SECTION 14. 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 Legislative History Explanation of Provision Effect of Provision Coverage Trends in Coverage Individual Retirement Plans Legislative History Explanation of Provision Effect of Provision Exclusion of Social Security and Railroad Retirement Benefits Legislative History Explanation of Provision Effect of Provision Exclusion of Employer Contribution for Medical Insurance Premiums and Medical Care Legislative History Explanation of Provision Effect of Provision Medical Savings Accounts Explanation of Provision Cafeteria Plans Legislative History Explanation of Provision Effect of Provision Health Care Continuation Rules Legislative History Explanation of Provision Group Health Plan Requirements Explanation of Provision Tax Benefits for Long-Term Care Insurance and Accelerated Death Benefits Legislative History Explanation of Provision Deduction for Health Insurance Expenses of Self-Employed Individuals Explanation of Provision Exclusion of Medicare Benefits Legislative History Explanation of Provision Deductibility of Medical Expenses Legislative History Explanation of Provision Effect of Provision Earned Income Credit Legislative History Explanation of Provision Interaction with Means-Tested Programs Effect of Provision Exclusion of Public Assistance and SSI Benefits Legislative History Explanation of Provision Dependent Care Tax Credit Legislative History Explanation of Provision Effect of Provision Exclusion for Employer-Provided Dependent Care Legislative History Explanation of Provision Effect of Provision Work Opportunity Tax Credit Explanation of Provision Exclusion of Workers' Compensation and Special Benefits for Disabled Coal Miners Legislative History Explanation of Provision Additional Standard Deduction for the Elderly and Blind Legislative History Explanation of Provision Effect of Provision Tax Credit for the Elderly and Certain Disabled Individuals Legislative History Explanation of Provision Effect of Provision Tax Provisions Related to Housing Owner-Occupied Housing Low-Income Housing Credit The 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 Tax Credit and Exclusion for Adoption Expenses 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 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 adjusted gross income. 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 AFDC, Supplemental Security Income, food stamps, housing subsidies, and general assistance). The tax return is the unit of analysis. Table 14-1 shows the distribution of all tax returns for 1995 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 1995 forecast of the Congressional Budget Office. Tax Provision Estimates Table 14-2 estimates the 25 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. TABLE 14-1.--DISTRIBUTION OF TAX RETURNS BY INCOME CLASS, 1995 [Money amounts in millions of dollars, returns in thousands] ---------------------------------------------------------------------------------------------------------------- All returns Taxable Itemized Tax Income class (thousands) \1\ \2\ returns returns liability ---------------------------------------------------------------------------------------------------------------- Below $10................................................... 22,750 2,324 157 -$5,442 $10-$20..................................................... 25,752 9,538 899 -1,870 $20-$30..................................................... 20,735 13,669 2,058 18,777 $30-$40..................................................... 16,649 14,202 3,489 35,921 $40-$50..................................................... 12,208 11,674 4,179 42,732 $50-$75..................................................... 17,703 17,566 9,861 99,675 $75-$100.................................................... 7,817 7,790 6,174 78,062 $100-$200................................................... 5,833 5,817 5,233 114,829 $200 and over............................................... 1,568 1,565 1,469 184,398 --------------------------------------------------- Total................................................... 131,015 84,145 33,519 567,081 ---------------------------------------------------------------------------------------------------------------- \1\ The income concept is defined on the preceding page of this chapter. \2\ 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.). Note.--Detail may not add to total due to rounding. Source: Joint Committee on Taxation. 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. 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. TABLE 14-2.--ESTIMATED TAX BASE EXCEPTIONS AND CREDITS UNDER THE PRESENT INCOME TAX FOR VARIOUS ITEMS, \1\ CALENDAR YEARS 1997-2001 [In billions of dollars] ---------------------------------------------------------------------------------------------------------------- Item 1997 1998 1999 2000 2001 1997-2001 ---------------------------------------------------------------------------------------------------------------- I. Tax base exceptions related to: Retirement: Net exclusion of pension contributions and earnings......... $312.4 $324.9 $337.5 $350.8 $342.6 $1,668.2 Keogh plans......................... 18.4 19.6 20.8 22.2 23.6 104.6 Individual retirement plans......... 40.8 42.8 44.9 47.2 49.8 225.5 Exclusion of Social Security and railroad retirement benefits in excess of employee share of payroll tax \2\............................ 255.2 264.8 274.9 285.2 296.0 1,376.1 Health: Exclusions of employer contributions for medical care, health insurance premiums and long-term care insurance premiums \3\............. 304.9 329.3 352.5 378.3 404.5 1,769.5 Exclusion of Medicare benefits: Medicare part A................. 129.1 139.9 151.6 164.2 177.9 762.7 Medicare part B................. 62.5 69.4 77.0 85.5 94.8 389.2 Deductibility of medical expenses \4\................................ 35.5 39.0 42.7 46.8 51.4 215.4 Deductibility of health insurance expenses of the self employed \5\.. 5.0 6.3 6.8 7.5 8.2 33.7 Exclusion of accelerated death benefits........................... 0.7 1.1 1.4 1.7 2.1 7.0 Poverty: Exclusion of public assistance and SSI cash benefits.................. 55.4 55.9 58.8 62.0 58.4 290.5 Employment: Exclusion of employer-provided dependent care \6\................. 4.5 5.2 6.0 6.6 7.2 29.5 Employee stock ownership plans (ESOPs)............................ 10.3 11.1 12.1 13.2 14.1 60.8 Exclusion for benefits provided under cafeteria plans \7\.......... 25.7 29.6 33.3 36.6 40.2 165.5 Elderly and disabled: Exclusion of workers' compensation and special benefits for disabled coal miners: Workers' compensation........... 30.4 31.2 32.0 32.9 33.8 160.3 Special benefits for disabled coal miners.................... 0.4 0.4 0.4 0.4 0.4 2.0 Additional standard deduction for elderly and blind.................. 11.2 12.3 13.0 13.9 14.6 65.0 Housing: Deductibility of mortgage interest.. 159.1 164.0 168.7 174.1 179.7 845.6 Deductibility of property tax on owner-occupied housing............. 64.7 68.0 71.7 75.3 79.5 359.1 Deferral of capital gain on sale of principal residence................ 76.4 77.2 77.9 78.7 79.5 389.7 Exclusion of capital gain on sale of residence of persons 55 and over... 20.9 21.5 22.2 22.8 23.5 111.0 Exclusion of interest on State and local government bonds for owner- occupied housing................... 9.6 9.7 10.0 10.2 10.3 49.8 Depreciation of rental housing in excess of alternative depreciation system............................. 10.1 9.2 8.4 8.4 8.8 44.9 Exclusion of interest on State and local government bonds for rental housing............................ 4.5 4.6 4.8 4.9 4.9 23.8 II. Tax credits related to: Poverty: Earned income credit: Nonrefundable portion........... 3.6 3.9 3.9 4.5 4.9 20.8 Refundable portion.............. 22.4 23.1 24.4 25.4 26.2 121.5 Employment: Dependent care credit............... 2.8 2.9 2.9 3.0 3.0 14.6 Work opportunity tax credit......... 0.1 0.2 0.1 (\8\) (\8\) 0.4 Elderly and disabled: Tax credit for elderly and disabled. (\8\) (\8\) (\8\) (\8\) (\8\) 0.1 Housing: Low-income housing tax credit....... 2.8 3.2 3.5 3.9 4.5 17.9 ---------------------------------------------------------------------------------------------------------------- \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 (40 percent of health insurance expenses in 1997 and 45 percent in 1998- 2001). Remaining amounts are deductible on schedule A with other itemized medical expenses. \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 flexible spending accounts. These amounts are also included in other line items in this table. \8\ Less than $50 million. Note.--Details may not add to totals due to rounding. Source: Joint Committee on Taxation. An employee stock ownership plan (ESOP) 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 ESOPs 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 payable by the employer (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 plan is not a qualified plan unless it benefits the lesser of (1) 50 employees or (2) 40 percent of the employees of the employer (sec. 401(a)(26)). For years beginning after 1996, pursuant to the Small Business Job Protection Act of 1996, the latter rule is modified to apply only to defined benefit plans. For years beginning after 1996, 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 (a) 40 percent of the employees of the employer or (b) 2 employees (or if there is only 1 employee, such employee). 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 (1) 100 percent of average compensation, or (2) $120,000 for 1996 (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)). A 15-percent excise tax is imposed on distributions that exceed a certain amount in any year (sec. 4980A). The Small Business Job Protection Act of 1996 temporarily waives this 15-percent excise tax for distributions in 1997, 1998, and 1999. 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 creates 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 arrangement (``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 best current comprehensive evidence on pension coverage comes from a supplement to the April 1993 Current Population Survey (U.S. Department of Labor, 1994). The data referred to below come from that survey unless otherwise noted. As of April 1993, 63 percent of full-time wage and salary workers employed in the private sector reported that they worked in firms with an employer-sponsored pension plan. Half of the full-time wage and salary workers employed in the private sector were covered by an employer-sponsored pension plan. Most of these workers were covered by basic defined benefit or defined contribution plans (23 percent), and another 10 percent had both a basic plan and a 401(k) type contributory plan (see table 14-3). \2\ For another 17 percent, the 401(k) type plan was their only retirement plan. --------------------------------------------------------------------------- \2\ Some private-sector employees contribute to 403(b) tax- sheltered annuities instead of 401(k) plans. TABLE 14-3.--EMPLOYER SPONSORSHIP AND EMPLOYEE COVERAGE UNDER PENSION OR RETIREMENT PLAN, PRIVATE WAGE AND SALARY WORKERS [Percent of workers in firms with plans and percent of workers covered by plans] ------------------------------------------------------------------------ Total Full time Part time ------------------------------------------------------------------------ Employer sponsors plan........... 58 63 37 Basic pension only........... 24 24 23 Basic and 401(k) type........ 14 16 4 401(k) type only............. 21 23 10 Employer does not sponsor........ 35 32 49 Does not know.................... 7 5 14 Employee covered under plan...... 43 50 12 Basic pension only........... 20 23 7 Basic and 401(k) type........ 8 10 2 401(k) type only............. 15 17 4 Employee is not covered.......... 50 44 73 Does not know.................... 7 6 14 -------------------------------------- Number of private wage and salary workers (in thousands)................ 88,679 72,752 15,927 ------------------------------------------------------------------------ Source: U.S. Department of Labor, 1994, tables A2, B1, B2. 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. Younger workers are much less likely to be covered by a pension than middle aged and older workers. Coverage rates rise steadily from 21 percent for those under age 25 to about 60 percent for those aged 40 or over. 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 (see table 14-4). TABLE 14-4.--DISTRIBUTION BY AGE AND GENDER, COVERAGE UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, FULL-TIME PRIVATE WAGE AND SALARY WORKERS ------------------------------------------------------------------------ Percent covered Age (in years) -------------------------------------- Total Men Women ------------------------------------------------------------------------ Under 25......................... 21 19 22 25-29............................ 41 41 42 30-34............................ 50 50 51 35-39............................ 54 57 51 40-44............................ 58 61 54 45-49............................ 63 66 59 50-54............................ 61 60 62 55-59............................ 59 60 57 60-64............................ 56 59 52 65 or older...................... 46 54 34 -------------------------------------- Total...................... 50 51 48 ------------------------------------------------------------------------ Source: U.S. Department of Labor, 1994, table B5. Higher paying jobs are more likely to offer pensions. Just 8 percent of full-time private wage and salary workers earning less than $10,000 per year in 1993 were covered compared to 81 percent of those earning $50,000 or more (see table 14-5). 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. Industries with high pension coverage include manufacturing, mining, financial services, and communications and public utilities. Coverage rates exceed 60 percent for full-time private wage and salary workers in each of these industries (U.S. Department of Labor, 1994, pp. B-8 & B-9). In contrast, coverage rates are under 35 percent in agriculture, retail trade, and construction. Part of the difference among industries appears to be due to differences in firm size. Coverage is much lower for smaller firms. Smaller firms are less likely to offer comprehensive fringe benefit packages as part of total compensation. Only 13 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 14-6). TABLE 14-5.--DISTRIBUTION BY WORKERS' WAGES, COVERAGE UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, FULL-TIME PRIVATE WAGE AND SALARY WORKERS ------------------------------------------------------------------------ Percent covered Wages -------------------------------------- Total Men Women ------------------------------------------------------------------------ Under $10,000.................... 8 7 9 $10,000-$14,999.................. 27 21 31 $15,000-$19,999.................. 42 35 49 $20,000-$24,999.................. 57 51 65 $25,000-$29,999.................. 62 61 64 $30,000-$34,999.................. 67 66 71 $35,000-$39,999.................. 73 74 72 $40,000-$49,999.................. 78 79 77 $50,000-$74,999.................. 81 81 80 $75,000 or over.................. 81 82 78 -------------------------------------- Total \1\.................. 50 51 48 ------------------------------------------------------------------------ \1\ Total includes workers not responding on wages, not shown separately. Source: U.S. Department of Labor, 1994, table B11. TABLE 14-6.--DISTRIBUTION BY SIZE OF FIRM, COVERAGE UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, FULL-TIME PRIVATE WAGE AND SALARY WORKERS ------------------------------------------------------------------------ Percent covered Firm size (number of workers) -------------------------------------- Total Men Women ------------------------------------------------------------------------ Fewer than 10.................... 13 12 14 10-24............................ 25 23 28 25-49............................ 30 32 27 50-99............................ 42 46 37 100-249.......................... 53 57 49 250-499.......................... 62 66 57 500-999.......................... 62 66 58 1,000 or more.................... 73 76 70 -------------------------------------- Total \1\.................... 50 51 48 ------------------------------------------------------------------------ \1\ Total includes workers not responding or for whom firm size is unknown, not shown separately. Source: U.S. Department of Labor, 1994, table B9. 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-seven percent of public sector wage and salary workers are covered including 85 percent of those who are full-time workers (see table 14-7). TABLE 14-7.--COVERAGE OF WAGE AND SALARY WORKERS UNDER EMPLOYER- SPONSORED PENSION OR RETIREMENT PLAN, BY SECTOR AND WORK STATUS ------------------------------------------------------------------------ Percent covered Sector -------------------------------------- Total Full time Part time ------------------------------------------------------------------------ All wage and salary workers...... 49 56 15 Men.......................... 51 56 9 Women........................ 46 56 17 Private sector................... 43 50 12 Men.......................... 46 51 8 Women........................ 39 48 15 Public sector.................... 77 85 30 Men.......................... 80 86 22 Women........................ 74 84 33 ------------------------------------------------------------------------ Source: U.S. Department of Labor, 1994, table B1. 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 found that coverage reached 50 percent in 1979, but by 1983 had fallen back to 48 percent. The decline continued in the 1980s, reaching 46 percent in 1988 (Woods, 1989, p. 17). By 1993, coverage had returned to 50 percent. 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. Defined benefit plans provided basic plan coverage for 87 percent of private wage and salary workers in 1975 (Turner & Beller, 1989, pp. 65 & 357). This proportion dropped to 83 percent by 1980 and to 71 percent by 1985. 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 of the Internal Revenue Code, providing a tax deduction for certain contributions to individual retirement arrangements (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. Explanation of Provision An individual who is an active participant in an employer plan may deduct 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 $25,000 for an unmarried individual, $40,000 for a married couple filing a joint return, and $0 for a married individual filing separately. 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 deduction is phased out over the following AGI ranges: (1) $25,000- $35,000 for unmarried individuals, (2) $40,000-$50,000 for married individuals filing a joint return, and (3) 0-$10,000 for married individuals filing separate returns. An individual is entitled to make nondeductible contributions to the extent deductible contributions are disallowed as a result of the phaseout. For years beginning before 1997, the $2,000 limit on IRA contributions is increased to $2,250 if a contribution is made on behalf of the individual's nonworking spouse. For years beginning after 1996, deductible contributions of up to $2,000 can be made for each spouse (including a nonworking spouse) if the combined compensation of both spouses is at least equal to the contributed amount. An individual who is not an active participant in an employer 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 after 1996 and is used to pay for medical expenses in excess of 7.5 percent of adjusted gross income or for insurance premiums for unemployed individuals. 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 to 15.5 million in 1986. In 1987, only 7.3 million taxpayers reported deductible contributions. Since then, the number has continued to fall (see table 14-8). TABLE 14-8.--USE OF DEDUCTIBLE IRAs FROM 1980-94 ------------------------------------------------------------------------ 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 ------------------------------------------------------------------------ Source: Internal Revenue Service, Statistics of Income, 1980 to 1994. 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. 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. \3\ --------------------------------------------------------------------------- \3\ See I.T. 3194, 1938-1 C.B. 114; I.T. 3229, 1938-2 C.B. 136; and I.T. 3447, 1941-1 C.B. 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 4 above). Explanation of Provision For taxpayers whose ``modified adjusted gross income'' exceeds certain limits, a portion of Social Security and tier 1 railroad retirement benefits is included in taxable income. ``Modified adjusted gross income'' is adjusted gross income 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 (1) 50 percent of the Social Security and tier 1 railroad retirement benefits, or (2) 50 percent of the excess of the taxpayer's combined income over the base amount. The second tier applies to taxpayers with ``modified adjusted gross income'' 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 (1) 85 percent of Social Security benefits, or (2) the sum of 85 percent of the amount by which modified adjusted gross income 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 About 23 percent 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). Additionally, 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. \4\ 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. --------------------------------------------------------------------------- \4\ 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. In 1993, for 59 percent of the population employment-based health insurance was the primary source of health coverage, while 6 percent purchased insurance privately, 13 percent received Medicare benefits, and 8 percent received Medicaid benefits. Fifteen percent of the population had no health insurance (Congressional Budget Office, 1994, p. 7). Health coverage through employer-based plans tends to be more prevalent in the manufacturing sector of the economy, among medium and large firms, and for more highly paid workers, especially those over the age of 30 (see table 14-9). TABLE 14-9.--PRIMARY SOURCE OF HEALTH INSURANCE FOR WORKERS UNDER AGE 65, BY DEMOGRAPHIC CATEGORY, 1994 ---------------------------------------------------------------------------------------------------------------- Percentage distribution by source of insurance Number of --------------------------------------------------------- Category workers Own Other Individual Public No (millions) employer employer policy insurance \1\ insurance ---------------------------------------------------------------------------------------------------------------- All workers............................... 123.0 56.9 13.0 8.6 3.6 17.9 Industry: Agriculture........................... 2.9 26.4 10.6 23.0 4.2 35.8 Construction.......................... 7.3 42.9 11.5 10.9 2.8 31.9 Finance............................... 7.7 66.3 13.7 8.4 1.5 10.2 Government............................ 5.6 79.3 7.6 3.5 2.4 7.2 Manufacturing......................... 20.1 73.1 6.7 4.3 1.9 13.9 Mining................................ 0.7 74.4 5.6 4.6 2.8 12.7 Retail trade.......................... 18.2 40.7 16.2 12.2 4.8 26.0 Services: Professional...................... 27.8 62.7 16.7 7.5 2.8 10.4 Other............................. 12.9 40.7 14.8 12.2 4.5 27.8 Transportation........................ 8.5 72.3 7.2 5.0 1.9 13.5 Wholesale trade....................... 4.3 64.5 10.9 7.8 2.2 14.6 Wage rate \2\ Below $5.00........................... 6.3 28.3 16.1 10.7 9.6 35.3 $5.00-$9.99........................... 33.9 55.9 14.4 6.4 2.6 20.7 $10.00-$14.99......................... 21.6 76.4 10.5 4.0 1.2 7.9 $15.00 or more........................ 23.9 83.9 9.2 2.4 0.4 4.2 Family income as percentage of poverty level: Under 100............................. 9.4 14.4 3.0 10.5 22.0 50.1 100-199............................... 19.6 39.8 8.0 9.9 6.4 36.0 200-299............................... 22.2 56.2 13.5 9.4 2.2 18.7 300 and over.......................... 71.7 67.4 15.6 7.7 0.9 8.4 Firm size (number of employees): Fewer than 10......................... 26.3 28.2 20.9 17.2 4.8 28.9 10-24................................. 12.0 44.1 14.9 11.3 4.1 25.6 25-99................................. 16.6 56.3 12.7 7.5 3.9 19.6 100-499............................... 17.7 65.9 10.5 5.5 3.2 14.8 500-999............................... 7.6 68.9 11.4 5.5 2.5 11.7 1,000 or more......................... 42.8 72.6 9.2 4.8 2.9 10.6 Age (years): Under 30.............................. 31.6 45.9 10.5 10.7 6.1 26.8 30-39................................. 37.4 58.7 13.5 7.0 3.1 17.3 40-49................................. 30.8 61.3 15.0 7.8 2.1 13.7 50-64................................. 23.2 63.4 13.2 9.2 2.2 12.0 ---------------------------------------------------------------------------------------------------------------- \1\ Public insurance includes Medicaid, Medicare, and coverage provided by the Department of Veterans Affairs. \2\ ``Wage'' is the hourly wage for hourly employees and earnings per week divided by hours worked for nonhourly employees. The figures exclude individuals for whom an hourly wage could not be determined. Source: Congressional Budget Office estimates based on the March 1994 Current Population Survey. MEDICAL SAVINGS ACCOUNTS Explanation of Provision 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. Beginning in 1997, 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 generally 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 1974 provided that an employer contribution made before January 1, 1977, to a cafeteria plan in existence on June 27, 1974, was required 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. 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 FUTA taxes are considered, 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 have these taxes assessed on them. 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 1991, 36 percent of employees at large and medium sized firms were eligible for flexible benefits and/or reimbursement accounts. This figure has grown from an estimated 5 percent in 1986 (see U.S. Bureau of Labor Statistics, forthcoming). Smaller firms generally do not offer cafeteria plans to their workers. For example, in 1992, only 14 percent of the workers in small, private establishments (nonfarm establishments with fewer than 100 employees) were eligible to participate in a cafeteria plan. 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. 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 Explanation of Provision 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 generally 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 generally the lesser of (1) 10 percent of the employer's payments during the taxable year in which the failure occurred under group health plans, or (2) $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, the 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 (1) amounts received under a life insurance contract and (2) 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 provided by the act 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 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. 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 those 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 $175 per day ($63,875 annually) as indexed, 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 utilized 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. 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 shall be construed or applied so as 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 adjusted gross income). 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 Explanation of Provision Self-employed individuals may currently deduct 30 percent of their health insurance expenses for themselves and their spouses and dependents. Under the Health Insurance Portability and Accountability Act of 1996, the deduction for health insurance of self-employed individuals has been increased as follows: the deduction is 40 percent in 1997, 45 percent in 1998 through 2002; 50 percent in 2003; 60 percent in 2004; 70 percent in 2005; and 80 percent in 2006 and thereafter. Because, under that act, certain long-term care premiums are treated as medical expenses, the self-employed health deduction applies to such premiums after 1996. 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.) 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 adjusted gross incomes above a certain limit ($117,950 for 1996 and adjusted annually for inflation). Effect of Provision The 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 medical expenses, medical expenses are deductible only to the extent that they exceed 7.5 percent of the taxpayer's AGI. Table 14-10 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 while taxpayers with large expenses continue to qualify. The average deduction in excess of the 7.5 percent of AGI floor has increased substantially, from $769 in 1980 to $5,200 in 1995. 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. TABLE 14-10.--TAX RETURNS CLAIMING DEDUCTIBLE MEDICAL AND DENTAL EXPENSES, 1980-95 ---------------------------------------------------------------------------------------------------------------- Returns claiming medical and dental Total expenses in excess of the AGI floor number of -------------------------------------------- Year of deduction returns Expenses in filed (in Number of excess of the AGI Average millions) returns (in floor (in amount over millions) billions) the floor ---------------------------------------------------------------------------------------------------------------- 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 4,080 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 4,674 1993.................................................. 114.6 5.5 26.5 4,829 1994 \1\.............................................. 116.1 5.2 25.8 4,980 1995 \2\.............................................. 117.4 5.4 27.9 5,200 ---------------------------------------------------------------------------------------------------------------- \1\ Preliminary. \2\ Estimate. Source: Internal Revenue Service. 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 1995, it is estimated that 5,368,000 taxpayers claimed itemized medical expenses in excess of the medical deductions floor (7.5 percent of adjusted gross income). Of that number, 78 percent had incomes of less than $50,000 (see table 14-11). However, taxpayers with incomes over $50,000 are estimated to have received far more than half of the total tax savings attributable to medical expense deductions. TABLE 14-11.--DISTRIBUTION OF ITEMIZED DEDUCTIONS FOR MEDICAL EXPENSES, 1995 ------------------------------------------------------------------------ Returns Amount Income class (thousands) \1\ Average (thousands) (billions) \2\ ------------------------------------------------------------------------ 0-$10......................... $7,700 515 $4.0 $10-$20....................... 6,400 963 6.2 $20-$30....................... 4,200 1,063 4.5 $30-$40....................... 3,900 912 3.5 $40-$50....................... 3,700 736 8.8 $50-$75....................... 4,900 843 4.2 $75-$100...................... 6,600 211 1.4 $100-$200..................... 9,500 112 1.1 $200 and over................. 28,900 14 0.4 ----------------------------------------- Total................... 5,200 5,368 27.9 ------------------------------------------------------------------------ \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 (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 (see table 14-12). In 1987, the credit was indexed for inflation. In 1990 and 1993, the expansions of the credit were quite large. In 1990, auxiliary credits were added for very young children and for health insurance premiums paid on behalf of a qualifying child. These were repealed in 1993. Also in 1993, the group eligible 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). 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 1996 of 34 percent of their earnings up to $6,330, resulting in a maximum credit of $2,152. The maximum credit is available for those with earnings between $6,330 and $11,610. At $11,610 of earnings the credit begins to phase down at a rate of 15.98 percent of the amount of earnings above that amount. The credit is phased down to 0 at $25,078 of earnings. TABLE 14-12.--EARNED INCOME CREDIT PARAMETERS, 1975-96 [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 ---------------------------------------------------------------------------------------------------------------- Source: Joint Committee on Taxation. Taxpayers with more than one qualifying child may claim a credit in 1996 of 40 percent of earnings up to $8,890, resulting in a maximum credit of $3,556. The maximum credit is available for those with earnings between $8,890 and $11,610. At $11,610 of earnings the credit begins to phase down at a rate of 21.06 percent of earnings above that amount. The credit is phased down to $0 at $28,495 of earnings. 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 $4,220, resulting in a maximum credit of $323. The maximum is available for those with incomes between $4,220 and $5,280. At $5,280 of earnings, the credit begins to phase down at rate of 7.65 percent of earnings above that amount, resulting in a $0 credit at $9,500. 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 earned income credit if the aggregate amount of ``disqualified income'' of the taxpayer for the taxable year exceeds $2,200. 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 gain net income, and 5. Net passive income (if greater than zero) that is not self- employment income. For taxpayers with earned income (or AGI, if greater) in excess of the beginning of the phaseout range, the maximum earned income credit amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed. The definition of AGI used for phasing out the earned income credit 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. Fifty 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. Individuals are not eligible 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. 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 the only 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. Under an advance payment system (available since 1979), eligible taxpayers may elect to receive the benefit of the credit in their periodic paychecks, rather than waiting to claim a refund on their 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 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 Eighteen million taxpayers are expected to take advantage of the EIC in 1996 (see table 14-13). Their claims are expected to total $25.1 billion, 86 percent of which will be refunded as direct payments to these families. As table 14-13 also shows, approximately 70 percent of the tax relief or direct spending from the EIC accrues to single parents who file as heads of households. Table 14-14 shows the total amount of earned income credit 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. TABLE 14-13.--DISTRIBUTION OF TAX PROVISIONS: EARNED INCOME CREDIT, 1996 [Number in thousands; amount in millions] ---------------------------------------------------------------------------------------------------------------- Joint returns Head of household and All returns -------------------------- single returns ------------------------- Income class (thousands) \1\ -------------------------- Number Amount Number Amount Number Amount ---------------------------------------------------------------------------------------------------------------- $0-$10............................ 814 $1,063 4,845 $5,137 5,660 $6,201 $10-$20........................... 1,539 3,240 4,751 8,811 6,290 12,051 $20-$30........................... 1,846 2,400 2,651 2,592 4,497 5,589 $30-$40........................... 735 593 588 491 1,323 1,084 $40-$50........................... 87 80 19 15 106 95 $50-$75........................... 22 22 4 12 26 34 $75-$100.......................... (\2\) (\3\) ........... ........... (\2\) (\3\) $100-$200......................... ........... ........... ........... ........... ........... ........... $200 and over..................... ........... ........... ........... ........... ........... ........... ----------------------------------------------------------------------------- Total....................... 5,043 7,400 12,860 17,654 17,902 25,054 ----------------------------------------------------------------------------- Percent distribution by type of return........................... 28.2 29.5 71.8 70.5 100 100 ---------------------------------------------------------------------------------------------------------------- \1\ The income concept is defined in the introduction to this chapter. \2\ Less than 500 returns. \3\ Less than $500,000. Source: Joint Committee on Taxation. TABLE 14-14.--EARNED INCOME CREDIT, 1975-2000 ---------------------------------------------------------------------------------------------------------------- Number of Total Refunded recipient amount of portion of Average Calendar year to which credit applies 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........................................................ 12,612 6,928 5,303 549 1991........................................................ 13,105 10,589 7,849 808 1992........................................................ 14,097 13,028 9,959 926 1993........................................................ 15,117 15,537 12,028 945 1994 \1\.................................................... 17,156 18,666 15,722 1,088 1995 \2\.................................................... 17,376 22,208 19,040 1,278 1996 \2\.................................................... 17,902 25,054 21,566 1,400 1997 \2\.................................................... 18,119 26,016 22,367 1,436 1998 \2\.................................................... 18,287 27,063 23,142 1,480 1999 \2\.................................................... 18,628 28,332 24,421 1,521 2000 \2\.................................................... 19,083 29,858 25,381 1,565 ---------------------------------------------------------------------------------------------------------------- \1\ Preliminary. \2\ Projected. Source: 1975-94: Internal Revenue Service; 1995-2000: Joint Committee on Taxation calculations. 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 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. 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 Aid to Families with Dependent Children (AFDC) and Supplemental Security Income (SSI) Programs. In-kind payments include food stamps, Medicaid, and housing assistance. None of these payments is subject to income tax. 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