.3 0.2 0.1 (\8\) 0.8 Welfare-to-work tax credit......... 0.1 0.1 (\8\) (\8\) (\8\) 0.2 Elderly and disabled: Tax credit for elderly and disabled. (\8\) (\8\) (\8\) (\8\) (\8\) 0.1 Housing: Low-income housing tax credit....... 3.7 3.9 4.0 4.1 4.2 19.7 Families: Child tax credit: Nonrefundable portion.......... 19.1 18.5 18.3 17.8 17.2 90.9 Refundable portion............. 0.8 0.8 0.8 0.8 0.8 4.0 HOPE credit and lifetime learning 4.6 4.2 4.3 4.3 4.3 21.6 credit............................. Adoption credit.................... 0.3 0.1 0.1 0.1 0.1 0.5 ---------------------------------------------------------------------------------------------------------------- \1\ Estimates of exclusions and deductions represent changes in the tax base; they do not measure changes in tax liability. Tax effects of provisions are not comparable. \2\ In addition to OASDI benefits for retired workers, these figures also include disability insurance benefits and benefits for dependents and survivors. \3\ Estimate includes employer-provided health insurance purchased through cafeteria plans and health care spending through flexible spending accounts. \4\ Amounts reported on tax returns in excess of the medical deductions floor (7.5 percent of adjusted gross income). \5\ Amounts deductible from gross income (60 percent of health insurance expenses in 2001, 70 percent in 2002, and 100 percent in 2003-5). \6\ Estimate includes employer-provided child care purchased through dependent care flexible spending accounts. \7\ Estimate includes amounts of employer-provided health insurance purchased through cafeteria plans and employer-provided child care purchased through dependent care flexible spending accounts. These amounts are also included in other line items in this table. \8\ Less than $50 million. \9\ Estimate provided by the Congressional Budget Office. Note.--Details may not add to totals due to rounding. Source: Joint Committee on Taxation. The rules relating to qualified plans were substantially revised by the Employee Retirement Income Security Act of 1974 (ERISA), which added overall limitations on contributions and benefits and other requirements on minimum participation, coverage, vesting, benefit accrual, and funding. Further revisions of these rules have been made in every major tax bill enacted after 1974. Since ERISA, Congress has also acted to broaden the range of qualified plans. In the Revenue Act of 1978, Congress provided special rules for qualified cash or deferred arrangements under section 401(k). Under these arrangements, known popularly as 401(k) plans, employees can elect to receive cash or have their employers contribute a portion of their earnings to a qualified profit sharing, stock bonus, or pre- ERISA money purchase pension plan. An employee stock ownership plan is a special type of qualified plan that is designed to invest primarily in securities of the employer maintaining the plan. Certain qualification rules and tax benefits apply to employee stock ownership plans that do not apply to other types of qualified plans. Explanation of Provision In general Under a plan of deferred compensation that meets the qualification standards of the Internal Revenue Code (sec. 401(a)), an employer is allowed a deduction for contributions to a tax-exempt trust to provide employee benefits. Similar rules apply to plans funded with annuity contracts. An employer that makes contributions to a qualified plan in excess of the deduction limits is subject to a 10-percent excise tax on such excess (sec. 4972). The qualification rules limit the amount of benefits that can be provided through a qualified plan and require that benefits be provided on a basis that does not discriminate in favor of highly compensated employees. In addition, qualified plans are required to meet minimum standards relating to participation (the restrictions that may be imposed on participation in the plan), coverage (the number of employees participating in the plan), vesting (the time at which an employee's benefit becomes nonforfeitable), and benefit accrual (the rate at which an employee earns a benefit). Also, minimum funding standards apply to the rate at which employer contributions are required to be made to certain plans to ensure the solvency of pension plans. If a defined benefit pension plan is terminated, any assets remaining after satisfaction of the plan's liabilities may revert to the employer. Such reversions are included in the gross income of the employer and are subject to income tax plus an additional excise tax (sec. 4980). The excise tax is 20 percent if the employer establishes a qualified replacement plan or provides certain benefit increases. Otherwise, the excise tax is 50 percent. Transfers of excess assets can be made from an ongoing defined benefit plan to pay certain retiree health benefits if certain requirements are satisfied (sec. 420). The assets transferred are not includable in the income of the employer or subject to the tax on reversions. Minimum participation rules A qualified plan generally may not require as a condition of participation that an employee complete more than 1 year of service or be older than age 21 (sec. 410(a)). Vesting rules A plan is not a qualified plan unless a participant's employer-provided benefit vests at least as rapidly as under one of two alternative minimum vesting schedules (sec. 411). Benefit accrual rules The protection afforded employees under the minimum vesting rules depends not only on the minimum vesting schedules, but also on the accrued benefits to which these schedules are applied. In the case of a defined contribution plan, the accrued benefit is the participant's account balance. In the case of a defined benefit plan, a participant's accrued benefit is determined under the plan benefit formula, subject to certain restrictions. In general, the accrued benefit is defined in terms of the benefit payable at normal retirement age and does not include certain ancillary nonretirement benefits. Each defined benefit plan is required to satisfy one of three accrued benefit tests. The primary purpose of these tests is to prevent undue backloading of benefit accruals (i.e., by providing low rates of benefit accrual in the employee's early years of service when the employee is most likely to leave and by concentrating the accrual of benefits in the employee's later years of service when he is most likely to remain with the employer until retirement) (sec. 412). Coverage rules A plan is not qualified unless the plan satisfies at least one of the following coverage requirements: (1) the plan benefits at least 70 percent of all nonhighly compensated employees, (2) the plan benefits a percentage of nonhighly compensated employees that is at least 70 percent of the percentage of highly compensated employees benefiting under the plan, or (3) the plan meets an average benefits test (sec. 410(b)). In addition, a defined benefit plan is not a qualified plan unless it benefits at least the lesser of: (1) 50 employees, or (2) the greater of 40 percent of the employees of the employer or 2 employees (or if there is only 1 employee, such employee; sec. 401(a)(26)). General nondiscrimination rule In general, a plan is not a qualified plan if the contributions or benefits under the plan discriminate in favor of highly compensated employees (sec. 401(a)(4)). Limitations on contributions and benefits The maximum annual benefit that may be provided by a defined benefit pension plan (payable at the Social Security retirement age) is the lesser of 100 percent of average compensation, or $135,000 for 2000 (sec. 415(b)). The dollar limit is adjusted annually for inflation. The dollar limit is reduced if payments of benefits begin before the Social Security retirement age and increased if benefits begin after the Social Security retirement age. Funding rules Pension plans are required to meet a minimum funding standard for each plan year (sec. 412). In the case of a defined benefit pension plan, an employer must contribute an annual amount sufficient to fund a portion of participants' projected benefits determined in accordance with one of several prescribed funding methods, using reasonable actuarial assumptions. Plans with asset values of less than 100 percent of current liabilities are subject to additional, faster funding rules. Taxation of distributions An employee who participates in a qualified plan is taxed when the employee receives a distribution from the plan to the extent the distribution is not attributable to employee contributions (sec. 402). With certain exceptions, a 10-percent additional income tax is imposed on early distributions from a qualified plan (sec. 72(t)). Failure to satisfy qualification requirements If a plan fails to satisfy the qualification requirements, the trust that holds the plan's assets is not tax exempt. An employer's deduction for plan contributions is only allowed when the employee includes the contributions or benefits in income, and benefits generally are includable in an employee's income when they are no longer subject to a substantial risk of forfeiture. SIMPLE retirement plans The Small Business Job Protection Act of 1996 created a simplified retirement plan for small business called the Savings Incentive Match Plan for Employees (SIMPLE) (secs. 408(p) and 401(k)(11)). SIMPLE plans may be adopted by employers with 100 or fewer employees and who do not maintain another employer-sponsored retirement plan. A SIMPLE plan can be either an individual retirement account (IRA) for each employee or part of a qualified cash or deferred arrangement (401(k) plan). If established in IRA form, a SIMPLE plan is not subject to the nondiscrimination rules generally applicable to qualified plans and simplified reporting requirements apply. If adopted as part of a 401(k) plan, the plan does not have to satisfy the special nondiscrimination tests applicable to 401(k) plans and is not subject to the top-heavy rules. The other qualified plan rules continue to apply. SIMPLE plans are subject to special rules regarding eligibility of employees to participate and special contribution limits. Effect of Provision The tax treatment of pension contributions and earnings has encouraged employers to establish qualified retirement plans and to compensate employees in the form of pension contributions to such plans. There are two potential tax advantages of being compensated through pension contributions. One advantage is the ability to earn tax-free returns to savings. When saving is done through a pension plan, the employee earns a higher rate of return than on fully taxed savings.\1\ The second advantage is that an employee's tax rate may be lower during retirement than during the working years. --------------------------------------------------------------------------- \1\ This applies to pension contributions made by employers. Employees may also be able to contribute to qualified plans. Employee contributions may be made with aftertax dollars. If so, the tax advantage given to these contributions is smaller than the tax advantage given to employer contributions, and consists of the deferral of tax on accumulated earnings. --------------------------------------------------------------------------- These tax provisions directly benefit only persons who work for employers with qualified plans and who work for a sufficient period of time before their benefits vest in such plans. The current extent of this coverage and recent trends in coverage are described below. Coverage The term ``covered,'' as used here, means that an employee is accruing benefits in an employer pension or other retirement plan. The most recent data regarding pension coverage is the March 1999 Current Population Survey. The data referred to below come from that survey unless otherwise noted. As of March 1998, 63 percent of the nonelderly full-time wage and salary workers employed in the private sector reported that they worked in firms with an employer-sponsored pension plan (table 13-3). Half of the full-time wage and salary workers employed in the private sector were covered by an employer-sponsored pension plan. Pension coverage varies substantially among full-time, privately employed workers. Differences depend on the age of the worker, job earnings, the industry of employment, and the size of the firm. TABLE 13-3.--EMPLOYER SPONSORSHIP AND EMPLOYEE COVERAGE UNDER PENSION OR RETIREMENT PLAN, PRIVATE WAGE AND SALARY WORKERS, 1998 ------------------------------------------------------------------------ Percent covered -------------------------------------- Total Full time Part time ------------------------------------------------------------------------ Employer sponsorship: Employer sponsors plan....... 57 63 34 Employer does not sponsor.... 43 37 66 Employee coverage: Employee covered under plan.. 43 50 12 Employee is not covered...... 57 50 88 -------------------------------------- Number of private wage and 108,930 86,709 22,221 salary workers (in thousands)................ ------------------------------------------------------------------------ Source: Congressional Research Service estimates based on the U.S. Census Bureau's Current Population Survey of March 1999. Younger workers are much less likely to be covered by a pension than middle aged and older workers. Coverage rates rise steadily from 20 percent for those under age 25 to about 60 percent for those between ages 40 and 60 before falling off substantially for those over age 65. This pattern holds for both men and women. However, the jump in coverage for middle aged men is slightly larger than the increase for middle aged women (table 13-4). Higher paying jobs are more likely to offer pensions. Just 11 percent of full-time private wage and salary workers earning less than $10,000 per year in 1998 were covered compared to 77 percent or more of those earning $50,000 or more (table 13-5). Coverage may be higher for higher paying jobs because of the greater value of the pension tax benefits to workers in higher tax brackets and because of the declining replacement rate of Social Security at higher earnings levels. TABLE 13-4.--COVERAGE UNDER EMPLOYER-SPONSORED PENSION OR RETIREMENT PLANS FOR FULL-TIME PRIVATE WAGE AND SALARY WORKERS BY WORKERS' AGE, 1998 ------------------------------------------------------------------------ Percent covered Age -------------------------------------- Total Men Women ------------------------------------------------------------------------ Under 25......................... 20 21 19 25-29............................ 41 39 43 30-34............................ 50 52 46 35-39............................ 55 57 52 40-44............................ 59 62 56 45-49............................ 62 66 58 50-54............................ 63 67 58 55-59............................ 61 64 56 60-64............................ 59 61 55 65 or older...................... 41 42 38 -------------------------------------- Total...................... 50 52 47 ------------------------------------------------------------------------ Source: Congressional Research Service estimates based on the U.S. Census Bureau's Current Population Survey of March 1999. TABLE 13-5.--COVERAGE UNDER EMPLOYER-SPONSORED PENSION OR RETIREMENT PLANS FOR FULL-TIME PRIVATE WAGE AND SALARY WORKERS BY WORKERS' WAGES, 1998 ------------------------------------------------------------------------ Percent covered Annual earnings -------------------------------------- Total Men Women ------------------------------------------------------------------------ Under $10,000.................... 11 10 12 $10,000-$14,999.................. 22 17 26 $15,000-$19,999.................. 35 30 40 $20,000-$24,999.................. 45 38 52 $25,000-$29,999.................. 56 53 60 $30,000-$34,999.................. 63 61 66 $35,000-$39,999.................. 65 63 69 $40,000-$49,999.................. 71 71 72 $50,000-$74,999.................. 77 77 76 $75,000 or over.................. 79 80 73 -------------------------------------- Total \1\.................. 50 52 47 ------------------------------------------------------------------------ \1\ Total includes workers not responding on wages. Source: Congressional Research Service estimates based on the U.S. Census Bureau's Current Population Survey of March 1999. Coverage is much lower for smaller firms (table 13-6). Smaller firms are less likely to offer comprehensive fringe benefit packages as part of total compensation. Only 17 percent of full-time private wage and salary workers in firms with fewer than 10 employees are covered. The rate rises with employer size but does not reach 50 percent (the average across all firm sizes) until firms have 100 or more employees (table 13-6). Significant differences in coverage also are apparent between full-time private wage and salary workers and other wage and salary workers. Coverage is much lower among part-time workers and much higher among public employees. Among part- time, private wage and salary workers, 12 percent are covered. Seventy-four percent of public sector wage and salary workers are covered including 82 percent of those who are full-time workers (table 13-7). TABLE 13-6.--COVERAGE UNDER EMPLOYER-SPONSORED PENSION OR RETIREMENT PLANS FOR FULL-TIME PRIVATE WAGE AND SALARY WORKERS BY SIZE OF FIRM, 1998 ------------------------------------------------------------------------ Percent covered Firm size (number of workers) -------------------------------------- Total Men Women ------------------------------------------------------------------------ Fewer than 10.................... 17 17 17 10-24............................ 28 28 28 25-99............................ 41 43 37 100-499.......................... 54 57 51 500-999.......................... 61 63 59 1,000 or more.................... 66 70 61 -------------------------------------- Total........................ 50 52 47 ------------------------------------------------------------------------ Source: Congressional Research Service estimates based on the U.S. Census Bureau's Current Population Survey of March 1999. TABLE 13-7.--COVERAGE OF WAGE AND SALARY WORKERS UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, BY PRIVATE OR PUBLIC SECTOR, 1998 ------------------------------------------------------------------------ Percent covered Sector of employment -------------------------------------- Total Full time Part time ------------------------------------------------------------------------ All wage and salary workers...... 48 56 15 Men.......................... 51 57 10 Women........................ 44 54 17 Private sector................... 43 50 12 Men.......................... 47 52 9 Women........................ 38 47 14 Public sector.................... 74 82 30 Men.......................... 76 82 19 Women........................ 72 82 34 ------------------------------------------------------------------------ Source: Congressional Research Service estimates based on the U.S. Census Bureau's Current Population Survey of March 1999. Trends in Coverage At the outset of World War II, private employer pensions were offered by about 12,000 firms. Pensions spread rapidly during and after the war, encouraged by high marginal tax rates and wartime wage controls that exempted pension benefits. By 1972, when the first comprehensive survey was undertaken, 48 percent of full-time private employees were covered. Subsequent surveys in 1979, 1983, 1988, and 1993 showed that coverage remained fairly constant, never falling below 46 percent or rising above 50 percent. However, the most recent survey in 1998 showed a drop in coverage to 43 percent (table 13-7). The decline in coverage in the 1980s was concentrated among younger men. The coverage rate among older men has fallen less dramatically, and among women it has risen at some ages and fallen at others. The decline in pension coverage has occurred at the same time that employers have been shifting from defined benefit plans. Of the private wage and salary workers covered by a pension plan in 1975, 87 percent were covered by a defined benefits plan (Turner & Beller, 1989, pp. 65 & 357). This proportion dropped to 83 percent by 1980 and to 71 percent by 1985. This proportion dropped even lower to 65 percent in 1993 (Department of Labor, 1994, tables A2, B1, B2). This shifting composition has largely been the result of rapid growth in primary defined contribution plans. Employee stock ownership plans and 401(k) plans have been among the most rapidly growing defined contribution plans. INDIVIDUAL RETIREMENT PLANS Legislative History ERISA added section 219 to the Internal Revenue Code, providing a tax deduction for certain contributions to IRAs and permitting the deferral of tax on amounts held in such arrangements until withdrawal. Active participants in employer plans were not permitted to make deductible IRA contributions. The Economic Recovery Tax Act of 1981 expanded eligibility to individuals who were active participants and increased the amount of the permitted deduction. The Tax Reform Act of 1986 limited the full IRA deduction to individuals with income below certain levels and to individuals who are not active participants in employer plans. Individuals who are not entitled to the full IRA deduction may make nondeductible contributions to an IRA. The Small Business Job Protection Act of 1996 increased contributions that can be made to the IRA of a nonworking spouse. The Health Insurance Portability and Accountability Act provided that the early withdrawal tax does not apply to withdrawals from IRAs: (1) for medical expenses that would be deductible (i.e., to the extent that total medical expenses exceed 7.5 percent of AGI); and (2) for health insurance expenses of unemployed individuals. The Taxpayer Relief Act of 1997, effective for years beginning after December 31, 1997, made the following changes to the IRA provisions: (1) the income limits on deductible IRA contributions that apply to active participants in an employer- sponsored retirement plan were increased; (2) the nonworking spouse of an active participant in an employer-sponsored retirement plan may make a deductible contribution of up to $2,000 to an IRA; (3) a new tax-free nondeductible IRA, the Roth IRA, was added; and (4) the 10-percent early withdrawal tax was waived for distributions from IRAs for education and first-time home buyer expenses. Explanation of Provision Deductible IRAs An individual who is an active participant in an employer- sponsored retirement plan may deduct annual IRA contributions up to the lesser of $2,000 or 100 percent of compensation if the individual's adjusted gross income (AGI) does not exceed certain limits. The full $2,000 IRA deduction limit is phased out for married individuals over the following levels of AGI: for 2000, $52,000-$62,000; for 2001, $53,000-$63,000; for 2002, $54,000- $64,000; for 2003, $60,000-$70,000; for 2004, $65,000-$75,000; for 2005, $70,000-$80,000; for 2006, $75,000-$85,000; and for 2007 and thereafter, $80,000-$100,000. The phase-out range for married individuals filing separate returns is $0-$10,000. A couple is not treated as married if the spouses file separate returns and do not live together at any time during the year. The phase-out range for single individuals is: for 2000, $32,000-$42,000; for 2001, $33,000-$43,000; for 2002, $34,000- $44,000; for 2003, $40,000-$50,000; for 2004, $45,000-$55,000; for 2005 and thereafter, $50,000-$60,000. An individual who is not an active participant, but whose spouse is, may make a full $2,000 deductible IRA contribution if the AGI for the couple does not exceed $150,000. The deduction limit is phased out for AGI between $150,000 and $160,000. An individual who is not an active participant in an employer-sponsored retirement plan may deduct IRA contributions up to the limits described above without limitation based on income. The investment income of IRA accounts is not taxed until withdrawn. Withdrawn amounts attributable to deductible contributions and all earnings are includable in income. A 10- percent additional income tax is levied unless the withdrawal: (1) is made after the IRA owner attains age 59\1/2\ or dies; (2) is made on account of the disability of the IRA owner; (3) is one of a series of substantially equal periodic payments made not less frequently than annually over the life or life expectancy of the IRA owner (or the IRA owner and his or her beneficiary); or (4) is made to pay medical expenses in excess of 7.5 percent of AGI or for insurance premiums for unemployed individuals; or (5) is made for first-time home buyer expenses (subject to a $10,000 lifetime cap) or for qualified higher education expenses. Roth IRAs An individual may make nondeductible contributions up to the lesser of $2,000 or 100 percent of compensation to a Roth IRA if the individual's AGI does not exceed $95,000 for an unmarried individual, or $150,000 for a married couple filing a joint return. The maximum contribution is phased out between AGI ranges of $95,000-$110,000 for unmarried individuals and of $150,000-$160,000 for married individuals filing a joint return. No more than $2,000 of contributions can be made to all an individual's IRAs for a taxable year. Qualified distributions from a Roth IRA are not includable in income. Qualified distributions are distributions: (1) made after the 5-year taxable period beginning with the first taxable year for which a contribution is made, and (2) which are made on or after the date the individual attains age 59\1/ 2\, are made to a beneficiary on or after the death of the individual, are attributable to the individual's being disabled, or are for a qualified special purpose distribution. A qualified special purpose distribution is a distribution for first-time home buyer expenses, as described above. Distributions that are not qualified distributions are includable in income, to the extent earnings are included in the distribution, and are subject to the 10-percent tax on early withdrawal, unless an exception applies, as described above for deductible IRAs. Taxpayers with AGI of less than $100,000 may convert an IRA to a Roth IRA at any time. If the conversion was made before January 1, 1999, the amounts that would have been includable in income had the amounts converted been withdrawn are includable in income ratably over 4 years. The 10-percent tax on early withdrawals does not apply to conversions of IRAs to Roth IRAs. Nondeductible IRAs An individual may make nondeductible contributions to an IRA to the extent the individual does not or cannot make deductible contributions to an IRA or contributions to a Roth IRA. Earnings on contributions to a nondeductible IRA accumulate tax free, and are includable in income when withdrawn. The 10-percent early withdrawal tax applies to such earnings, subject to the exceptions for deductible and Roth IRAs as described above. Effect of Provision Use of IRAs expanded significantly when eligibility was expanded in 1982 to all persons with earnings and contracted correspondingly in 1987 when deductibility was restricted for higher income taxpayers who were covered by an employer- provided pension. The number of taxpayers claiming a deductible IRA contribution jumped from 3.4 million in 1981 to 12.0 million in 1982 and peaked at 16.2 million in 1985. In 1987, only 7.3 million taxpayers reported deductible contributions. Since then, the number has continued to fall (table 13-8). Upper-income taxpayers facing higher marginal tax rates receive more benefit per dollar of IRA deduction than do low- income taxpayers facing lower marginal tax rates. When IRAs were available to all workers, the percentage of taxpayers contributing to an IRA was substantially higher among taxpayers with higher income. For example, in 1985, 13.6 percent of taxpayers with AGI between $10,000 and $30,000 contributed to an IRA compared with 74.1 percent of taxpayers with AGI between $75,000 and $100,000. The decline in IRA use between 1985 and 1990 among those with AGI between $10,000 and $30,000 appears to be larger than the reduction required by the change in law since the restrictions on deductible contributions apply only to a small fraction of taxpayers with AGI below $30,000. TABLE 13-8.--USE OF DEDUCTIBLE INDIVIDUAL RETIREMENT ACCOUNTS, 1980-97 ------------------------------------------------------------------------ Number of tax returns Total IRA Year deducting IRA deductions contributions (billions) (millions) ------------------------------------------------------------------------ 1980.................................. 2.6 $3.4 1981.................................. 3.4 4.8 1982.................................. 12.0 28.3 1983.................................. 13.6 32.1 1984.................................. 15.2 35.4 1985.................................. 16.2 38.2 1986.................................. 15.5 37.8 1987.................................. 7.3 14.1 1988.................................. 6.4 11.9 1989.................................. 5.8 10.8 1990.................................. 5.2 9.9 1991.................................. 4.7 9.0 1992.................................. 4.5 8.7 1993.................................. 4.4 8.5 1994.................................. 4.3 8.4 1995.................................. 4.1 8.3 1996.................................. 4.4 8.6 1997.................................. 4.1 8.7 ------------------------------------------------------------------------ Source: Internal Revenue Service, Statistics of Income, various years. Eligibility percentages and the real value of the IRA contribution limits decline over time because present law does not index the contribution limits or the income eligibility limits for inflation. For example, the real value of a $2,000 contribution has declined more than 30 percent since 1986 because of inflation. Congress established IRAs to allow workers not covered by employer pension plans to have tax-advantaged retirement saving. Nonetheless, since 1981 IRA participation rates have been higher among those covered by an employer-provided pension plan than those without one, and many of those who are not covered by a pension plan do not contribute to an IRA. In 1987, 10 percent of full-time private-sector earners without pension coverage contributed to an IRA, while 15 percent of those with coverage contributed (Woods, 1989, p. 9). EXCLUSION OF SOCIAL SECURITY AND RAILROAD RETIREMENT BENEFITS Legislative History The exclusion from gross income for Social Security benefits was not initially established by statute. Prior to the Social Security Amendments of 1983, the exclusion was based on a series of administrative rulings issued by the Internal Revenue Service in 1938 and 1941.\2\ --------------------------------------------------------------------------- \2\ See Internal Revenue Service, Internal Revenue Bulletin, 1938- 1, Income Tax Unit 3154, p. 114; 1938-2, Income Tax Unit 3229, p. 136; and 1941-1, Income Tax Unit 3447, p. 191. --------------------------------------------------------------------------- Under the Social Security Amendments of 1983, a portion of the Social Security benefits paid to higher income taxpayers is included in gross income. In 1993, the Omnibus Budget Reconciliation Act increased the amount of benefits subject to tax and increased the rate of tax for some benefit recipients. The exclusion from gross income of benefits paid under the Railroad Retirement System was enacted in the Railroad Retirement Act of 1935. A portion of the benefits payable under the Railroad Retirement System (generally, tier 1 benefits) is equivalent to Social Security benefits. The tax treatment of tier 1 railroad retirement benefits was modified in the Social Security Amendments of 1983 to conform to the tax treatment of Social Security benefits. Other railroad retirement benefits are taxable in the same manner as employer-provided retirement benefits. The Consolidated Omnibus Budget Reconciliation Act of 1985 provided that tier 1 benefits are taxable in the same manner as Social Security benefits only to the extent that Social Security benefits otherwise would be payable. Other tier 1 benefits are taxable in the same manner as all other railroad retirement benefits (for further details, see section 5). Explanation of Provision For taxpayers whose modified AGI exceeds certain limits, a portion of Social Security and tier 1 railroad retirement benefits is included in taxable income. Modified AGI is AGI plus interest on tax-exempt bonds plus 50 percent of Social Security and tier 1 railroad retirement benefits. A two-tier structure applies. The base tier is $25,000 for unmarried individuals and $32,000 for married couples filing joint returns, and zero for married persons filing separate returns who do not live apart at all times during the taxable year. The amount of benefits includable in income is the lesser of 50 percent of the Social Security and tier 1 railroad retirement benefits or 50 percent of the excess of the taxpayer's combined income over the base amount. The second tier applies to taxpayers with modified AGI of at least $34,000 (unmarried taxpayers) or $44,000 (married taxpayers filing joint returns). For these taxpayers, the amount of benefits includable in gross income is the lesser of 85 percent of Social Security benefits or the sum of 85 percent of the amount by which modified AGI exceeds the second-tier thresholds, and the smaller of the amount included under prior law or $4,500 (unmarried taxpayers) or $6,000 (married taxpayers filing jointly). The portion of tier 1 railroad retirement benefits potentially includable in taxable income under the above formula is the amount of benefits the taxpayer would have received if covered under Social Security. Pursuant to section 72(r) of the Internal Revenue Code of 1986, all other benefits payable under the Railroad Retirement System are includable in income when received to the extent they exceed employee contributions. Effect of Provision Approximately one-third of all Social Security recipients pay taxes on their benefits. This percentage is likely to increase over time because the thresholds are not adjusted annually for past inflation or other factors. EXCLUSION OF EMPLOYER CONTRIBUTION FOR MEDICAL INSURANCE PREMIUMS AND MEDICAL CARE Legislative History In 1943, the Internal Revenue Service (IRS) ruled that employer contributions to group health insurance policies were not taxable to the employee. Employer contributions to individual health insurance policies, however, were declared to be taxable income in an IRS revenue ruling in 1953. Section 106 of the Internal Revenue Code, enacted in 1954, reversed the 1953 IRS ruling. As a result, employer contributions to all accident or health plans generally are excluded from gross income and therefore are not subject to tax. Under section 105 of the Internal Revenue Code, benefits received under an employer's accident or health plan generally are not included in the employee's income. In the Revenue Act of 1978, Congress added section 105(h) to tax the benefits payable to highly compensated employees under a self-insured medical reimbursement plan if the plan discriminated in favor of highly compensated employees. Explanation of Provision Gross income of an employee generally excludes employer- provided coverage under an accident or health plan. The exclusion applies to coverage provided to former employees, their spouses, or dependents. Amounts excluded include those received by an employee for personal injuries or sickness if the amounts are paid directly or indirectly to reimburse the employee for expenses incurred for medical care. However, this exclusion does not apply in the case of amounts paid to a highly compensated individual under a self-insured medical reimbursement plan if the plan violates the nondiscrimination rules of section 105(h). Present law permits employers to prefund medical benefits for retirees. Postretirement medical benefits may be prefunded by the employer in two basic ways: (1) through a separate account in a tax-qualified pension plan (sec. 401(h)); or (2) through a welfare benefit fund (secs. 419 and 419A). Generally, the amounts contributed are excluded from the income of the plan or participants. Although amounts held in a section 401(h) account are accorded tax-favored treatment similar to assets held in a pension trust, the benefits provided under a section 401(h) account are required to be incidental to the retirement benefits provided by the plan. Amounts contributed to welfare benefit funds are subject to certain deduction limitations (secs. 419 and 419A). In addition, the fund is subject to income tax relating to any set-aside to provide postretirement medical benefits. Effect of Provision The exclusion for employer-provided health coverage provides an incentive for compensation to be furnished to the employee in the form of health coverage, rather than in cash subject to current taxation. For example, an employer designing a compensation package for an employee would be indifferent between paying the employee one dollar in cash and purchasing one dollar's worth of health insurance for the employee.\3\ On the other hand, because the employee is likely to pay Federal and State income taxes and payroll taxes on cash compensation and no tax on health insurance contributions made on his behalf, the employee would likely prefer that some compensation be in the form of health insurance. Employees subject to tax at the highest marginal tax rates have the greatest incentive to receive compensation in nontaxable forms. --------------------------------------------------------------------------- \3\ To the extent the employer bears a portion of the payroll tax, the employer may actually prefer to provide compensation through health insurance (which is not subject to payroll tax). --------------------------------------------------------------------------- The tax preference that the exclusion provides is substantial and has resulted in widespread access to health coverage. A majority of the population now receives health insurance as a consequence of their own employment or of a family member's employment. According to a special analysis of data from the Current Population Survey conducted by the Congressional Budget Office, nearly 75 percent of all workers under age 65 were covered by employment-based health insurance. Slightly over 4 percent of the workers under age 65 purchased insurance privately and nearly 3 percent received public insurance either through Medicare, Medicaid, or the Department of Veterans Affairs. The analysis reveals that slightly more than 18 percent of the workers under age 65 had no health insurance, up from 15 percent in 1996 (Committee, 1998, pp. 853-54). Health coverage through employer-based plans tends to be more prevalent: in the finance, government, manufacturing, mining, professional service, transportation, and wholesale trade sectors of the economy; among medium and large firms; for more highly paid workers; and among those over age 30 (table 13-9). MEDICAL SAVINGS ACCOUNTS The Health Insurance Portability and Accountability Act of 1996 included provisions for medical savings accounts (MSAs), effective for years beginning after December 31, 1996. Within limits, contributions to an MSA are deductible if made by an eligible individual and are excludable from income and employment taxes if made by the employer (other than contributions made through a cafeteria plan). Earnings on amounts in an MSA are not currently taxable. Distributions from an MSA for medical expenses are not includable in gross income. Distributions from an MSA that are not for medical expenses are includable in gross income and are subject to an additional tax of 15 percent, unless the distribution is made after death, disability, or age 65. TABLE 13-9.--PRIMARY SOURCE OF HEALTH INSURANCE FOR WORKERS UNDER AGE 65 BY DEMOGRAPHIC CATEGORY, MARCH 1999 ---------------------------------------------------------------------------------------------------------------- Percentage distribution by source of insurance Number of ----------------------------------------------- Category workers Own or (millions) other Individual Public No employer policy insurance \1\ insurance ---------------------------------------------------------------------------------------------------------------- Industry: Agriculture..................................... 2.8 45.4 14.5 3.9 36.1 Mining.......................................... 0.6 85.0 3.3 0.1 11.6 Construction.................................... 8.8 59.9 5.9 1.5 32.7 Manufacturing................................... 20.1 84.5 1.7 1.4 12.3 Transportation.................................. 9.1 81.7 2.4 1.4 14.5 Wholesale trade................................. 5.0 81.0 4.2 1.3 13.5 Retail trade.................................... 18.8 62.3 4.9 5.0 27.8 Finance......................................... 8.4 83.2 4.5 0.9 11.4 Professional services........................... 30.4 82.9 3.7 2.2 11.1 Other services.................................. 14.5 63.3 6.1 4.1 26.5 Government...................................... 5.9 91.3 1.4 1.3 6.1 Family income (as a percentage of poverty): under 100....................................... 8.6 28.0 5.3 20.2 46.5 100-199......................................... 17.7 50.4 5.1 6.4 38.1 200-299......................................... 21.9 71.6 3.9 2.2 22.3 300 or more..................................... 83.2 85.7 3.9 0.5 9.9 Firm size (number of employees): Fewer than 10................................... 25.2 53.1 12.1 3.8 31.1 10-24........................................... 11.6 64.0 5.4 3.5 27.0 25-99........................................... 16.6 73.8 2.5 3.3 20.5 100-499......................................... 18.8 79.9 2.1 2.9 15.1 500-999......................................... 7.6 84.8 1.7 2.0 11.5 1,000 or more................................... 51.6 84.9 1.6 2.3 11.2 Age: Under 30........................................ 31.2 61.6 3.6 5.4 29.3 30-39........................................... 36.5 76.1 3.3 3.1 17.5 40-49........................................... 35.6 80.6 4.2 1.7 13.6 50-64........................................... 28.1 80.6 5.8 1.2 12.4 Region: Northeast....................................... 24.7 76.7 4.0 2.8 16.5 Midwest......................................... 31.2 79.3 4.1 2.7 13.9 South........................................... 45.5 73.4 4.0 2.6 20.0 West............................................ 30.0 70.8 4.5 3.6 21.1 ----------------------------------------------------------- All nonelderly workers 131.4 74.8 4.1 2.9 18.2 ---------------------------------------------------------------------------------------------------------------- \1\ Public insurance includes Medicaid, Medicare, and coverage provided by the Department of Veterans Affairs. Source: Congressional Budget Office estimates based on the March 1999 Current Population Survey. MSAs are available to employees covered under an employer- sponsored high deductible health plan of a small employer and to self-employed individuals covered under a high deductible health plan (regardless of the size of the entity for which the self-employed individual performs services). A small employer is defined as an employer with 50 or fewer employees. In order to be eligible for an MSA contribution, an otherwise eligible individual must be covered under a high deductible health plan and no other health plan. A high deductible health plan is a plan with an annual deductible of at least $1,500 and no more than $2,250 in the case of individual coverage (and at least $3,000 and no more than $4,500 in the case of family coverage). The dollar limits are indexed for inflation. High deductible plans must also meet certain limits on out-of-pocket expenses. The number of taxpayers benefiting annually from an MSA contribution is limited to a threshold level (generally, 750,000 taxpayers). If it is determined in a year that the threshold level has been exceeded (called a cutoff year), then, in general, for succeeding years during the 4-year pilot period 1997-2000, only those individuals who (1) made an MSA contribution or had an employer MSA contribution for the year or a preceding year (i.e., are active MSA participants) or (2) are employed by a participating employer, would be eligible for an MSA contribution. In determining whether the threshold for any year has been exceeded, MSAs of previously uninsured individuals are not taken into account. After December 31, 2000, no new contributions may be made to MSAs except by or on behalf of an individual who previously had MSA contributions and employees who are employed by a participating employer. Self-employed individuals who made contributions to an MSA during the period 1997-2000 also may continue to make contributions after 2000. CAFETERIA PLANS Legislative History Under present law, compensation generally is includable in gross income when received. An exception applies if an employee may choose between cash and certain employer-provided nontaxable benefits under a cafeteria plan. Prior to 1978, ERISA provided that an employer contribution made before January 1, 1977 to a cafeteria plan in existence on June 27, 1974, had to be included in an employee's gross income only to the extent that the employee actually elected taxable benefits. If a plan did not exist on June 27, 1974, the employer contribution was to be included in income to the extent the employee could have elected taxable benefits. The Revenue Act of 1978 set up permanent rules for plans that offer an election between taxable and nontaxable benefits. The Deficit Reduction Act of 1984 (Public Law 98-369) clarified the types of employer-provided benefits that could be provided through a cafeteria plan, added a 25-percent concentration test, and required annual reporting to the IRS by employers. The Tax Reform Act of 1986 also modified the rules relating to cafeteria plans in several respects. Explanation of Provision A participant in a cafeteria plan (sec. 125) is not treated as having received taxable income solely because the participant had the opportunity to elect to receive cash or certain nontaxable benefits. In order to meet the requirements of section 125, the plan must be in writing, must include only employees (including former employees) as participants, and must satisfy certain nondiscrimination requirements. In general, a nontaxable benefit may be provided through a cafeteria plan if the benefit is excludable from the participant's gross income by reason of a specific provision of the Code. These include employer-provided health coverage, group-term life insurance coverage, and benefits under dependent care assistance programs. A cafeteria plan may not provide qualified scholarships or tuition reduction, educational assistance, miscellaneous employer-provided fringe benefits, or deferred compensation except through a qualified cash or deferred arrangement. If the plan discriminates in favor of highly compensated individuals regarding eligibility to participate, to make contributions, or to receive benefits under the plan, then the exclusion does not apply to such individuals. For purposes of these nondiscrimination requirements, a highly compensated individual is an officer, a shareholder owning more than 5 percent of the employing firm, a highly compensated individual determined under the facts and circumstances of the case, or a spouse or dependent of the above individuals. Effect of Provision The optimal compensation of employees (in a tax planning sense) would require that employers and employees arrive at the compensation package that provides the largest aftertax benefit to the employee at minimum aftertax cost to the employer (see Scholes & Wolfson, 1992, chapter 10). Both the potential taxation of compensation provided to employees and the deductibility of compensation provided by the employer would be considered. If only income taxes were considered, employers would be indifferent between the payment of $1 in salary or wages and the payment of $1 in fringe benefits to an employee, because both types of compensation are fully deductible. When the employer payments for FICA and Federal Unemployment Tax Act (FUTA) taxes are considered, however, the employer might actually find it less costly to compensate an employee with a dollar's worth of fringe benefit not subject to FICA and FUTA taxes rather than a dollar of wage or salary payments that are subject to these taxes. The employee, however, would prefer to be compensated in the form that provides the highest aftertax value. An additional dollar of salary or wage paid to the employee will be subject to tax. If a fringe benefit is excludable from the employee's income, the employee pays no tax on receipt of the benefit. Consequently, the employee receives greater compensation via the fringe benefit. This differential treatment of salary or wage payments and excludable fringe benefits implies that compensation packages designed to minimize the joint tax liability of employers and employees could include substantial amounts of excludable fringe benefits. Employees may have different preferences about the allocation of their compensation. For example, an employee with no dependents may place little value on employer-provided life insurance. Cafeteria plans permit employees some discretion as to the provided benefits, and will tend to be preferred to benefit plans in which all employees of the firm receive the identical benefit package. Cafeteria plans are a growing part of compensation plans, particularly for larger employers. The Bureau of Labor Statistics estimated that in 1997, 52 percent of employees at large- and medium-sized firms were eligible for some type of cafeteria plan. This figure has grown from an estimated 5 percent in 1986 (U.S. Bureau of Labor Statistics, 1993). Smaller firms generally do not offer cafeteria plans to their workers. For example, in 1996, only 23 percent of the workers in small, private establishments (nonfarm establishments with fewer than 100 employees) were eligible to participate in a cafeteria plan (U.S. Bureau of Labor Statistics, 1996). The lower figure for smaller firms reflects in part the less generous fringe benefit packages provided by smaller firms. Like any income exclusion, the exclusion from gross income for cafeteria plan benefits can lead to disparities in the tax system. Employees with the same total compensation can have taxable incomes that are substantially different because of the form in which compensation is received. The exclusion for cafeteria plan benefits also may be used in some cases to avoid the 7.5 percent of AGI floor on deductible medical expenses. The use of cafeteria plans reduces the aftertax cost of health care to employees using these plans, which could cause these employees to purchase a larger amount of health care services. On the other hand, cafeteria plans could encourage employers to increase the share of premiums, copayments, and deductibles paid by employees, resulting in increased employee awareness of the costs of their health plans. This incentive could result in reduced health care costs. HEALTH CARE CONTINUATION RULES Legislative History The Consolidated Omnibus Budget Reconciliation Act of 1985 added sections 106(b), 162(i)(2), and 162(k) to the Internal Revenue Code under which certain group health plans are required to offer health coverage to certain employees and former employees, as well as to their spouses and dependents. Parallel requirements were added to title I of ERISA and the Public Health Services Act. If an employer failed to satisfy the health care continuation rules, the employer was denied a deduction for contributions to its group health plans and highly compensated employees were required to include in taxable income the employer-provided value of the coverage received under such plans. The Technical and Miscellaneous Revenue Act of 1988 made several changes to the health care continuation rules. Sections 106(b), 162(i)(2), and 162(k) were repealed and replaced by section 4980B. Section 4980B imposes an excise tax on the employer or other responsible party who fails to satisfy the rules instead of denying deductions and the exclusion. The Health Insurance Portability and Accountability Act of 1996 made some changes to the health care continuation rules in cases of disability. Explanation of Provision The health care continuation rules in section 4980B require that an employer provide qualified beneficiaries with the opportunity to participate for a specified period in the employer's health plan after that participation otherwise would have terminated. If the employee elects such continuation coverage, the employee may be required to pay for the coverage. The amount the employee can be required to pay is subject to certain limits. The qualifying events that may trigger rights to continuation coverage are: (1) the death of the employee; (2) the voluntary or involuntary termination of the employee's employment (other than by reason of gross misconduct); (3) a reduction of the employee's hours; (4) the divorce or legal separation of the employee; (5) the employee becoming entitled to benefits under Medicare; and (6) a dependent child of the employee ceasing to be a dependent under the employer's plan. The maximum period of continuation coverage is 36 months, except in the case of termination of employment or reduction of hours for which the maximum period is 18 months. The 18-month period is extended to 29 months in certain cases involving the disability of the qualified beneficiary. Certain events, such as the failure by the qualified beneficiary to pay the required premium, may trigger an earlier cessation of the continuation coverage. A beneficiary has a prescribed period of time during which to elect continuation coverage after the employee receives notice from the plan administrator of the right to continuation coverage. GROUP HEALTH PLAN REQUIREMENTS The Health Insurance Portability and Accountability Act of 1996 imposes certain requirements regarding health coverage portability through limitations on preexisting condition exclusions, prohibitions on excluding individuals from coverage based on health status, and guaranteed renewability of health insurance coverage. An excise tax is imposed with respect to failures of a group health plan to comply with the requirements. The tax is usually imposed on the employer sponsoring the plan. The amount of the tax is generally equal to $100 per day for each day during which the failure occurs until the failure is corrected. The maximum tax that can be imposed is the lesser of 10 percent of the employer's payments during the taxable year in which the failure occurred under group health plans or $500,000. The Secretary of the Treasury may waive all or part of the tax to the extent that payment of the tax would be excessive relative to the failure involved (see discussion of health care continuation rules). TAX BENEFITS FOR ACCELERATED DEATH BENEFITS AND LONG-TERM CARE INSURANCE Legislative History Accelerated death benefits If a contract meets the definition of a life insurance contract, gross income does not include insurance proceeds that are paid pursuant to the contract by reason of the death of the insured (sec. 101(a)). In addition, the undistributed investment income (inside buildup) earned on premiums credited under the contract is not subject to current taxation to the owner of the contract. The exclusion under section 101 applies regardless of whether the death benefits are paid as a lump sum or otherwise. If a contract fails to be treated as a life insurance contract under section 7702(a), inside buildup on the contract is generally subject to tax (sec. 7702(g)). To qualify as a life insurance contract for Federal income tax purposes, a contract must be a life insurance contract under the applicable State or foreign law and must satisfy either of two alternative tests: (1) a cash value accumulation test, or (2) a test consisting of a guideline premium requirement and a cash value corridor requirement (sec. 7702(a)). A contract satisfies the cash value accumulation test if the cash surrender value of the contract may not at any time exceed the net single premium that would have to be paid at such time to fund future benefits under the contract. A contract satisfies the guideline premium and cash value corridor tests if the premiums paid under the contract do not at any time exceed the greater of the guideline single premium or the sum of the guideline level premiums, and if the death benefit under the contract is not less than a varying statutory percentage of the cash surrender value of the contract. Long-term care insurance Prior to the Health Insurance Portability and Accountability Act of 1996, tax law generally did not provide explicit rules relating to the tax treatment of long-term care insurance contracts or long-term care services. Thus, the treatment of long-term care contracts and services was unclear. Prior and present law provide rules relating to medical expenses and accident or health insurance. Amounts received by a taxpayer under accident or health insurance for personal injuries or sickness generally are excluded from gross income to the extent that the amounts received are not attributable to medical expenses that were allowed as a deduction for a prior taxable year (sec. 104). Explanation of Provision Accelerated death benefits The Health Insurance Portability and Accountability Act of 1996 provides an exclusion from gross income as an amount paid by reason of the death of an insured for amounts received under a life insurance contract and for amounts received for the sale or assignment of a life insurance contract to a qualified viatical settlement provider, provided that the insured under the life insurance contract is either terminally ill or chronically ill. The exclusion does not apply in the case of an amount paid to any taxpayer other than the insured, if such taxpayer has an insurable interest by reason of the insured being a director, officer, or employee of the taxpayer, or by reason of the insured being financially interested in any trade or business carried on by the taxpayer. A terminally ill individual is defined as one who has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within 24 months of the date of certification. A chronically ill individual has the same meaning as provided under the long-term care rules (see below). In the case of a chronically ill individual, the exclusion with respect to amounts paid under a life insurance contract and amounts paid in a sale or assignment to a viatical settlement provider applies if the payment received is for costs incurred by the payee (not compensated by insurance or otherwise) for qualified long-term care services for the insured person for the period, and two other requirements (similar to requirements applicable to long-term care insurance contracts) are met. The first requirement is that under the terms of the contract giving rise to the payment, the payment is not a payment or reimbursement of expenses reimbursable under Medicare (except where Medicare is a secondary payor under the arrangement, or the arrangement provides for per diem or other periodic payments without regard to expenses for qualified long-term care services). No provision of law shall be construed or applied so as to prohibit the offering of such a contract giving rise to such a payment on the basis that the contract coordinates its payments with those provided under Medicare. The second requirement is that the arrangement complies with the consumer protection provisions applicable to long-term care insurance contracts and issuers that are specified in Treasury regulations. Long-term care insurance Exclusion of long-term care insurance proceeds.--The Health Insurance Portability and Accountability Act of 1996 provides that a long-term care insurance contract generally is treated as an accident and health insurance contract. Amounts (other than policyholder dividends or premium refunds) received under a long-term care insurance contract generally are excludable as amounts received for personal injuries and sickness, subject to a dollar cap on aggregate payments under per diem contracts. A reporting requirement applies to payors of excludable amounts. The amount of the dollar cap on aggregate payments under per diem contracts with respect to any one chronically ill individual (who is not also terminally ill) is $190 per day for calendar year 2000 ($69,540 annually) as indexed,\4\ reduced by the amount of reimbursements and payments received by anyone for the cost of qualified long-term care services for the chronically ill individual. If more than one payee receives payments with respect to any one chronically ill individual, then everyone receiving periodic payments with respect to the same insured is treated as one person for purposes of the dollar cap. The amount of the dollar cap is used first by the chronically ill person, and any remaining amount is to be allocated in accordance with Treasury regulations. If payments under such contracts exceed the dollar cap, then the excess is excludable only to the extent of actual costs (in excess of the dollar cap) incurred for long-term care services. Amounts in excess of the dollar cap, with respect to which no actual costs were incurred for long-term care services, are fully includable in income without regard to rules relating to return of basis under section 72. A grandfather rule applies to any per diem- type contract issued to a policyholder on or before July 31, 1996. --------------------------------------------------------------------------- \4\ Internal Revenue Service (1999). --------------------------------------------------------------------------- Exclusion for employer-provided long-term care coverage.--A plan of an employer providing coverage under a long-term care insurance contract generally is treated as an accident and health plan. Thus, employer-provided long-term care coverage is generally excludable from income and wages and deductible by the employer. Employer-provided coverage under a long-term care insurance contract is not, however, excludable by an employee if provided through a cafeteria plan; similarly, expenses for long-term care services cannot be reimbursed under a flexible spending arrangement. Definition of long-term care insurance contract.--A long- term care insurance contract is defined as any insurance contract that provides only coverage of qualified long-term care services and that meets other requirements. The other requirements are that: (1) the contract is guaranteed renewable; (2) the contract does not provide for a cash surrender value or other money that can be paid, assigned, pledged or borrowed; (3) refunds (other than refunds on the death of the insured or complete surrender or cancellation of the contract) and dividends under the contract may be used only to reduce future premiums or increase future benefits; and (4) the contract generally does not pay or reimburse expenses reimbursable under Medicare (except where Medicare is a secondary payor, or the contract makes per diem or other periodic payments without regard to expenses). A contract does not fail to be treated as a long-term care insurance contract solely because it provides for payments on a per diem or other periodic basis without regard to expenses incurred during the period. Medicare duplication rules.--No provision of law may be applied to prohibit the offering of a long-term care insurance contract on the basis that the contract coordinates its benefits with those provided under Medicare. Definition of qualified long-term care services.--Qualified long-term care services means necessary diagnostic, preventive, therapeutic, curing, treating, mitigating and rehabilitative services, and maintenance or personal care services that are required by a chronically ill individual and that are provided pursuant to a plan of care prescribed by a licensed health care practitioner. Chronically ill individual.--A chronically ill individual is one who has been certified within the previous 12 months by a licensed health care practitioner as: (1) being unable to perform (without substantial assistance) at least two activities of daily living for at least 90 days due to a loss of functional capacity; (2) having a similar level of disability as determined by the Secretary of the Treasury in consultation with the Secretary of Health and Human Services; or (3) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. Activities of daily living are eating, toileting, transferring, bathing, dressing and continence. For purposes of determining whether an individual is chronically ill, the number of activities of daily living that are taken into account under the long-term care insurance contract may not be less than five. Expenses for long-term care services treated as medical expenses.--Unreimbursed expenses for qualified long-term care services provided to the taxpayer or the taxpayer's spouse or dependents are treated as medical expenses for purposes of the itemized deduction for medical expenses (subject to the present-law floor of 7.5 percent of AGI). For this purpose, amounts received under a long-term care insurance contract (regardless of whether the contract reimburses expenses or pays benefits on a per diem or other periodic basis) are treated as reimbursement for expenses actually incurred for medical care. For purposes of the deduction for medical expenses, qualified long-term care services do not include services provided to an individual by a relative or spouse (directly, or through a partnership, corporation, or other entity), unless the relative is a licensed professional with respect to such services, or by a related corporation (within the meaning of Code section 267(b) or 707(b)). Long-term care insurance premiums treated as medical expenses.--Long-term care insurance premiums that do not exceed specified dollar limits are treated as medical expenses for purposes of the itemized deduction for medical expenses. Consumer protection provisions.--Certain consumer protection provisions apply with respect to the terms of a long-term care insurance contract, for purposes of determining whether the contract is a qualified long-term care insurance contract. In addition, certain consumer protection provisions apply to issuers of long-term care insurance contracts. DEDUCTION FOR HEALTH INSURANCE EXPENSES OF SELF-EMPLOYED INDIVIDUALS Self-employed individuals may currently deduct 60 percent of their health insurance expenses for themselves and their spouses and dependents. The deduction also applies to certain long-term care premiums treated as medical expenses. Under the Tax and Trade Relief Extension Act of 1998, the deduction for health insurance of self-employed individuals will increase as follows: the deduction will be 60 percent in 2000 and 2001; 70 percent in 2002; and 100 percent in 2003 and thereafter. EXCLUSION OF MEDICARE BENEFITS Legislative History The exclusion from income of Medicare benefits has never been expressly established by statute. A 1970 IRS ruling, Rev. Rul. 70-341, 1970-2 C.B. 31, provided that the benefits under part A of Medicare are not includable in gross income because they are disbursements made to further the social welfare objectives of the Federal Government. The Internal Revenue Service relied on a similar ruling, Rev. Rul. 70-217, 1970-1 C.B. 13, with respect to the excludability of Social Security disability insurance benefits in reaching this conclusion. (For background on the exclusion of Social Security benefits, see above section on pension contributions.) Rev. Rul. 70-341 also held that benefits under part B of Medicare are excludable as amounts received through accident and health insurance (though the subsidized portion of part B also may be excluded under the same theory applicable to the exclusion of part A benefits). Explanation of Provision Benefits under part A and part B of Medicare are excludable from the gross income of the recipient. In general, part A pays for certain inpatient hospital care, skilled nursing facility care, home health care, and hospice care for eligible individuals (generally the elderly and the disabled). Part B covers certain services of a physician and other medical services for elderly or disabled individuals who elect to pay the required premium. DEDUCTIBILITY OF MEDICAL EXPENSES Legislative History An itemized deduction for unreimbursed medical expenses above a specified floor has been allowed since 1942. From 1954 through 1982, the floor under the medical expense deduction was 3 percent of the taxpayer's adjusted gross income (AGI); a separate floor of 1 percent of AGI applied to expenditures for medicine and drugs. In the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the floor was increased to 5 percent of AGI (effective for 1983 and thereafter) and was applied to the total of all eligible medical expenses, including prescription drugs and insulin. TEFRA made nonprescription drugs ineligible for the deduction and eliminated the separate floor for drug costs. The Tax Reform Act of 1986 increased the floor under the medical expense deduction to 7.5 percent of AGI, beginning in 1987. Explanation of Provision Individuals who itemize deductions may deduct amounts they pay during the taxable year, if not reimbursed by insurance or otherwise, for medical care of the taxpayer and of the taxpayer's spouse and dependents, to the extent that the total of such expenses exceeds 7.5 percent of AGI (sec. 213). Medical care expenses eligible include: (1) health insurance (including aftertax employee contributions to employer health plans); (2) diagnosis, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body; (3) transportation primarily for and essential to medical care; (4) lodging away from home primarily for and essential to medical care, up to $50 per night; and (5) prescription drugs and insulin. Expenses paid for the general improvement of health, such as fees for exercise programs, are not eligible for the deduction unless prescribed by a physician to treat a specific illness. A deduction is not allowed for cosmetic surgery or similar procedures that do not meaningfully promote the proper function of the body or treat disease. However, such expenses are deductible if the cosmetic procedure is necessary to correct a deformity arising from a congenital abnormality, an injury resulting from an accident, or disfiguring disease. Medical expenses are not subject to the general limitation on itemized deductions applicable to taxpayers with AGIs above a certain limit ($128,950 for 2000 and adjusted annually for inflation; Joint Committee on Taxation staff projections). Effect of Provision The Tax Code allows taxpayers to claim an itemized deduction if unreimbursed medical expenses absorb a substantial portion of income and thus adversely affect the taxpayer's ability to pay taxes. In order to limit the deduction to extraordinary expenses, medical expenses are deductible only to the extent that they exceed 7.5 percent of the taxpayer's AGI. Table 13-10 shows the effect on medical expense deductions of the increases in the floor on medical deductions. In the absence of those increases, one would have expected the number of taxpayers claiming the deduction to have increased because of inflation of medical costs. However, increasing the floor should reduce the number of taxpayers claiming the deduction because many taxpayers with relatively modest expenses no longer qualify. The average deduction in excess of the 7.5 percent of AGI floor has increased substantially, from $769 in 1980 to $5,571 in 1997. Both increases in the floor (to 5 percent in 1983 and to 7.5 percent in 1987) substantially reduced the number of taxpayers claiming deductions. Taxpayers in higher tax rate brackets receive more of a benefit from each dollar of deductible medical expense than do taxpayers in lower tax rate brackets. However, because the floor automatically rises with a taxpayer's income, higher income taxpayers are able to deduct a smaller amount (if any) of medical expenses above their floor than are low-income taxpayers incurring the same aggregate amount of medical expenses. In 2000 it is estimated that approximately 5.4 million taxpayers will claim itemized medical expenses in excess of the medical deductions floor (7.5 percent of AGI; Joint Committee on Taxation staff projections). It is also estimated by the staff of the Joint Committee that 81 percent will have incomes of less than $50,000 (table 13-11). However, taxpayers with incomes over $50,000 will receive far more than half of the total tax savings attributable to medical expense deductions. TABLE 13-10.--TAX RETURNS CLAIMING DEDUCTIBLE MEDICAL AND DENTAL EXPENSES, 1980-97 ---------------------------------------------------------------------------------------------------------------- Returns claiming medical and dental expenses in excess of the AGI floor Total -------------------------------------- number of Expenses in Year returns Number of excess of Average filed (in returns the AGI amount over millions) (in floor (in the floor millions) billions) ---------------------------------------------------------------------------------------------------------------- 1980........................................................ 93.9 19.5 $15.0 $769 1981........................................................ 95.4 21.4 17.9 836 1982........................................................ 95.3 22.0 21.7 986 1983........................................................ 96.3 9.7 18.1 1,859 1984........................................................ 99.4 10.7 21.5 2,009 1985........................................................ 101.7 10.8 22.9 2,127 1986........................................................ 103.0 10.5 25.1 2,382 1987........................................................ 107.0 5.4 17.2 3,202 1988........................................................ 110.1 4.8 18.0 3,741 1989........................................................ 112.1 5.1 20.9 4,079 1990........................................................ 113.7 5.1 21.5 4,215 1991........................................................ 114.7 5.3 23.7 4,444 1992........................................................ 113.6 5.5 25.7 4,675 1993........................................................ 114.6 5.5 26.5 4,829 1994........................................................ 115.9 5.2 26.4 5,044 1995........................................................ 118.2 5.4 27.0 5,039 1996........................................................ 120.4 5.4 27.0 5,003 1997........................................................ 122.4 5.3 29.3 5,571 ---------------------------------------------------------------------------------------------------------------- Source: Internal Revenue Service. TABLE 13-11.--DISTRIBUTION OF ITEMIZED DEDUCTIONS FOR MEDICAL EXPENSES, 2000 ------------------------------------------------------------------------ Average Returns Total amount Income class (thousands) \1\ deduction (thousands) (billions) \2\ ------------------------------------------------------------------------ 0-$10......................... $4,135 185 $0.8 $10-$20....................... 4,352 318 1.4 $20-$30....................... 4,882 603 2.9 $30-$40....................... 5,522 880 4.9 $40-$50....................... 4,386 907 4.0 $50-$75....................... 4,871 1,493 7.3 $75-$100...................... 4,805 627 3.0 $100-$200..................... 10,360 372 3.9 $200 and over................. 31,109 46 1.4 ----------------------------------------- Total.................... 5,431 5,432 29.5 ------------------------------------------------------------------------ \1\ The income concept is defined in the introduction to this chapter. \2\ Amounts in excess of the floor on itemized medical deductions (7.5 percent of adjusted gross income). Source: Joint Committee on Taxation. EARNED INCOME CREDIT Legislative History The earned income credit (EIC Code sec. 32), enacted in 1975, generally equals a specified percentage of wages up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. The income ranges and percentages have been revised several times since original enactment, expanding the credit (table 13-12). In 1987, the credit was indexed for inflation. In 1990 and again in 1993, Congress enacted substantial expansions of the credit. Auxiliary credits were added for very young children and for health insurance premiums paid on behalf of a qualifying child in 1990. These were repealed in 1993. Also in 1993, eligibility for the credit was expanded to include childless workers. The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 incorporated new rules relating to taxpayer identification numbers and the modified AGI phaseout of the credit in addition to amending the credit's unearned income test (described below). The Taxpayer Relief Act of 1997 also included provisions to improve compliance. The provisions: (1) deny the EIC for 10 years to taxpayers who fraudulently claimed the EIC, 2 years for EIC claims which are a result of reckless or intentional disregard of rules or regulations); (2) require EIC recertification for a taxpayer who is denied the EIC; (3) imposes due diligence requirements on paid preparers of returns involving the EIC; (4) requires information sharing between the Treasury Department and State and local governments regarding child support orders; and (5) allows expanded use of Social Security Administration records to enforce the tax laws, including the EIC. The Balanced Budget Act of 1997 also increased the IRS authorization to improve enforcement of the EIC. Explanation of Provision The EIC is available to low-income working taxpayers. Three separate schedules apply. Taxpayers with one qualifying child may claim a credit in 1999 of 34 percent of their earnings up to $6,800, resulting in a maximum credit of $2,312. The maximum credit is available for those with earnings between $6,800 and $12,460. At $12,460 of earnings the credit begins to phase down at a rate of 15.98 percent of earnings above $12,460. The credit is phased down to 0 at $26,928 of earnings. Taxpayers with more than one qualifying child may claim a credit in 1999 of 40 percent of earnings up to $9,540, resulting in a maximum credit of $3,816. The maximum credit is available for those with earnings between $9,540 and $12,460. At $12,460 of earnings the credit begins to phase down at a rate of 21.06 percent of earnings above $12,460. The credit is phased down to $0 at $30,580 of earnings. TABLE 13-12.--EARNED INCOME CREDIT PARAMETERS, 1975-99 [Dollar amounts unadjusted for inflation] ---------------------------------------------------------------------------------------------------------------- Mininum Phaseout range Credit income Phaseout ------------------- Calendar year rate for Maximum rate (percent) maximum credit (percent) Beginning Ending credit income income ---------------------------------------------------------------------------------------------------------------- 1975-78............................................. 10.00 $4,000 $400 10.00 $4,000 $8,000 1979-84............................................. 10.00 5,000 500 12.50 6,000 10,000 1985-86............................................. 14.00 5,000 550 12.22 6,500 11,000 1987................................................ 14.00 6,080 851 10.00 6,920 15,432 1988................................................ 14.00 6,240 874 10.00 9,840 18,576 1989................................................ 14.00 6,500 910 10.00 10,240 19,340 1990................................................ 14.00 6,810 953 10.00 10,730 20,264 1991: One child......................................... 16.70 7,140 1,192 11.93 11,250 21,250 Two children...................................... 17.30 7,140 1,235 12.36 11,250 21,250 1992: One child......................................... 17.60 7,520 1,324 12.57 11,840 22,370 Two children...................................... 18.40 7,520 1,384 13.14 11,840 22,370 1993: One child......................................... 18.50 7,750 1,434 13.21 12,200 23,050 Two children...................................... 19.50 7,750 1,511 13.93 12,200 23,050 1994: No children....................................... 7.65 4,000 306 7.65 5,000 9,000 One child......................................... 26.30 7,750 2,038 15.98 11,000 23,755 Two children...................................... 30.00 8,425 2,528 17.68 11,000 25,296 1995: No children....................................... 7.65 4,100 314 7.65 5,130 9,230 One child......................................... 34.00 6,160 2,094 15.98 11,290 24,396 Two children...................................... 36.00 8,640 3,110 20.22 11,290 26,673 1996: No children....................................... 7.65 4,220 323 7.65 5,280 9,500 One child......................................... 34.00 6,330 2,152 15.98 11,610 25,078 Two children...................................... 40.00 8,890 3,556 21.06 11,610 28,495 1997: No children....................................... 7.65 4,340 332 7.65 5,430 9,770 One child......................................... 34.00 6,500 2,210 15.98 11,930 25,750 Two children...................................... 40.00 9,140 3,656 21.06 11,930 29,290 1998: No children....................................... 7.65 4,460 341 7.65 5,570 10,030 One child......................................... 34.00 6,680 2,271 15.98 12,260 26,473 Two children...................................... 40.00 9,390 3,756 21.06 12,260 30,095 1999: No children....................................... 7.65 4,530 347 7.65 5,670 10,200 One child......................................... 34.00 6,800 2,312 15.98 12,460 26,928 Two children...................................... 40.00 9,540 3,816 21.06 12,460 30,580 ---------------------------------------------------------------------------------------------------------------- Source: Joint Committee on Taxation. Taxpayers with no qualifying children may claim a credit if they are over age 24 and below age 65. The credit is 7.65 percent of earnings up to $4,530, resulting in a maximum credit of $347. The maximum is available for those with incomes between $4,530 and $5,670. At $5,670 of earnings, the credit begins to phase down at a rate of 7.65 percent of earnings above that amount, resulting in a $0 credit at $10,200. All income thresholds are indexed for inflation annually. In order to be a qualifying child, an individual must satisfy a relationship test, a residency test, and an age test. The relationship test requires that the individual be a child, stepchild, a descendant of a child, or a foster or adopted child of the taxpayer. The residency test requires that the individual have the same place of abode as the taxpayer for more than half the taxable year. The household must be located in the United States. The age test requires that the individual be under 19 (24 for a full-time student) or be permanently and totally disabled. An individual is not eligible for the EIC if the aggregate amount of disqualified income of the taxpayer for the taxable year exceeds $2,350. This threshold is indexed. Disqualified income is the sum of: 1. Interest (taxable and tax exempt), 2. Dividends, 3. Net rent and royalty income (if greater than zero), 4. Capital gains net income, and 5. Net passive income (if greater than zero) that is not self- employment income. For taxpayers with earned income (or modified AGI, if greater) in excess of the beginning of the phaseout range, the maximum EIC amount is reduced by the phaseout rate multiplied by the amount of earned income (or modified AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or modified AGI, if greater) in excess of the end of the phaseout range, no credit is allowed. The definition of modified AGI used for phasing out the EIC disregards certain losses. The losses disregarded are: 1. Net capital losses (if greater than zero), 2. Net losses from trusts and estates, 3. Net losses from nonbusiness rents and royalties, and 4. Seventy-five percent of the net losses from businesses, computed separately with respect to sole proprietorships (other than in farming), sole proprietorships in farming, and other businesses. The definition of modified AGI also includes tax-exempt interest and nontaxable distributions from pensions, annuities, and individual retirement accounts (IRAs; but only if not called over into similar vehicles during the applicable rollover period). Individuals are ineligible for the credit if they do not include their taxpayer identification number and their qualifying child's number (and, if married, their spouse's taxpayer identification number) on their tax return. Solely for these purposes and for purposes of the present-law identification test for a qualifying child, a taxpayer identification number is defined as a Social Security number issued to an individual by the Social Security Administration other than a number issued under section 205(c)(2)(B)(i)(II) (or that portion of sec. 205(c)(2)(B)(i)(III) relating to it) of the Social Security Act regarding the issuance of a number to an individual applying for or receiving federally funded benefits. If an individual fails to provide a correct taxpayer identification number, such omission will be treated as a mathematical or clerical error by the Internal Revenue Service. Similarly, if an individual who claims the credit with respect to net earnings from self-employment fails to pay the proper amount of self-employment tax on such net earnings, the failure will be treated as a mathematical or clerical error for purposes of the amount of credit allowed. The EIC is relatively unique because it is a refundable tax credit; i.e., if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment. In this sense, the EIC is like other Federal programs that provide poor and low-income families with public benefits. However, the EIC differs from other Federal programs in that its benefits require earnings. Under an advance payment system, available since 1979, eligible taxpayers may elect to receive the credit in their paychecks, rather than waiting to claim a refund on their tax return filed by April 15 of the following year. In 1993, Congress required that the IRS begin to notify eligible taxpayers of the advance payment option. Interaction with Means-Tested Programs The treatment of the EIC for purposes of Aid to Families with Dependent Children (AFDC) and food stamp benefit computations has varied since inception of the credit. When enacted in 1975, the credit was not considered income in determining AFDC and food stamp benefits, and the credit could not be received on an advance basis. From January 1979 through September 1981, the credit was treated as earned income when actually received. From October 1981 to September 1984, the amount of the credit was treated as earned income and was imputed to the family even though it may not have been received as an advance payment. Pursuant to the Deficit Reduction Act of 1984, the credit was treated as earned income only when received, either as an advance payment or as a refund after the conclusion of the year. Under the Family Support Act of 1988, States generally were required to disregard any advance payment or refund of the EIC when calculating AFDC eligibility or benefits. However, the credit was counted against the gross income eligibility standard (185 percent of the State need standard) for both applicants and recipients. OBRA 1990 specified that, effective January 1, 1991, the EIC was not to be taken into account as income (for the month in which the payment is received or any following month) or as a resource (for the month in which the payment is received or the following month) for determining the eligibility or amount of benefit for AFDC, Medicaid, SSI, food stamps, or low-income housing programs. Effect of Provision More than 18.4 million taxpayers are expected to take advantage of the EIC in 2000 (table 13-13). Their claims are expected to total $30 billion, 87 percent of which will be refunded as direct payments to these families. As table 13-13 also shows, approximately 72 percent of the tax relief or direct spending from the EIC accrues to taxpayers who file as singles or heads of households. TABLE 13-13.--DISTRIBUTION OF TAX PROVISIONS: EARNED INCOME CREDIT, 2000 ---------------------------------------------------------------------------------------------------------------- Joint returns Head of All returns ----------------- household and ----------------- Income class single returns Number Amount ------------------ Number Amount Number Amount ---------------------------------------------------------------------------------------------------------------- $0-$10,000................................................. 592 $1,041 4,490 $4,575 5,082 $5,616 $10,000-$20,000............................................ 1,187 2,993 4,724 10,056 5,910 13,049 $20,000-$30,000............................................ 1,747 3,196 3,312 5,989 5,059 9,185 $30,000-$40,000............................................ 1,026 996 1,143 970 2,169 1,966 $40,000-$50,000............................................ 172 130 17 12 189 141 $50,000-$75,000............................................ 29 43 0 0 29 43 $75,000 and over........................................... 0 0 0 0 0 0 ---------------------------------------------------- Total................................................ 4,754 8,398 13,685 21,602 18,459 30,000 ==================================================== Percent distribution by type of return..................... 25.8 28.0 74.2 72.0 100.0 100.0 ---------------------------------------------------------------------------------------------------------------- Note.--Number of returns in thousands; amount of credit in millions. Source: Joint Committee on Taxation. Table 13-14 shows the total amount of EIC received for each of the calendar years since the inception of the program, the number of recipient families, the amount of the credit received as refunded payments, and the average amount of credit received per family. EXCLUSION OF PUBLIC ASSISTANCE AND SSI BENEFITS Legislative History While there is no specific statutory authorization, a number of revenue rulings under Code section 61 have held that specific types of public assistance payments are excludable from gross income. Revenue rulings generally exclude government transfer payments from income because they are considered to be general welfare payments. In addition, taxing benefits provided in kind, rather than in cash, would require valuation of these benefits, which could create administrative difficulties. Explanation of Provision The Federal Government provides tax-free public assistance benefits to individuals either by cash payments or by provision of certain goods and services at reduced cost or free of charge. Cash payments come mainly from the AFDC and Supplemental Security Income (SSI) Programs. Inkind payments include food stamps, Medicaid, and housing assistance. None of these payments is subject to income tax. TABLE 13-14.--EARNED INCOME CREDIT: NUMBER OF RECIPIENTS AND AMOUNT OF CREDIT, 1975-2000 ---------------------------------------------------------------------------------------------------------------- Number of Total Refunded recipient amount of portions of Average Year families credit credit credit per (thousands) (millions) (millions) family ---------------------------------------------------------------------------------------------------------------- 1975........................................................ 6,215 $1,250 $900 $201 1976........................................................ 6,473 1,295 890 200 1977........................................................ 5,627 1,127 880 200 1978........................................................ 5,192 1,048 801 202 1979........................................................ 7,135 2,052 1,395 288 1980........................................................ 6,954 1,986 1,370 286 1981........................................................ 6,717 1,912 1,278 285 1982........................................................ 6,395 1,775 1,222 278 1983........................................................ 7,368 1,795 1,289 224 1984........................................................ 6,376 1,638 1,162 257 1985........................................................ 7,432 2,088 1,499 281 1986........................................................ 7,156 2,009 1,479 281 1987........................................................ 8,738 3,391 2,930 450 1988........................................................ 11,148 5,896 4,257 529 1989........................................................ 11,696 6,595 4,636 564 1990........................................................ 12,542 7,542 5,266 601 1991........................................................ 13,665 11,105 8,183 813 1992........................................................ 14,097 13,028 9,959 924 1993........................................................ 15,117 15,537 12,028 1,028 1994........................................................ 19,017 21,105 16,598 1,110 1995........................................................ 19,334 25,956 20,829 1,342 1996........................................................ 19,464 28,825 23,157 1,481 1997........................................................ 19,391 30,389 24,396 1,567 1998 \1\.................................................... 20,273 32,340 27,175 1,595 1999 \2\.................................................... 19,440 29,965 25,800 1,541 2000 \2\.................................................... 18,439 30,002 26,148 1,625 2001 \2\.................................................... 18,502 30,662 26,763 1,657 2002 \2\.................................................... 18,233 31,010 26,916 1,701 ---------------------------------------------------------------------------------------------------------------- \1\ Preliminary. \2\ Projected. Source: For 1975-98, Internal Revenue Service; for 1999-2002, Joint Committee on Taxation. DEPENDENT CARE TAX CREDIT Legislative History Under section 21 of the Internal Revenue Code, taxpayers are allowed an income tax credit for certain employment-related expenses for dependent care. The Internal Revenue Code of 1954 provided a deduction to gainfully employed women, widowers, and legally separated or divorced men for certain employment- related dependent care expenses. The deduction was limited to $600 per year and phased out for families with incomes between $4,500 and $5,100. The Revenue Act of 1964 made husbands with incapacitated wives eligible for the dependent care deduction and raised the threshold for the income phaseout from $4,500 to $6,000. The Revenue Act of 1971: (1) made any individual who maintained a household and was gainfully employed eligible for the deduction; (2) modified the definition of a dependent; (3) raised the deduction limit to $4,800 per year; (4) increased from $6,000 to $18,000 the income level at which the deduction began to phase out; (5) allowed the deduction for household services in addition to direct dependent care; and (6) limited the deduction with respect to services outside the taxpayer's household. The Tax Reduction Act of 1975 increased from $18,000 to $35,000 the income level at which the deduction began to be phased out. The Tax Reform Act of 1976 replaced the deduction with a nonrefundable credit. This change broadened eligibility to those who do not itemize deductions and provided relatively greater benefit to low-income taxpayers. In addition, the act eased the rules related to family status and simplified the computation. In the Economic Recovery Tax Act of 1981, Congress provided a higher ceiling on creditable expenses, a larger credit for low-income individuals, and modified rules relating to care provided outside the home. The Family Support Act of 1988 reduced to 13 the age of a child for whom the dependent care credit may be claimed, reduced the amount of eligible expenses by the amount of expenses excludable from that taxpayer's income under the dependent care exclusion, lowered from 5 to 2 the age at which a taxpayer identification number had to be submitted for children for whom the credit was claimed, and disallowed the credit unless the taxpayer reports on her tax return the correct name, address, and taxpayer identification number (generally, an employer identification number or a Social Security number) of the dependent care provider. The Small Business Protection Act of 1996 required a TIN for all children for whom a dependent care credit may be claimed. Explanation of Provision A taxpayer may claim a nonrefundable credit against income tax liability for up to 30 percent of a limited amount of employment-related dependent care expenses. Eligible employment-related expenses are limited to $2,400 if there is one qualifying dependent or $4,800 if there are two or more qualifying dependents. Generally, a qualifying individual is a dependent under the age of 13 or a physically or mentally incapacitated dependent or spouse. Employment-related dependent care expenses are expenses for the care of a qualifying individual incurred to enable the taxpayer to be gainfully employed, other than expenses incurred for an overnight camp. For example, amounts paid for the services of a housekeeper generally qualify if such services are performed at least partly for the benefit of a qualifying individual; amounts paid for a chauffeur or gardener do not qualify. Expenses that may be taken into account in computing the credit generally may not exceed an individual's earned income or, in the case of married taxpayers, the earned income of the spouse with the lesser earnings. Thus, if one spouse is not working, no credit generally is allowed. Also, the amount of expenses eligible for the dependent care credit is reduced, dollar for dollar, by the amount of expenses excludable from that taxpayer's income under the dependent care exclusion (discussed below). The 30-percent credit rate is reduced, but not below 20 percent, by 1 percentage point for each $2,000 (or fraction thereof) of AGI above $10,000. Because married couples are required to file a joint return to claim the credit, a married couple's combined AGI is used for purposes of this computation. Effect of Provision From 1976 to 1997, the number of families that claimed the dependent care credit increased from 2.7 to 5.8 million, the aggregate amount of credits claimed increased from $0.5 to $2.5 billion, and the average amount of credit claimed per family increased from $206 to $425 (table 13-15). In 1998, 6.1 million families are expected to claim an average credit of $433, for a total of $2.6 billion. Changes made in the Family Support Act of 1988 reduced the use of the credit in 1989. The number of families who claimed the credit dropped by about one-third and the amount of credit claimed declined by $1.373 billion. Data for 1997 from the Internal Revenue Service show that about 10 percent of the benefit from the credit accrues to families with AGI of less than $20,000; about 42 percent to families with AGI between $20,000 and $50,000; and about 48 percent to families with AGI above $50,000. HOPE CREDIT AND LIFETIME LEARNING CREDIT The Taxpayer Relief Act of 1997 established the HOPE credit and the lifetime learning credit as nonrefundable credits against Federal income tax liability for qualified tuition and fees required for the attendance of an eligible student at an eligible educational institution. The HOPE credit rate is 100 percent of the first $1,000 of qualified tuition and fees per eligible student per year, and 50 percent of the next $1,000 of qualified tuition and fees per eligible student per year. The HOPE credit is available only for the first 2 years of postsecondary education. The qualified tuition and fees must be incurred on behalf of the taxpayer, the taxpayer's spouse, or a dependent. Charges and fees associated with meals, lodging, books, student activities, athletics, insurance, transportation, and similar personal, living, or family expenses are not eligible for the credit. An eligible student for purposes of the HOPE credit is a student enrolled in a degree, certificate, or other program on at least a half-time basis. Eligible educational institutions are defined by reference to section 481 of the Higher Education Act of 1965. Such institutions generally are accredited postsecondary educational institutions offering credit toward a bachelor's degree, an associate's de- TABLE 13-15.--DEPENDENT CARE TAX CREDIT: NUMBER OF FAMILIES AND AMOUNT OF CREDIT, 1976-98 ------------------------------------------------------------------------ Number of returns Aggregate Average claiming amount of credit Year dependent credit claimed per credit claimed return (thousands) (millions) ------------------------------------------------------------------------ 1976............................. 2,660 $548 $206 1977............................. 2,910 521 179 1978............................. 3,431 654 191 1979............................. 3,833 793 207 1980............................. 4,231 956 226 1981............................. 4,578 1,148 251 1982............................. 5,004 1,501 300 1983............................. 6,367